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Abnormal Return Definition
The benefits expected from a specific portfolio or security beyond its expected return over a certain period of time are termed as abnormal returns.
The abnormal return is not the expected return since it exceeds of what was expected.
A Little More on What is Abnormal Returns
With abnormal returns, you can find the risk-adjusted performance of a portfolio in relation to usual market standards and benchmark indexes. Hence, you can know whether your investments are sufficiently compensated for the risk you are assuming.
An abnormal return is obtained by subtracting actual returns from the forecasted ones, and thus, can be positive or negative. A mutual fund with 12% average return expected a year, if delivers 26% return, it implies 14% abnormal return. On the contrary, if it actually gave 3% return, you will get negative 9% anomaly return.
The Capital Asset Pricing Model (CAPM) determines the expected return rate for a specific portfolio or security, considering risk-free returns, expected market returns and beta. Once you determine expected income, you can determine abnormal income by subtracting expected yield from realized return rate. Abnormal returns are dependent on the security’s or portfolio’s performance. For instance, consider a risk-free return 2% and benchmark return as 15%. Now if you want to know the abnormal income of your portfolio for the last year, then relative to the benchmark index, your portfolio is carrying 1.25 beta and 25% return.
Hence, taking into an account the risk, your portfolio must give 18.25% return , implying your abnormal return rate of last year as 6.75%. The same procedure is applied for the stocks.
References for Abnormal Return
Academic Research for Abnormal Return
- The persistence of abnormal returns, Jacobsen, R. (1988), Strategic management journal, 9(5), 415-430. The ROI analysis over time helps determine core factors of competitive markets and abnormal profit ranges. This analysis is based on consolidated ROI evaluation and the ways market and long term factors affect the process. Parallel to abnormal returns arising out of a disequilibrium, a mean reverting time-series cycle revealed ROI behavior. With numerous factors affecting the returns, the circumstances under which the market factors don’t restore the rate back to competitive rate seem difficult. However, such factors can shield the business from competitive factors and may bring abnormal profits in future.
- The financial effects of takeover: Accounting rates of return and accounting regulation, Chatterjee, R., & Meeks, G. (1996). The financial effects of takeover: Accounting rates of return and accounting regulation. Journal of Business Finance & Accounting, 23(5‐6), 851-868.
- A tale of values-driven and profit-seeking social investors, Derwall, J., Koedijk, K., & Ter Horst, J. (2011), Journal of Banking & Finance, 35(8), 2137-2147. The analysis of socially responsible investing (SRI) movement with value-versus-profit assessment helps understand how the SRI and value-driven stocks bring higher returns.Value-driven investors usually exploit negative screens to prevent troublesome stocks, while the profit-driven ones believe in positive screens. Based on our empirical study between 1992 and 2008, our segmentation focused such screens to determine what influences the prices. We deduce that profit-driven investors get abnormal returns only in short run and such scenarios don’t stay for long for SRI stocks. Nevertheless, diverse perspectives on SRI can help for short term.
- The search for the best financial performance measure, Bacidore, J. M., Boquist, J. A., Milbourn, T. T., & Thakor, A. V. (1997), Financial Analysts Journal, 53(3), 11-20. Refined economic value added (REVA) is an analytical framework that help assessing operating performance factors for value creation for shareholders. EVA performs good being correlated with shareholders’ wealth and is also better measure theoretically for evaluating business performance in terms of its financiers and the risk assumed on capital. The article presents a detailed statistical analysis of the ability of REVA and EVA to determine shareholder value. In statistical terms, REVA is better than EVA. In addition, the returns realized between 1988 and 1992 for the top 25 REVA businesses were more than those for top 25 EVA businesses.
- The effect of financial ratios, firm size, and cash flow from operating activities in the interim report to the stock return, Martani, D., Khairurizka, R., & Khairurizka, R. (2009), Chinese Business Review, 8(6), 44-55. The study examines accounting data relevancy for stock return prediction, using profitability, leverage, liquidity, size, market ratio and cash flow as key accounting information. The study has taken cumulative abnormal returns and market adjusted returns as stock return variables. The samples are the listed manufacturing businesses trading between 2003 and 2006 in Indonesian stock market. The study found turn over, profitability and market ratio as factors having high impact on stock returns; the findings that support previous studies by Restraningsih (2007), Hobart (2006) and Utama & Santoso (1998).
- Dividend changes, abnormal returns, and intra-lndustry firm valuations, Firth, M. (1996), Journal of financial and Quantitative Analysis, 31(2), 189-211. Previous research associated dividend changes with high abnormal returns, considering that dividend announcements lead to future earning. Another research affirms the presence of industry-wide information transfer, where news regarding one business is used by others. Such transfers have been termed as positive, wherein good news for one business leads to higher stock prices of its competitors. Considering dividend announcements and information transfers, we conducted tests to know if dividend change of one business affects the other businesses’ stock price performance within same industry. The findings show information transfer having impact on earnings and growth of other businesses and their stock prices.
- Personnel investments and abnormal return: knowledge-based firms and human resource accounting, Hansson, B. (1997), Journal of Human Resource Costing & Accounting, 2(2), 9-29. The study compares pricing of knowledge-based businesses with those less reliant on human resources and showed that high reliance on human resources lead to higher abnormal returns. As per findings, investors cannot realize the difference between personnel investment and expenses, which causes underestimation of earning and returns. The findings established the need for accounting information to make better investment decisions and suggested that knowledge-based businesses are riskier than those having more tangible assets.
- Investor flows and the assessed performance of open-end mutual funds, Edelen, R. M. (1999), Journal of Financial Economics, 53(3), 439-466. Investors get higher liquidity with little cost due to diversified equity positions of open-end equity funds. This study presents a statistically important indirect cost termed as a negative association between abnormal return and investor flow. The control of indirect cost of the liquidity affects average abnormal return; from 1.6% a year to -0.2%, aside from explaining the negative market-timing performance as found in other studies as well for mutual funds return.Hence, performance of open-end mutual funds is subject to liquidity-oriented trading costs.
- Event studies in management research: Theoretical and empirical issues, McWilliams, A., & Siegel, D. (1997), Academy of management journal, 40(3), 626-657. Using event studies, we determined lack of attention given to theoretical and research design problem, which led to false decisions about importance of events and respective theories’ validity that were tested. We replicated three latest studies to determine this issue’s extent. The processes for suitable usage of event study model are also given to help authors and readers.
- The effect of long‐term performance plans on corporate sell‐off‐induced abnormal returns, Tehranian, H., Travlos, N. G., & Waegelein, J. F. (1987), The Journal of Finance, 42(4), 933-942. This study determines the link between strategic performance plans and wealth impacts happening to stockholders of divesting businesses when sell-off proposals are launched. As per findings, divesting businesses having strategic performance plans enjoy more positive stock market situation at that time compared to those without such plans. Hence strategic performance plans improve managers’ decision making.
- Abnormal returns to acquired firms by type of acquisition and method of payment, Wansley, J. W., Lane, W. R., & Yang, H. C. (1983), Financial management, 16-22. This paper tested the systematic variations in premiums given to acquired business shareholders across various mergers kinds and payment modes. Pure conglomerate mergers have little bit higher cumulative average residuals for the shareholders. For payment modes, cash acquisition gives more abnormal returns. The variation is mainly led by tax effect and to regulatory differences influencing cash acquisitions.
- Profitability of return and volume-based investment strategies in China’s stock market, Wang, C., & Chin, S. (2004), Pacific-Basin Finance Journal, 12(5), 541-564. The study determines the association between past returns and trading volume to forecast cross-sectional returns over specific time periods in China’s stock market. The findings showed better performance of low-volume stocks, higher volume discounts for past winners, persistence in return of low-volume stocks and reverse returns for high-volume winners. Our findings are more concrete than Fama and French’s 3-factor model, as well as to stock exchange and big stock sub-samples.