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

Using returns-based style analysis, an analyst regresses a fund's monthly returns on three style indices with weights constrained to be non-negative and to sum to 100%. The estimated weights are 55% large-cap value, 35% large-cap growth and 10% small-cap. The fund's R-squared is 0.92. What is the correct interpretation of the R-squared?

An R-squared of 0.92 means 92% of the fund's return variance is explained by its style asset mix, and the remaining 8% is attributed to security selection. It is a variance measure, not a holdings percentage, win rate or beta.

  1. A92% of the fund's return variance is explained by style exposures, and the remaining 8% is attributed to selectionCorrect
  2. B92% of the fund's holdings are in the three style indices
  3. CThe fund outperformed its style benchmark by 92% of the time
  4. DThe fund has a beta of 0.92 to the market

Explanation

In Sharpe style analysis, R-squared measures the share of return variance explained by the style mix. The residual (1 - 0.92 = 8%) is the portion due to security selection, i.e., the fund's active, non-style component. It says nothing about holdings percentages, hit rates or market beta.

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