Question

15. You are trying to make decisions on which mutual fund you should invest in based on the past performance of two fund managers. Manger A averaged a 17% return with a portfolio beta of 1.5, and manager B averaged a 15% return with a portfolio beta of 1.2. If the T-bill rate was 5% and the market return during the period was 13%, which fund manager was the better stock picker?

    A.         Advisor A was better because he generated a larger alpha.

    B.         Advisor B was better because she generated a larger alpha.

    C.         Advisor A was better because he generated a higher return.

    D.         Advisor B was better because she achieved a good return with a lower beta.

Answer 1

Given that,

Risk free rate Rf = 5%

market return Rm = 13%

Manger A averaged a 17% return with a portfolio beta of 1.5

Based on CAPM, expected return on a fund is calculated as Rf + beta*(Rm - Rf)

=> Expected return of manager A's fund = 5 + 1.5*(13 - 5) = 17%

So, alpha of the fund = average return - expected return = 17% - 17% = 0

Manger B averaged a 15% return with a portfolio beta of 1.2

Based on CAPM, expected return on a fund is calculated as Rf + beta*(Rm - Rf)

=> Expected return of manager B's fund = 5 + 1.2*(13 - 5) = 14.6%

So, alpha of the fund = average return - expected return = 15% - 14.6% = 0.4%

Advisor B was better because she generated a larger alpha.

Option B is correct.