What is Abnormal Rate of Return?
Abnormal rate of return, also known as 'alpha' or 'excess return,' is the fraction of a security's or portfolio's return not explained by the rate of return of the market. Rather, it is produced from the expertise of the investor or portfolio manager, and is one of the most common measures of risk-adjusted performance.
How Does Abnormal Rate of Return Work?
Let's assume you are a portfolio manager who expects your client's portfolio to return 15% next year. At the end of the year the portfolio actually returns 16%. In simple terms, the abnormal rate of return on the portfolio is 16% - 15% = 1%.
Mathematically speaking, abnormal rate of return is the return that surpasses what was expected by models like the capital asset pricing model (CAPM). To understand how it works, let's look at the CAPM formula:
r = Rf + beta * (Rm - Rf ) + abnormal rate of return
r = the security's or portfolio's return
Rf = the risk-free rate of return
beta = the security's or portfolio's price volatility relative to the overall market
Rm = the market return
The greater part of the CAPM formula (all but the abnormal return factor) determines the rate of return on a certain security or portfolio given certain market conditions. note that two similar portfolios could carry the same amount of risk (beta) but because of variations in abnormal rate of return, one might have greater returns than the other. This is a primary dilemma for investors, who always desire the highest rate of return with the least amount of risk.
Why Does Abnormal Rate of Return Matter?
The abnormal rate of return is a quantifiable way to determine whether a manager's skill has contributed to the value of a portfolio on a risk-adjusted basis. For this reason, it is the holy grail of investing for some.
The very existence of the abnormal rate of return is controversial. Because those who believe in the efficient market hypothesis (which says, among other things, that it is impossible to beat the market) believe a higher rate of return is a result of luck rather than skill, they support their ideas with the fact that, over the long-term, many active portfolio managers don't make much more for their clients than those managers who simply follow passive, indexing strategies. Thus, investors who believe managers add value accordingly expect above-market or above-benchmark returns -- that is, they expect an abnormal rate of return.