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?
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%
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%
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.
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