Finance Discipline Group

UTS Business School

25503 Investment Analysis

Tutorial 11 Answers
1. We want to measure portfolio performance that is attributable to the skill of the
manager, not to the risk of the portfolio or to the performance of the market. For
example, we do not want to give high marks to a manager who obtained a
relatively high return merely by selecting a high beta portfolio during a period
when the market was strong.

2. (a) TA = 0.1 and TB = 0.067. Since TA > TB , A is superior to B under the

Treynor criteria.
(b) JA = 0.025 = JB . Both A and B are interpreted as generating abnormally
high returns, but they are regarded as giving equally good performance.
(c) Since neither Jensen’s index nor Treynor’s index are affected by the degree of
diversification of a portfolio, they are both inappropriate measures if you
wish to include diversification as a criterion for evaluating a manager’s
performance. These indices are also derived from the standard form of the
CAPM, so your confidence in them is determined by your confidence in the
standard CAPM as well as your ability to identify the market portfolio.

3. (a) SB = 0.1. Since this is less than the Sharpe’s index for portfolios on the
CML, B is interpreted as under-performing.
(b) SA = 0.15. Since A has the same Sharpe’s index as all other portfolios on the
CML, it is interpreted as providing neutral performance (i.e. no better or
worse than can be achieved with any portfolio combination of the risk-free
security and the market portfolio).
(c) Under the assumptions of this model, the CML would be curved and concave
for expected returns higher than (at the most) the expected return of the
market portfolio. (Beyond the market portfolio, the CML would follow the
risky security-only MVS). In this case the performance of A would be better
than neutral. Unfortunately, Sharpe’s index is too simple to adequately
measure a portfolio’s performance for this version of the CAPM—the shape
of the CML is too complex.
(d) From the diagram, any security with a beta of 0.5 should have an equilibrium
expected return of 7%, according to the CAPM. Since Jensens’s index is the
difference between the actual return and the CAPM predicted return, it
would be be 0.5% in this instance.

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4. (a) J1 = 0.035 and J2 = −0.005. Using Jensen’s index as the criterion, we would
judge Portfolio 1 as offering superior performance, and Portfolio 2 as
producing inferior performance.
(b) T1 = 0.0769 and T2 = 0.0444. Using Treynor’s index as the criterion, we
would judge Portfolio 1 as offering superior performance, and Portfolio 2 as
producing inferior performance. Note that Treynor’s index for the market
portfolio us TM = 0.05.
(c) SM = 0.167.
(d) S1 = 0.256 and S2 = 0.119. Portfolio 1 exhibits better performance than
Portfolio 2. Portfolio 1 exhibits superior performance relative to the market,
while Portfolio 2 displays inferior performance relative to the market.

5. You should tell the head of the tractor-drivers that the risk of a portfolio must be
considered in relation to the market portfolio. When the market goes up, his
portfolio also goes up. Then compare his portfolio’s return to the the return on
the market portfolio, which should also show a significant gain in a bull market. A
riskier portfolio that was well managed probably went up much more than your
more modest portfolio, and you should show him such a portfolio, and the gains it
made. Make sure to point out to him how he would be right to be worries about
his return if the market portfolio were only earning 10%, but since the market
itself went up quite a bit, his portfolio, even with low risk, has shown a pleasing
return.

6. (a) A positive Jensen Index indicates a superior performance.

(b) The security market line is used as a benchmark for the Jensen Index.
(c) A major problem with the Jensen Index is that it is only sensitive to depth,
or distance from the SML, and not breadth, or the number of different
securities that have captured excess returns. In effect, a “lucky” manager
who invested all his funds in one stock and was, thus, not diversified against
risk could have gotten a great return for one year on his investment and be
ranked the same as a superior manager who diversified against risk and
captured great returns on many securities in his portfolio.

7. (a) Fund B’s Jensens Index is twice that of fund A:

JA = 13% − [8% + 1.0 × (12% − 8%)] = 1% and
JB = 18% − [8% + 2.0 × (12% − 8%)] = 2%. Both funds plot above the SML.
(b) The Treynor Index shows the securities performing at the same level:
TA = (13% − 8%)/1.0 = 5 and TB = (18% − 8%)/2.0 = 5. The market’s
Treynor Index is TM = (12% − 8%)/1.0 = 4, hence both funds plot above the
SML.
(c) The Sharpe Index places fund B ahead of fund A, but by a lesser margin
than the Jensen Index: SA = (13% − 8%)/15% = 0.333 and
SB = (18% − 8%)/19% = 0.526. The market’s Sharpe Index is
SM = (12% − 8%)/8% = 0.500, hence fund B outperformed the market
whilse fund A underperformed.

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 (d) Both funds appear to be able to indentify undervalued securities because
they have positive Jensen indices. Fund B’s Jensen is larger, but when
considering the investor’s ability to lever fund A’s 1% excess return, they
both look pretty much the same in this respect (as indicated by their equal
Treynor indices). Fund B, however, clearly has the better management
because it can capture the excess return while diversifying over many
individual assets, as indicated by its superior Sharpe Index. Fund B is
therefore most appropriate.

8. SA = 0.3, SB = 0.875 and SM = 1.0. The market is therefore superior to both A

and B.

9. (a) J1 = −0.5% and J2 = 1.5%.

(b) T1 = 6.67, T2 = 10.00 and TM = 7.00.
(c) S1 = 0.65, S2 = 2.50 and TM = 1.75.