What Is an Abnormal Return?
Abnormal Return is the difference between the expected return and the actual return on an investment. Abnormal returns may be either positive or negative; indeed an abnormal return may be negative even if the actual return is positive. That is, suppose the expected return on an investment is 7% and the actual return is 5%. While the investor has 5% more than he/she had when he/she started, the abnormal return is still -2%. On the other hand, if the expected return is 5% and the actual return is 9%, then there is a positive abnormal return of 4%. One may use an abnormal return to gauge the accuracy of various asset pricing models.
How Does Abnormal Return Work?
An abnormal return is referred to as either a positive abnormal return or a negative abnormal return, depending on where the actual return falls in relation to the normal return. The abnormal return on an investment is calculated as follows:
RAbnormal = RActual – RNormal
The normal return on an investment can be a forecasted return or it can be the return on an index, such as the Dow Jones or the S&P 500 during the same period. For instance, the normal return for an investment portfolio, such as a mutual fund, might be a forecasted return of 10% for a given year based on past performance; or the 10% (example) return on the S&P 500 index in a given year. In the latter case, it is said that a given investment experienced a given abnormal return relative to the S&P 500.
To illustrate, suppose a stock XYZ experiences a 20% return in a given year. Analysts expected XYZ to experience a return of 10% for that year. The (positive) abnormal rate of return XYZ is:
20% actual return – 10% projected return = 10% positive abnormal return
XYZ experience a positive abnormal return of 10% during in that year.
Determinants of Abnormal Return
Abnormal returns can happen due to different company-related announcements. The occurrence of a positive or negative abnormal return depends on the types of news and investors’ perception about the effects. A stock split, merger and acquisitions, earnings announcements or dividend announcements could impact stock prices. Dividend yields can lead to abnormal returns when the news about paying higher than expected dividends are announced. Higher dividends would produce higher dividend yields, which could give the perception that the company is doing well. It will also attract investors who will want to gain access to higher dividends by purchasing stocks. Abnormal return can be incorporated into an investing strategy because it can show the reaction of the market and investors to different announcements.
Why Abnormal Returns Are Important
Abnormal returns are a critical concept in finance because they shed light on risk-adjusted performance. Just because an investment outperforms the overall stock market doesn’t mean that an investment manager did a great job; in fact, the opposite is often true. The earlier example illustrates how risk-adjusted performance offers a more accurate picture of performance. A portfolio’s beta is therefore critical to determine an investment’s riskiness and expected and abnormal returns.
Abnormal returns are essential in determining a security’s or portfolio’s risk-adjusted performance when compared to the overall market or a benchmark index. Abnormal returns could help to identify a portfolio manager’s skill on a risk-adjusted basis. It will also illustrate whether investors received adequate compensation for the amount of investment risk assumed.
An abnormal return can be either positive or negative. The figure is merely a summary of how the actual returns differ from the predicted yield. For example, earning 30% in a mutual fund which is expected to average 10% per year would create a positive abnormal return of 20%. If, on the other hand, in this same example, the actual return was 5%, this would generate a negative abnormal return of 5%.
- Performance Attribution Metric: It is directly affected by the stock selection of the portfolio manager, therefore this measure is a key to judge her performance as compared to the appropriate benchmark and thereby it also helps in determining her performance-based compensation and skill-level.
- A check on Harmful Divergence: As mentioned earlier, Abnormal return can be negative if the actual return is lower than the expected return. Therefore, if this is for multiple periods, then it acts as an alarm for reducing the divergence from the benchmark index because it points out to a poor stock selection.
- Thorough Quantitative Analysis: As it can be calculated simply, it is a popular measure in the investment community, however, coming up with the correct estimates of the inputs of the CAPM model is not an easy task, as it involves use of regression analysis to predict beta and a thorough observation of the past return numbers of the market index, therefore if done correctly, these estimates pass through a sieve of a thorough quantitative analysis and are therefore more likely to produce numbers with greater predictive power.
- Time Series Analysis: Using a measure called the CAR or the cumulative abnormal return is helpful to analyze the effect of corporate actions such as dividend payout or stock split on the prices and return of the stock. It further helps in analyzing the effects of external events such as events on which certain corporate liabilities are contingent, for example, legal action or the settlement of a court case.
Cumulative Abnormal Return
Cumulative abnormal return (CAR), is the total of all abnormal returns. Usually, the calculation of cumulative abnormal return happens over a small window of time, often only days. This short duration is because evidence has shown that compounding daily abnormal returns can create bias in the results. Cumulative abnormal return (CAR) is used to measure the effect of lawsuits, buyouts, and other events have on stock prices. Cumulative abnormal return (CAR) is also useful for determining the accuracy of asset pricing model in predicting the expected performance.
The capital asset pricing model (CAPM) is a framework used to calculate a security’s or portfolio’s expected return based on the risk-free rate of return, beta, and the expected market return. After the calculation of a security’s or portfolio’s expected return, the estimate for the abnormal return is by subtracting the expected return from the realized return. The abnormal return may be positive or negative, depending on the performance of the security or portfolio over the specified period.