Concept Question: Chapter 13

What is a common weakness of Jensen's alpha and the Treynor ratio?

A common weakness of both the Jensen alpha and the Treynor ratio is that both require an estimate of beta, which can differ a lot depending on the source, which in turn can lead to a mismeasurement of risk adjusted return.

What are one advantage and one disadvantage of the Sharpe ratio?

An advantage of the Sharpe ratio is that a beta estimate is not required; however, the Sharpe ratio is not appropriate when evaluating individual stocks because it uses total risk rather than systematic risk.

See pages 449-451

Answers on Chapter 13: Performance Evaluation of Portfolios

Most sources report alphas and other metrics relative to a standard benchmark, such as the S&P 500. When might this method be an inappropriate comparison?

For sector funds or investments that only cover a portion of the market (e.g., value or growth), a more specific index may provide a better standard for judging performance.

Explain the relationship between Jensen's alpha and the security market line (SML) of the capital asset pricing model (CAPM).

Jensen's alpha is the difference between a stock's or a portfolio's actual return and that which is predicted by the CAPM. A positive alpha implies abnormal returns above the SML line (as drawn using the CAPM).

Explain the difference between the Sharpe ratio and the Treynor ratio.

The Sharpe ratio is calculated as a portfolio's risk premium, or excess return, divided by the standard deviation of the portfolio's return. The Treynor ratio is the portfolio risk premium divided by the portfolio's beta coefficient. So, the Sharpe ratio concentrates on total risk, while the Treynor focuses on systematic risk.

Suppose that two investments have the same alpha. What things might you consider to help you determine which investment to choose?

To determine significance, one might use the t-statistics or p-values from a regression estimate. Beyond this, the information ratio will standardize alpha to account for the volatility in the estimate. Also, a high R-squared will give some degree of confidence to the alpha estimate. Lastly, adherence to GIPS standards may give confidence to the estimate of one firm over another.