Two investment advisers are comparing performance. One averaged a 19% return and

Question

Two investment advisers are comparing performance.  One averaged a 19% return and the other a 16% return.  However, the beta of the first adviser was 1.5, while that of the second was 1.

a.  Can you tell which adviser was a better selector of individual stocks (aside from the issue of general movements in the market)?

b.  If the T-bill rate were 6% and the market return during the period were 14% which adviser would be the superior stock selector?

c.  What if the T-bill rate were 3% and the market return 15%?

Explanation / Answer

a. Here we cannot determine which stock adviser is better. In order to determine which stock selector is better we look at the abnormal return, the abnormal profit is the difference between the actual return and that predicted by Security Market Line. Without information of the parameters like risk free rate of return and return on market we cannot determine which investment adviser is better.

b. Rf =6%, RM = 14%,

Abnormal return = Return - Expected Return

First adviser

Abnormal return = 19% - [6% +1.5(14-6)] = 1

Second adviser

Abnormal return = 16% - [6%+1(14-6)] = 2

Here the second adviser is having higher abnormal return hence he is better stock adviser.

C. When Rf = 3%; Rm = 15%

First adviser

Abnormal return = 19 - [3 +1.5(15-3)] = -2

Second adviser

Abnormal return = 16 - [3+1(15-3)] = 1

Here second adviser is having higher abnormal return than the first adviser. Hence second adviser is better selector of individual stock.

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