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FRM Part I · FRM Exam Part I · Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)

An investor currently holds a well-diversified portfolio and is considering adding a new fund as one of several holdings. Which performance measure is most appropriate for evaluating the fund's contribution, and why?

The Treynor ratio is most appropriate, because within a well-diversified portfolio only systematic risk is rewarded and idiosyncratic risk is diversified away. Treynor measures excess return per unit of beta. Sharpe uses total risk and suits stand-alone portfolios.

  1. ATreynor ratio, because only systematic risk matters in a well-diversified portfolioCorrect
  2. BSharpe ratio, because total risk always matters for each holding
  3. CInformation ratio, because it uses the risk-free rate as the benchmark
  4. DJensen's alpha is unusable because it does not depend on beta

Explanation

When a fund is one component of a diversified portfolio, idiosyncratic risk is diversified away, so excess return per unit of beta (Treynor) is appropriate. Sharpe uses total risk and suits stand-alone portfolios. The information ratio uses a benchmark, not the risk-free rate, and Jensen's alpha does depend on beta.

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