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FRM Part II · FRM Exam Part II · Factors

An analyst regresses excess returns of a fund on market excess returns and finds alpha of 0.2% per year (not statistically significant) and a beta of 1.10. The market risk premium is 6% and the risk-free rate is 2%. The fund holds 70% in a diversified equity portfolio with beta 1.30 and 30% in risk-free cash. A manager claims the fund's outperformance over the market comes from skill. Which is the best assessment?

The holdings imply a beta of 0.91, which conflicts with the regression beta of 1.10, so the data need reconciling. Higher beta earns compensation as market risk, not skill, and the alpha of 0.2% is statistically insignificant, so skill is unsupported.

  1. AThe portfolio's beta of 0.91 from the stated holdings does not match the regression, so the holdings data should be reconciled before any conclusion on skillCorrect
  2. BOutperformance is skill because the beta exceeds 1
  3. CAlpha must be 6% because the market premium is 6%
  4. DThe beta of 1.10 proves the fund is mispriced

Explanation

Holdings imply beta = 0.7 × 1.30 + 0.3 × 0 = 0.91, not 1.10, so the data are inconsistent. Higher beta earns higher expected return by CAPM, not alpha, and alpha here is insignificant. Claims of skill are unsupported until the inconsistency is resolved.

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