Risk and Performance Measurement Flashcards

An investment manager's portfolio has an upside capture ratio of 110 and a downside capture ratio of 90. Which of the following statements BEST describes the manager's performance relative to their benchmark?

Answer: The manager captured more of the benchmark's gains in up markets than its losses in down markets, indicating favorable asymmetric performance.

An upside capture ratio greater than 100 indicates that the portfolio outperformed the benchmark during periods when the benchmark had positive returns. A downside capture ratio of less than 100 indicates that the portfolio lost less than its benchmark during periods of negative returns. The combination of capturing more of the upside (110) and less of the downside (90) is a desirable, asymmetric return profile, indicating skillful management.

An analyst is comparing two well-diversified portfolios. Portfolio A has a higher Sharpe ratio, while Portfolio B has a higher Treynor ratio. Which measure is more appropriate for evaluating these portfolios, and why?

Answer: The Treynor ratio, because for well-diversified portfolios, unsystematic risk is considered negligible, making systematic risk (beta) the key determinant of performance.

The Treynor ratio measures excess return per unit of systematic risk (beta). For a well-diversified portfolio, firm-specific (unsystematic) risk has been largely eliminated, and the primary remaining risk is market or systematic risk. Therefore, beta is the most relevant risk measure. The Sharpe ratio, which uses total risk (standard deviation) in the denominator, is more appropriate for portfolios that are not well-diversified.

A portfolio manager generated a return of 12%. The risk-free rate is 2%, the market return is 10%, and the portfolio's beta is 1.2. What is the portfolio's Jensen's alpha?

Answer: 0.4%

Jensen's alpha is calculated using the Capital Asset Pricing Model (CAPM) formula: Alpha = Portfolio Return - [Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)]. Plugging in the values: Alpha = 12% - [2% + 1.2 * (10% - 2%)] = 12% - [2% + 1.2 * 8%] = 12% - [2% + 9.6%] = 12% - 11.6% = 0.4%. A positive alpha indicates the manager outperformed the expected return for the given level of systematic risk.

An investor is particularly concerned with the potential for large losses and wants to evaluate managers based on their performance during negative market movements. Which risk-adjusted performance measure would be MOST suitable for this investor's objective?

Answer: Sortino Ratio

The Sortino ratio is a modification of the Sharpe ratio that differentiates harmful volatility from total overall volatility. It replaces standard deviation in the denominator with downside deviation, which measures only the volatility of returns falling below a specified target (often the risk-free rate). This makes it ideal for investors who are primarily concerned with protecting against losses.

Which of the following BEST defines the Information Ratio (IR)?

Answer: The active return of a portfolio (return minus benchmark return), divided by its tracking error (the standard deviation of the active return).

The Information Ratio (IR) specifically measures a portfolio manager's skill at generating excess returns relative to a benchmark, and the consistency of those returns. It is calculated as the active return (portfolio return - benchmark return) divided by the tracking error (the standard deviation of that active return). A higher IR indicates a more consistent ability to outperform the benchmark on a risk-adjusted basis.

A portfolio has a beta of 0.8 and an R-squared of 0.90 against its benchmark. How should an analyst interpret these figures?

Answer: The portfolio is 20% less volatile than its benchmark, and 90% of its return movements are explained by movements in the benchmark.

Beta measures the volatility or systematic risk of a security or a portfolio in comparison to the market as a whole. A beta of 0.8 indicates the portfolio is expected to be 20% less volatile than the benchmark. R-squared measures the percentage of a fund's or security's movements that can be explained by movements in a benchmark index. An R-squared of 0.90 means that 90% of the portfolio's price movements are explained by the benchmark's movements, implying a high correlation and that the benchmark is appropriate for comparison.