You are an analyst for a large public pension fund and you have been assigned th
ID: 2734943 • Letter: Y
Question
You are an analyst for a large public pension fund and you have been assigned the task of evaluating two different external portfolio managers (Y and Z). You consider the following historical average return standard deviation, and CAPM beta estimates for these two managers over the past five years: Additionally , your estimate for the risk premium for the market portfolio is 5.00% and the risk-free rate is currently 4.50% a) For both Manager Y and Manager Z, calculate the expected return using the CAPM, Express your answers to the nearest basis point (i.e. xx.xx%) b) Calculate each fund mgr's average "alpha" (i.e. actual return minus expected return) over the 5 year holding period. Show graphically where these alpha statics would plot on the security market line (SML) c) Explain whether you can conclude from the info. In Part b if: (1) either manager outperformed the other on a risk-adjusted basis, and (2) either manager outperformed market expectations in general
Portfolio Actual Avg.Return Standard Deviation Beta Manager Y 10.20% 12.00% 1.2 Manager Z 8.80% 9.90% 0.8Explanation / Answer
a)
Computation of expected return under CAPM for Manager Y and Z:
For Manager Y:
E(x) = Rf + (Rm – Rf)
= 4.5 + 1.2 (5.0 – 4.5)
= 4.5 + 0.6
= 5.1%
Therefore, Expected return of Manager Y is 5.1%.
For Manager Z:
E(x) = Rf + (Rm – Rf)
= 4.5 + 0.8 (5.0 – 4.5)
= 4.5 + 0.4
= 4.9%
Therefore, Expected return of Manager Z is 4.9%.
b)
Calculate the average alpha for Manager Y and Z:
For manager Y:
Alpha = Actual return – Expected return
= 10.20 – 5.10
= 5.10%
Therefore, alpha of manager Y is 5.10%.
For manager Z:
Alpha = Actual return – Expected return
= 8.80 – 4.90
= 3.90%
Therefore, alpha of manager Z is 3.90%.
C)
The alpha for security Y is higher than Z, indicating its better performance relative to Z. Hence, an investor should prefer Manager Y.
Alpha is appropriate, when the investment represents one of the many investments held by a client. Alpha measures the relative value addition provided by an asset manger compared to a market index, given a portfolio’s market risk. Alpha can also be interpreted as the deviation from the SML in the CAPM.
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