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

Returns-based style analysis regresses a fund's returns on style indices with the constraints that weights are non-negative and sum to 100%. A fund's regression gives weights of 60% large-cap value, 30% large-cap growth and 10% cash. The fund's R-squared is 0.92. What is the best interpretation of the R-squared?

R-squared of 0.92 means that 92% of the variation in the fund's returns is explained by the style mix of 60/30/10, while the remaining 8% is attributed to security selection or residual effects. It is not a measure of outperformance or holdings.

  1. A92% of the fund's return variance is explained by its style mix, and 8% is attributed to selectionCorrect
  2. BThe fund outperformed the style benchmark by 92%
  3. CThe fund holds 92% of its assets in the largest style exposure
  4. DThe style weights are 92% likely to be correct

Explanation

In Sharpe style analysis, R-squared measures the share of return variance explained by the style benchmark mix. The remaining 8% is attributed to security selection (the residual), not to excess return or portfolio weights.

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