Question

Two investment professionals are comparing their return performance. The first professional managed portfolios with an average return of 10% and the second professional managed portfolios with a 12% rate of return. The beta of the first portfolio was 0.8 while the beta of the second was 1.1. The risk-free rate of return was 2% and the expected market return is 8%.
A. [5 points] Which manager was a better selector of individual stocks, and why?

B. [2 points] Plot both of the portfolios on the security market line.

Answer 1

First we can find expected return using CAPM formula

Expected return = Risk free rate of return + beta(expected market return - Risk free return)

For first professional expected return was = 2% + 0.8(8%-2%)

=2% + 0.8(6%)

=2%+4.8% = 6.8%

For Second professional expected return was =

2% + 1.1(8%-2%)

=2% + 1.1(6%)

=2%+6.6% = 8.6%

Now First professional offered 3.2% excess return over expected return ( 10%-6.8%)

While Second professional offered 3.4% excess return over expected return (12%-8.6%)

Thus Second professional was better selector of individual stock

B)

SLM Line - Graph