NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesHard
An investment adviser is evaluating a client's portfolio performance and calculates that the portfolio generated a return of 8% over the past year. During the same period, the relevant benchmark index returned 10%. The portfolio's beta was 0.8, and the risk-free rate was 2%. What is the portfolio's Jensen's Alpha?
- A-1.6%
- B-1.2%
- C0.4%
- D0.0%
Show answer & explanationAnswer & explanation
Correct answer: B. -1.2%
Jensen's Alpha measures the excess return of a portfolio relative to its expected return, as predicted by the Capital Asset Pricing Model (CAPM). First, calculate the expected return using CAPM: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate) = 2% + 0.8 * (10% - 2%) = 2% + 0.8 * 8% = 2% + 6.4% = 8.4%. Then, Alpha = Actual Return - Expected Return = 8% - 8.4% = -0.4%.
Why the other options are wrong
- A. Incorrect calculation, possibly mixing up actual and expected returns.
- C. Incorrect calculation, possibly reversing the subtraction.
- D. Indicates no outperformance or underperformance relative to CAPM, which is not the case here.
Jensen's Alpha
A measure of the excess return of a portfolio compared to the return predicted by the Capital Asset Pricing Model (CAPM), given the portfolio's beta and the market risk premium.
- Alpha = Actual Return - CAPM Expected Return.
- Positive alpha indicates outperformance.
- Negative alpha indicates underperformance.
Memory trick: Alpha: Actual minus Expected CAPM return.