Understanding Abnormal Returns: Definition, Factors, Illustration

Understanding Abnormal Returns

An abnormal return refers to the atypical profits or losses generated by an investment or portfolio within a specific timeframe. This performance deviates from the anticipated rate of return (RoR), which is the expected risk-adjusted return based on various valuation techniques or historical averages.

Abnormal returns can indicate irregularities or potential issues such as fraud. It is important to differentiate abnormal returns from “alpha,” which represents excess returns from actively managed investments.

Key Takeaways:

• An abnormal return diverges from the expected return of an investment.
• Abnormal returns, whether positive or negative, aid in evaluating risk-adjusted performance.
• Abnormal returns may stem from chance, unforeseen events, or malicious activities.
• Cumulative Abnormal Return (CAR) tallies all abnormal returns and is valuable in assessing the impact of various events on stock prices.

Understanding Abnormal Returns

Abnormal returns play a crucial role in evaluating the risk-adjusted performance of a security or portfolio concerning the overall market or a benchmark index. They provide insights into a portfolio manager’s skill and whether investors are adequately compensated for the risks taken.

Abnormal returns can be positive or negative and reflect the deviation of actual returns from the expected ones. For instance, a mutual fund earning 30% when the anticipated return is 10% results in a positive abnormal return of 20%. Conversely, an actual return of 5% in the same scenario leads to a negative abnormal return of 5%.

Abnormal returns are computed by subtracting the expected return from the realized return, resulting in either a positive or negative value.

Cumulative Abnormal Return (CAR)

Cumulative Abnormal Return (CAR) consolidates all abnormal returns. Typically, CAR is calculated over a brief period, often days, to prevent bias from compounding daily abnormal returns.

CAR serves to gauge the influence of events like lawsuits or buyouts on stock prices and assess the precision of asset pricing models in predicting performance.

The Capital Asset Pricing Model (CAPM) is utilized to compute expected returns for a security or portfolio based on risk-free rate, beta, and market return predictions. After determining the expected return, the abnormal return is calculated by subtracting the expected from the realized return.

Example of Abnormal Returns

An investor seeks to calculate the abnormal return of a securities portfolio for the past year. Assuming a risk-free rate of 2% and an anticipated benchmark return of 15%.

With a portfolio return of 25% and a beta of 1.25 against the benchmark, the expected portfolio return, accounting for risk, is 18.25% (2% + 1.25 x (15% – 2%)). Thus, the abnormal return for the previous year is 6.75% (25 – 18.25%).

These calculations apply to individual stock holdings as well. For instance, stock ABC, with a return of 9% and a beta of 2 against its benchmark, expects a return of 19%. If the actual return was -10%, stock ABC underperformed the market during that period.