What is meant by a funds alpha? (4)

- the difference between expected return and actual return
- return not explained by market movements and beta
- risk adjusted return measure
- value added by the fund manager
- amount of return not accounted for by its beta

Alpha formula

Alpha = actual return - CAPM

Alpha = actual return - [Rf + Bi(Rm-Rf)]

Rf = risk free return Rm = market return Bi = beta of fund

What is beta?

- measures the risk of a fund compared to the rest of the market

What is meant by value investing and the assumption which underpins the concept (3)

- identifies stock which are undervalued/ trading at less…
- than their intrinsic value

Assumptions:

- the market is inefficient
- but will return to fair value

Explain How is technical analysis used to make investment decisions (4)

- based only on share price/ excludes fundamental analysis (company accounts etc)
- uses charts of past share price
- identifies patterns that predict future performance
- assumes these are repeated

What does information ratio measure and it’s limitations (6)

- relative performance
- compared to a benchmark
- adjusted for risk

Limitations:

- based on historical data
- needs to be compared to similar funds
- need to look at trends
- need to consider other factors

Information ratio formula

(Investment return - index or benchmark return) / tracking error

Measures risk adjusted returns vs benchmark

Reasons why funds with same benchmark have different information ratios (3)

- different tracking errors
- different performances
- different portfolio construction

What is tracking error?

tracking error or active risk is a measure of the risk in an investment portfolio that is due to active management decisions made by the portfolio manager.

it indicates how closely a portfolio follows the index to which it is benchmarked.

Explain potential causes of an ETF tracking error (7)

- inaccuracy of the method used
- management fees
- other costs
- currency hedging
- cash drag
- dividend reinvestment lag
- tax
- securities lending

Purpose of using a benchmark (4)

- sets assets allocation/ starting point
- Independant basis
- to manage risk expectations
- to measure relative performance to benchmark / value added by fund manager

Why include an asset in a portfolio which has lost money over the last 5 years (4)

- diversification
- negatively correlated to other assets
- lower volatility (if bonds or cash)
- better expected risk adjusted returns
- past performance no guide to future

Money weighted return:

What does it show?

What is the formula?

MWR measures overall return on capital over a specific period

= difference in value + income/capital distributions

R = [D + (V1 - V0)] / V0

V1 = value at end V0 = value st start D = income/ capital distributions

Sharpe ratio

- what does it show?
- what is the formula?

- measure of risk adjusted returns of an investment
- measures excess returns for every unit of risk taken
- uses to compare investments to see which offers most return for any given level of risk
- allows comparison
- if returns of different funds
- adjusted for risk

SR = (return on investment - Rf return) / SD

Difference between return on investment and Rf = excess return for taking the risk

- risk is measured by SD

If SR = 0.75 then 0.75% extra return for each unit of risk taken

The higher the SR the better the returns for the amount of risk taken

Negative SR shows Rf would have been better

SR is useful to measure if returns are due to fund manager decisions or purely because of extra risk being taken

Limitations of the sharper ratio (4)

- returns are not always normally distributed
- assumes that SD is correct measure of risk
- assumes risk free return rate is correct
- simplistic / ignores other factors
- ignores Charges
- ignores tax
- uses historic data
- can be manipulated

Explain why MWR is not considered appropriate when evaluating and comparing different portfolio returns and suggest a more suitable alternative measure (4)

- strongly influenced by timing of investments
- outside of the control

of the manager - doesn’t identify whether the returns are due to ability of the manager
- TWR

6 relative differences between SD and Beta and terms of what they measure and how they measure risk

What they measure:

- beta measures market risk
- SD measures fund risk

How they measure risk:

- beta measures volatility
- SD measures total risk

Benchmark:

- beta is measured against the market
- SD is not/ measured against actual return

Explain what is meant if a fund has a beta of more than 1 (3)

- moves in same direction / positive correlation as the market
- more volatile than market
- will our perform in rising market/ under perform in falling market