What it means
Comparing raw returns can be misleading, because a risky share is expected to move more than a safe one. Abnormal return solves this by first working out a fair benchmark return for the investment and then measuring the gap between that benchmark and the actual result.
The benchmark, called the expected return, can come from several models. The most common textbook choice is the capital asset pricing model, which sets the expected return at the risk-free rate plus the investment's beta (its sensitivity to the market) multiplied by the market's extra return over the risk-free rate.
Event studies rely heavily on the concept. To test whether a merger announcement, an earnings surprise or a new regulation moved a company's share price, analysts add up the abnormal returns around the date of the news.
If the figure is large and positive, the market is judged to have welcomed it. Fund managers are also assessed this way.
A manager who earns 12% when the risk-adjusted expectation was 9% has produced an abnormal return of 3 percentage points, often called alpha, and investors then ask whether the skill is likely to persist. The result is only as good as the model behind it.
A poor choice of benchmark, a short data window or unusual market conditions can make a normal return look abnormal, and the reverse. Finance teams also use it in practice, for example when assessing how a share-based incentive scheme or a buyback announcement affected the company's own stock.
It helps to separate the effect of the company's own news from the movement of the whole market.
In practice
Real-world examples
Example 1
A company announces an acquisition and its share price jumps 6% on the day, while the market rises 1% and the model expects a 1.2% gain. The abnormal return is 6% - 1.2% = 4.8%. The board takes this as a sign that investors like the deal. The finance team repeats the calculation over a five-day window to see whether the reaction lasts.
Example 2
A pension fund trustee reviews a manager who returned 10% in a year when the benchmark returned 7%. After adjusting for the higher risk in the manager's portfolio, the expected return was 9%. The abnormal return is only 1%, so the trustee questions whether the fee is justified. She asks the manager to explain which positions added the extra risk.
Example 3
A regulator studies how share prices of banks reacted to a new capital rule. Analysts compute abnormal returns for each bank over a three-day window around the announcement. They find that returns were below expectation, suggesting that investors expected the rule to reduce profits.
Think of it
Abnormal return is the extra return beyond what you'd expect given market movements-your excess gain or loss.
Formula
Calculation
Abnormal return = Actual return - Expected return
Expected return (CAPM) = Risk-free rate + Beta x (Market return - Risk-free rate)
Suppose a share returned 12% over the year, the risk-free rate is 3%, the market returned 8% and the share's beta is 1.2. Expected return = 3% + 1.2 x (8% - 3%) = 3% + 6% = 9%. Abnormal return = 12% - 9% = 3%. On a $100,000 holding, that is 100,000 x 0.03 = $3,000 earned above what the risk taken would normally justify.Case study
Seen in the real world
Orchard Instruments is an illustrative, fictional listed company that announced a surprise share buyback of $40,000,000. On the day of the announcement its shares rose 5.5%, while the stock market as a whole rose 0.5%.
The investor relations team asked an analyst to measure the effect. Using a beta of 1.1 and a normal market move of 0.5%, the analyst set the expected return at about 0.55% and calculated an abnormal return of 5.5% - 0.55% = 4.95%.
The board concluded that the buyback was well received, but they also noticed that the abnormal return faded over the following fortnight. The investor relations team added a note to the board pack explaining that the chosen model, the length of the window and the market conditions on the day all affect the figure, and that a second method would be used to cross-check it. The illustrative lesson is that abnormal return isolates the part of a price move linked to the news, and that the effect should be tracked over time rather than judged on a single day.
Watch out
Common mistakes
- Calling any positive return an abnormal return, when the figure only counts what exceeds the risk-adjusted expectation.
- Using the wrong benchmark, which can make an ordinary return look unusual.
- Reading one day's result as proof of skill or of the market's verdict, when short windows are noisy.
Questions
People also ask
Is abnormal return the same as alpha?
They are closely related, since alpha is usually the abnormal return of a fund or strategy measured over a longer period.
Can an abnormal return be negative?
Yes, a negative figure means the investment earned less than its risk-adjusted expectation.
Why does the expected return matter?
Without a fair benchmark, you cannot tell whether a high return reflects good performance or simply higher risk.
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