Abnormal Rate of Return
Abnormal rate of return can be described as the return 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.
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
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.
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.