Question

Two investment advisors are comparing performance. Advisor A averaged a 27% return with a portfolio beta of 2.75 and Advisor B averaged an 18% return with a portfolio beta of 1.55. If the T-bill rate was 2.50% and the market return during the period was 11.25%, which advisor was the better stock picker? Briefly, why?

Answer 1

One of the most commonly used measure to compare the performance of two investor is by calculating Jensen Alpha:

Jensen Alpha = Actual Return - Required Return

Required Return of Advisor A = Risk free Rate + Beta * (Return from Market - Risk Free Rate)

= 2.5% + 2.75 * (11.25% - 2.5%)

= 2.5% + 24.0625%

= 26.5625%

Jensen Alpha of Advisor A = 27% - 26.5625% = 0.4375%

Required Return of Advisor B = Risk free Rate + Beta * (Return from Market - Risk Free Rate)

= 2.5% + 1.55 * (11.25% - 2.5%)

= 2.5% + 13.5625%

= 16.0625%

Jensen Alpha of Advisor B = 18% - 16.0625% = 1.9375%

Adviser B is better Stock picker as it has Larger Jensen Alpha which means that its actual return is more than the required return.