CFA Level II ExamPortfolio Management and Wealth PlanningMedium
An investment committee is reviewing the performance of three external fund managers. Manager A generated an annualized return of 12% with a standard deviation of 15%. Manager B achieved an annualized return of 10% with a standard deviation of 10%. Manager C returned 15% with a standard deviation of 20%. The risk-free rate during the period was 3%. Which manager demonstrated the best risk-adjusted performance using the Sharpe Ratio?
- AManager A
- BManagers A and C had equal Sharpe Ratios.
- CManager C
- DManager B
Show answer & explanationAnswer & explanation
Correct answer: D. Manager B
Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Portfolio Standard Deviation. Manager A: (0.12 - 0.03) / 0.15 = 0.09 / 0.15 = 0.60. Manager B: (0.10 - 0.03) / 0.10 = 0.07 / 0.10 = 0.70. Manager C: (0.15 - 0.03) / 0.20 = 0.12 / 0.20 = 0.60. Manager B has the highest Sharpe Ratio.
Why the other options are wrong
- A. Manager A's Sharpe Ratio is 0.60, which is lower than Manager B's.
- B. Managers A and C have equal Sharpe Ratios, but Manager B's is higher.
- C. Manager C's Sharpe Ratio is 0.60, which is lower than Manager B's.
Sharpe Ratio
A measure of risk-adjusted return that indicates the excess return (or risk premium) per unit of total risk (standard deviation) in an investment.
- Formula: (Portfolio Return - Risk-Free Rate) / Portfolio Standard Deviation.
- Higher Sharpe Ratio indicates better risk-adjusted performance.
- Uses total risk (standard deviation) and is appropriate for well-diversified portfolios.
Memory trick: Risk-Adjusted Ratios: How much bang for your buck of risk.