What is an Abnormal Return
An abnormal return is a term used to describe the returns generated by a given security or portfolio over a period of time that is different from the expected rate of return. The expected rate of return is the estimated return based on an asset pricing model, using a long run historical average or multiple valuation.
BREAKING DOWN Abnormal Return
Abnormal returns are important 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 determine a portfolio manager's skill on a risk-adjusted basis and whether investors were adequately compensated for the amount of risk assumed.
An abnormal return can be either a good or bad thing, as it is merely a summary of how the actual returns differ from the predicted return. For example, earning 30% in a mutual fund that is expected to average 10% per year would create a positive abnormal return of 20%. If, on the other hand, the actual return was 5%, this would generate a negative abnormal return of 5%.
Calculating Abnormal Return Using CAPM
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 a security's or portfolio's expected return is calculated, the abnormal return could be calculated 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.
For example, assume that the risk-free rate of return is 2% and the benchmark index has an expected return of 15%. An investor holds a portfolio of securities and wishes to calculate his portfolio's abnormal return during the previous year. The investor's portfolio returned 25% and has a beta of 1.25, when measured against the benchmark index. Therefore, given the amount of risk assumed, the portfolio should have returned 18.25%, or (2% + 1.25 x (15% - 2%)). Consequently, the abnormal return during the previous year was 6.75%, or 25% - 18.25%.
The same calculations could be done for a security. For example, stock ABC returned 9% and has a beta of 2, when measured against its benchmark index. Assume that the risk-free rate of return is 5% and the benchmark index has an expected return of 12%. Based on CAPM, stock ABC has an expected return of 19%. Therefore, stock ABC has an abnormal return of -10% and underperformed the market during this period.