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CA Final · Advanced Financial Management · Security Analysis

A mutual fund manager in Pune claims her equity scheme beat the market. Over a year, the scheme returned 18% while the risk-free rate was 6%, the market return was 14%, and the scheme's beta was 1.25. Using CAPM as the benchmark of expected return, what is the scheme's alpha, and what does it imply under semi-strong EMH?

Alpha is +2%. CAPM expected return is 6% plus 1.25 times the 8% market premium, which equals 16%, against an actual 18%. Under semi-strong EMH, persistent abnormal returns from public information are not expected, so the alpha is likely chance rather than skill.

  1. AAlpha of +2%; under semi-strong EMH such persistent alpha from public information would not be expected to continueCorrect
  2. BAlpha of +4%; under semi-strong EMH it is guaranteed to continue
  3. CAlpha of +2%; under semi-strong EMH it proves the market is strong form efficient
  4. DAlpha of -2%; under semi-strong EMH the manager underperformed

Explanation

Expected return = 6% + 1.25 x (14% - 6%) = 6% + 10% = 16%. Alpha = 18% - 16% = +2%. Option with +4% compares to the market return (14%) and ignores beta. Under semi-strong EMH, public information cannot be used to earn persistent abnormal returns, so the alpha is likely luck and not persistent.

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