Question

Two investment advisers are comparing performance. One averaged a 16.03% rate of return and the other a 20.81% rate of return. However, the β of the first investor was 1.5, whereas that of the second investor was 1.

Required: Suppose that the T-bill rate was 3% and the market return during the period was 15%. Aside from the issue of general movements in the market, outline the difference between the superior and inferior portfolios.

Answer 1

According to CAPM Estimated Return = Risk Free Return + Beta*(Market Return - Risk Free Return)

Now for Investment 1 Estimated return = 3% + 1.5*(15-3) = 21%

and for Investment 2   Estimated return = 3% + 1*(15-3) = 15%

whereas the actual return = 1 = 16..03% and advisor 2 = 20.81%

So 1 portfolio is inferior as actual return < estimated return and 2 portfolio is isuperior as actual return > estimated return.

Difference between two portfolio is = 20.81 - 16.03 = 4.78%