Question

Which measure would you use to know whether alpha is truly significant or just the result of random chance?

Group of answer choices

Sharpe ratio

Jensen's alpha

Treynor ratio

Jensen-Treynor alpha

Information ratio

Answer 1

Information ratio would be used to know whether alpha is truly significant.

Information ratio = expected excess return of portfolio over benchmark return / standard deviation of portfolio returns from benchmark returns.

Information ratio measures the consistency of the portfolio manager in generating returns in excess of the benchmark. Therefore, this is the best measure to know whether alpha is significant.

Sharpe ratio measures the excess risk adjusted returns relative to the risk free rate and standard deviation of the returns, and is therefore not the best measure because the benchmark is not compared, and it does not measure consistency of excess returns.

Jensen's alpha measures the excess return over the expected CAPM return, and is therefore not the best measure because the benchmark is not compared, and it does not measure consistency of excess returns.

Treynor ratio measures the excess risk adjusted returns relative to the risk free rate and beta, and is therefore not the best measure because the benchmark is not compared, and it does not measure consistency of excess returns.