CFA Level I · CFA Level I Exam · Benchmarking Returns
A manager's portfolio returned 11.0% and the chosen benchmark returned 8.0%. The benchmark's holdings, however, have an average beta of 0.8 versus the portfolio's 1.2, and market return was 9.0% with a risk-free rate of 3.0%. Which conclusion is most appropriate?
The benchmark is mismatched in risk, so the 3.0% raw excess return partly reflects the portfolio's higher beta. CAPM implies about 10.2% for beta 1.2 versus 7.8% for beta 0.8, leaving only roughly 0.8% attributable to skill.
- AThe excess return of 3.0% is a valid measure of skill because both are equity portfolios
- BThe benchmark is mismatched in risk, so the 3.0% excess return partly reflects higher risk exposureCorrect
- CThe benchmark should be replaced by the risk-free rate, giving an excess return of 8.0%
Explanation
Expected return under CAPM for beta 1.2 is 3+1.2×6=10.2%, while for beta 0.8 it is 3+0.8×6=7.8%. Most of the 3.0% active return is explained by the extra risk: 11.0−10.2=0.8% is the risk-adjusted excess. The mismatched risk makes the raw comparison misleading.
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