This is the difference of the actual return from the Expected Rate of Return (ROR) in an investment portfolio. Since they're not due to market-wide systemic influences, abnormal returns attribute to an investment manager's investing skills.
How an Abnormal Return Works
A significant profit or loss generated by a portfolio or individual stock, and diverges from the anticipated or expected return rate, is termed an abnormal return. No specific pricing model can explain the generated return against the risk-adjusted and estimated ROR, and abnormal returns can be positive or negative.
When an actual return is more significant than an expected return, the abnormal return is positive, while a negative abnormal return will occur when it's lower than anticipated. Bad market actors and external or unforeseen events can produce abnormal returns on an investment portfolio.
CAPM or the Capital Asset Pricing Model is used to set parameters for determining the expected return rate, which in turn exposes any abnormal returns. A constant headache for investors desiring the highest return rate against the least risk is that given market conditions, similar portfolios can carry equal amounts of risk but with different returns due to variations in the abnormal rate of return.
Abnormal Return Example
The average or expected return rate comes from an index’s return, such as the 50-share Nifty index, S&P 500, and BSE Sensex, or you can use a forecasted return model like the CAPM. When comparing returns to market performance, investors use abnormal returns as a gauging tool to determine risk-adjusted stock performances.
For instance, an investment portfolio, let's call it stock XYZ has experienced a 30% annual return where analysts had expected it to generate 20% returns for that given year. You can calculate the abnormal return by subtracting the anticipated return from the actual return as;
Actual Return 30% - Expected Return 20% = Abnormal Return 10%
Stock XYZ experienced a 10% positive abnormal return for that year. By calculating abnormal returns, a CAR (cumulative abnormal return) can gauge how buyouts, product launches, lawsuits, and other factors have affected the stock prices.
Significance of an Abnormal Return
Using multiple valuation techniques or long-standing historical averages, investors can anticipate the ROR of the stock, such as when using an asset pricing model. In contrast, abnormal returns are often confused with excess returns, Alpha, which actively managed portfolios earn, and can also point to manipulation or fraud.
The fluctuation of stock prices may attribute to anything, even the company executives’ social media activity. In 2018, when Elon Musk, Tesla’s CEO, tweeted that he considered privatizing the electric car maker at $420 a share, prices dropped, and the stock was suspended from trading on the NASDAQ for a couple of days.
A company's financial announcements can also produce abnormal returns, such as Spotify's February 2020 stock dive after announcing a loss more significant than had been anticipated. Asset management firms can use positive abnormal returns to justify portfolio manager commissions and performance bases bonuses for their client's understanding.
Types of Abnormal Returns
An investment manager works along with the rules and guidance of an IPS or Investment Policy Statement, an agreement with the client providing their goals for investing. When strategizing a portfolio's performance, the prudent approach would be to aim for the risk-adjusted return rate so as not to deviate from IPS objectives.
In such an instance, a fund manager could be generating abnormal returns by not keeping risk tolerance concepts like when taking up investments that are high risk. Multiple irregular return periods can be observed from the standardized returns angle if the portfolio constantly beats the benchmark.
When that is the case, a lower standard deviation for abnormal return will result from the investment manager beating the benchmark by making better stock selections. However, concurrent uncommon return scenarios in the negative can act as an alarm for divergence reduction from the benchmark index such as CAPM and point to poor stock selection.