bff5040tute-4answer - T3Q1 a The basic procedure in...

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T3Q1 a. The basic procedure in portfolio evaluation is to compare the returns on a managed portfolio to the return expected on an unmanaged portfolio having the same risk, using the SML. That is, expected return is calculated from: E(r p ) = r f + β (E(r M ) - r f ). The performance benchmark then is the unmanaged portfolio. The typical proxy for this unmanaged portfolio is an aggregate stock market index such as the S&P 500. b. The benchmark error might occur when the unmanaged portfolio used in the evaluation process is not “optimized.” That is, market indices, such as the S&P 500, chosen as benchmarks are not on the manager’s ex ante mean/variance efficient frontier. c. E(r p ) “true” SML M “measured” SML F 0 1 β d. The answer to this question depends on one’s prior beliefs. Given a consistent track record, an agnostic observer might conclude that the data support the claim of superiority. Other observers might start with a strong prior that, since so many managers are attempting to beat a passive portfolio, a small number are bound to produce seemingly convincing track records. e. The question is really whether the CAPM is at all testable. The problem is that even a slight inefficiency in the benchmark portfolio may completely invalidate any test of the expected return-beta relationship. It appears from Roll’s argument that the best guide to the question of the validity of the CAPM is the difficulty of beating a passive strategy.
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