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FRM Part II · FRM Exam Part II · Portfolio Performance Evaluation

A returns-based style analysis regresses a fund's monthly returns on three style indices (large growth, large value, small cap) with weights constrained to be non-negative and sum to one. The estimated weights are 50%, 30% and 20%, and the R-squared is 0.92. Which statement is the best interpretation?

About 92% of the fund's return variability is explained by its effective style mix, and the remaining 8% is attributed to security selection. The weights are estimated average exposures from the regression, not actual holdings, and the 8% is a variance share rather than an alpha percentage.

  1. AThe fund holds exactly 50% of its stocks in large growth names at every month-end
  2. BAbout 92% of return variation is explained by style exposure, and the remaining 8% is attributed to selectionCorrect
  3. CThe fund's alpha equals 8% per year
  4. DThe weights show the fund has 92% of its assets in the three indices

Explanation

In Sharpe style analysis the R-squared measures the share of return variance explained by the style mix; the residual (1 - 0.92 = 8%) is attributed to security selection. The weights are effective average exposures from regression, not actual holdings. The residual share of variance is not an annual alpha figure.

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