Tutorial Solutions

As part of efforts to provide feedback on your learning progress, I provide an indicative

difficulty level of questions, measured as the passing rate (e.g., easy questions have higher
passing rates). This is based on the students’ performance in the previous years. For
example, a level “B” multiple choice question means about 70% students passed this
question; a level “B” problem solving question means on average students got about 70%
of total marks. You can use it to assess your performance.
Keep in mind that questions in the Problem Set are highly selective, so the Problem Set on
average is more difficult than the final exam paper.

Difficulty level Passing rate Indicator

Easy >80% A
Moderate 60 – 80% B
Difficult 40 – 60% C
Very difficult 25 – 40% D
Extremely difficult <25% E

1. A fund has excess performance of 1.5%. When looking at the fund's investment
breakdown you see that the fund overweighed equities relative to the benchmark and
the average return on the fund's equity portfolio was slightly lower than the equity
benchmark return. The excess performance for this fund is probably due to
_______________.
A. security selection ability
B. better sector weightings in the equity portfolio
C. the asset allocation decision
D. finding securities with positive alphas

Difficulty level: C 
Answer: (C)
Do by elimination. Equity portfolio performed worse than benchmark => A is false
=>D is false as well. A and D are talking about security selection ability. Overweight
equity but portfolio equity returns is worse than benchmark, so sector weightings in
equity portfolio cannot be better =>D is false. Only C is possible. Overweight equity
portfolio => underweight other asset classes. It could be that other asset classes have
negative returns in the benchmark, so underweighting in other asset classes generates
excess performance of the fund relative to the benchmark.

2. A portfolio generates an annual return of 16%, a beta of 1.2 and a standard deviation
of 19%. The market index return is 12% and has a standard deviation of 16%. What is
Jensen's alpha of the portfolio if the risk free rate is 6%?
A. 0.017
B. 0.028
C. 0.036
D. 0.078
Difficulty level: A 

Answer: (B)
Jensen measure = .16 - .06 - 1.2(.12 - .06) = 0.028

3. Suppose that over the same time period two portfolios have the same average return
and the same standard deviation of return, but portfolio A has a higher beta than
portfolio B. According to the Sharpe ratio, the performance of portfolio A __________.

A. is better than the performance of portfolio B

B. is the same as the performance of portfolio B
C. is poorer than the performance of portfolio B
D. cannot be measured since there is no data on the alpha of the portfolio
Difficulty level: B 

Answer: (B)

4. The __________ calculates the reward to risk trade-off by dividing the average
portfolio excess return by the portfolio beta.

A. Sharpe ratio
B. Treynor measure
C. Jensen measure
D. return
Difficulty level: B 

Answer: (B)

5. The table presents the actual return of each sector of the manager's portfolio in
column (1), the fraction of the portfolio allocated to each sector in column (2), the
benchmark or neutral sector allocations in column (3), and the returns of sector indexes
in column 4.
(1)Actual (2)Actual (3)Benchmark (4)Index
Return Weight Weight Return
Equity 3.0% 0.60 0.50 3.2%
Bonds 1.3% 0.30 0.40 1.4%
Cash 0.5% 0.10 0.10 0.5%
What is the contribution of security selection to relative performance?
A. -0.15%
B. 0.15%
C. -0.3%
D. 0.3%
E. None of the above
Difficulty level: B 

Answer: (A)
Differential Return Manager’s Contribution to
within Market (manager- portfolio performance
index) weight
Equity -0.2% .60 -0.12%
 Bonds -0.1% .30 -0.03%
Cash 0.0% .10 0%
Contribution of security selection -0.15%

6. A mutual fund invests in two asset classes only, i.e., equity and bonds. Column (1)
presents the actual returns of each asset class under its management. The benchmark
portfolio’s allocations are shown in column (2), and the returns of indexes for the
benchmark portfolio are given in column (3).
(1)Actual (2)Benchmark (3)Index
Return Weight Return
Equity 10% 0.70 8%
Bonds 1% 0.30 2%
Suppose the mutual fund outperforms the benchmark by 2%. What is the
fraction of this fund investing in equity?
A. 0.8
B. 0.9
C. 0.7
D. 0.6
E. None of the above
Difficulty level: C 

Answer: (A)

(1)Actual Compute the (2)Benchmark (3)Index

Return weights Weight Return
Equity 10% x 0.70 8%
Bonds 1% 1-x 0.30 2%
Abnormal returns = 10*x+1*(1-x)-[8*0.7+2*0.3]=2. So x=0.8

7. Two portfolio managers use different procedures to estimate alpha. One uses a single
index-model regression, the other Fama-French model. Other things equal, would you
prefer the portfolio with the larger alpha based on the index model or the Fama-French
model?
Difficulty level: B 

Definitely, the FF model. Research shows that passive investments (e.g., a market index
portfolio) will appear to have a zero alpha when evaluated using the multi-index model
but not using the single-index one. The nonzero alpha appears even in the absence of
superior performance. Thus, the single-index alpha can be misleading.

8. The rates of return on portfolios A and B are 11% and 14%, respectively. The beta
of A is 0.8 while that of B is 1.5. The T-bill rate is currently 6%, while the expected
return of the S&P500 index is 12%. The standard deviation of portfolio A is 18%
annually while that of B is 31%, and that of the index is 20%.
Difficulty level: B 
a. If you currently hold a market index portfolio, would you choose to add either of
these portfolios to your holdings? Explain.

E(r) σ β
Portfolio 11% 18% 0.8
A
Portfolio 14% 31% 1.5
B
Market 12% 20% 1.0
index
Risk-free 6% 0% 0.0
asset

The alphas for the two portfolios are:

αA = 11% – [6% + 0.8(12% – 6%)] = 0.2%
αB = 14% – [6% + 1.5(12% – 6%)] = –1.0%

εA=Sqrt(0.18*0.18-0.8*0.8*0.2*0.2)=8.25%
εB=Sqrt(0.31*0.31-1.5*1.5*0.2*0.2)=7.81%

Information ratio: A=0.2/8.25=0.024; B=-1/7.81= -0.128

B has a NEGATIVE alpha and a higher ABSOLUTE value of information ratio. So,
choose B if short selling is allowed (after short selling, the negative alpha asset turns
into a positive one); otherwise, choose A.

b. If instead you could invest only in bills and one of these portfolios, which would you
choose?
If you hold only one of the two portfolios, then the Sharpe measure is the appropriate
criterion:
SA = (11-6)/18=0.28
SB = (14-6)/31=0.26
Therefore, using the Sharpe criterion, Portfolio A is preferred.

9. In a particular year, Salmon Arm Mutual Fund earned a return of 16% by making the
following investments in asset classes:

Difficulty level: B 

A. Compute the total excess return on the managed portfolio.

Excess Return = .1600 - .1200 = .0400

B. What was the contribution of asset allocation across asset classes to the total excess
return?

(.20 - .60).10 + (.80 - .40).1500 = .0200

C. What was the contribution of selection to the total excess return?

(.12 - .10)20 + (.1700 - .1500).80 = .0200

10. There are 3 types of active fund managers. Type A manager delivers an average
return of 15%, a standard deviation of 25%, and a Jensen’s alpha of 2.4%. Type B
manager delivers an average return of 22%, standard deviation of 30%, and beta of 1.5.
Type C manager delivers an average return of 17% and a standard deviation of 20%;
You also know that the returns that type C manager generates have a correlation
coefficient of 0.9 with the market index – S&P 500.
In addition, the average return and standard deviation of the S&P 500 are 12% and 15%
respectively. The return on treasury bill is 6%.

(a) Your client is a big pension fund who wants to adopt a fund of funds operation. It
decides to pick only one type of managers out of the 3 types mentioned above so that it
can form a well-diversified operation.
What will be your recommendation: should your client pick the type A, or type B, or
type C manager? Show your calculation and explain briefly to your client about your
recommendation.

(b) You have another client who is a wealthy individual that holds the S&P 500 index
currently. He wants to add one mutual fund into his portfolio, and will consider the 3
managers mentioned above.
What will be your recommendation: should he pick a fund run by the type A, or type B
or type C manager? Show your calculation and explain briefly to your client about your
recommendation.
Difficulty level: C 

Answer:
fund Avg Std dev Beta alpha correlation
A 15% 25% 1.1 2.4%
B 22% 30% 1.5
C 17% 20% 1.2 0.9
S&P500 12% 15%
rf 6%
(a) When mixing many funds together, idiosyncratic risk can be largely diversified
away. So need to compute Treynor ratio, and focus on beta risk.
First, find betas:
Manger A:
(0.15-0.06)=αA + βA *(0.12-0.06) = 0.024+ βA *(0.12-0.06)
βA=1.1
Manager C:
 ρC=0.9; We know that: ρ2C=( β2C σ2M/ σ2C);
0.9=( βC *0.15)/ (0.20);
βC=1.2

Second, find Treynor ratios and rank

Treynor Ratio_A=(0.15-0.06)/1.1=0.09/1.1=0.0818
Treynor Ratio_B =(0.22-0.06)/1.5=0.16/1.5=0.1067
Treynor Ratio_C =(0.17-0.06)/1.2=0.11/1.2=0.0917

Pick manager B with the highest Treynor ratio

(b) You should pick the one with the highest information ratio, you need to compute
stddev of errors.
2i=βi22Market +2εi
2A=(0.25)2 – (1.1)2(0.15)2=0.035275; A=18.78%
2B=(0.30)2 – (1.5)2(0.15)2=0.039375; B=19.84%
2C=(0.20)2 – (1.2)2(0.15)2=0.0076; C=8.72%

αA=(0.15 -0.06) – 1.1(0.12-0.06)=0.024=2.4%

αB=(0.22-0.06) – 1.5(0.12-0.06)=0.07=7%
αC=(0.17 -0.06) – 1.2(0.12-0.06)=0.038=3.8%

Information Ratio_A=2.4%/18.78%=0.1278
Information Ratio_B=7%/19.84%=0.3528
Information Ratio_C=3.8%/8.72%=0.4359
Pick C as it provides the highest information ratio.

11. The investment committee of a fund is given the following information about the
past year for the market portfolio M as well as two actively managed portfolios, i.e.,
Portfolio G and Portfolio H. The risk-free rate is 4% p.a.
G H M

Average return (p.a.) 12.6% 8.2% 6.7%

Standard deviation ? ? 18.5%

Beta 1.73 0.62 1.00

Standard deviation of
1.95% 8.98% 0.00%
residual returns

Consider the following alternative situations independently:

(1) Suppose the investment committee wishes to place all of the fund’s assets in either
Portfolio G or Portfolio H. Which one would it choose? Give reasons for your answer.
(2) The fund is very large, and consists of various portfolios. Portfolio G and Portfolio
H are just two of the portfolios in the fund. The investment committee is reviewing the
performance of these two portfolios. Which one has performed better? Give reasons for
your answer.
(3) The fund is currently passively managed using a portfolio that tracks the market
portfolio M. The investment committee chooses to add Portfolio H to the fund.
Calculate the Sharpe ratio for the combined fund. Should the committee have selected
Portfolio G instead? Give reasons for your answer.
Difficulty level: C 
 

(1) Committee would choose a portfolio with a higher Sharpe ratio

𝑅
𝑆
𝜎

Excess return for G is 12.6% − 4% = 8.6%, for H, 8.2% − 4% = 4.2%;

𝜎 𝑆𝑄𝑅𝑇 1.73 ∗ 1.73 ∗ 0.185 ∗ 0.185 0.0195 0.3206
𝜎 𝑆𝑄𝑅𝑇 0.62 ∗ 0.62 ∗ 0.185 ∗ 0.185 0.0898 0.1457
8.6% 4.2%
𝑆 0.268; 𝑆 0.288
32.06% 14.57%
So Portfolio H would be selected.

(2) Choose a portfolio with higher Treynor measure:

Treynor measure 𝑇 .
8.6% 4.2%
𝑇 4.97%; 𝑇 6.77%
1.73 0.62
Choose H.

(3)
𝛼
𝑆 𝑆𝑄𝑅𝑇 𝑆
𝜎
The committee should choose the portfolio with the higher information ratio
𝛼
𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜
𝜎

2.7%
𝑆 0.021
18.5%
𝛼 𝑅 𝛽 𝑅 4.2% 0.62 2.7% 2.526%

𝛼 2.526%
0.28 0.079
𝜎 8.98%
𝑆 𝑆𝑄𝑅𝑇 0.021 0.079 0.317
𝛼 2.526%
0.28
𝜎 8.98%
𝛼 8.6% 1.73 2.7% 3.929%
. %
For G, information ratio is 2.01
. %
So Portfolio G should have been selected.