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Thus derivative securities contingent on a number of

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Unformatted text preview: dividual managers may lack diversification as they focus their investments on assets they believe are mispriced. However, the aggregate portfolio may be well diversified with little unsystematic risk. As such, it is appropriate for senior management to use the Treynor index to evaluate and reward the performance of individual managers. T HE JENSON ALPHA The Jenson alpha is the difference between the average return and the expected return depicted by CAPM. ( ) This equation is similar to the equation of SIM, except for the estimation of a characteristic line for a portfolio rather for an individual stock. If the estimated alpha of a stock is significantly greater than zero, the stock has achieved a return above that implied by the CAPM, and indicative of the fund manager’s ability to invest in underpriced assets and earn a level of return that is more than justified by the level of systematic risk incurred. The Jensen alpha is generally used by academics to test if a particular trading strategy can earn abnormal returns – e.g. Basu (1983) P/E ratio effect. T HE APPRAISAL RATIO The appraisal ratio is the alpha divided by the standard deviation of residual returns. For actively managed funds which try to beat the market index portfolio by investing only in stocks that are believed to be underpriced with positive alphas, and/or short selling stocks that are believed to be underpriced with negative alphas, the number of stocks included in the portfolio is often less than that of the market portfolio. Thus investors seeking to invest in an active fund should not base their choice solely on alpha and neglect the consequent unsystematic risk. They should use the appraisal ratio, which adjusts the portfolio alpha/abnormal return for unsystematic risk exposure, to rank and select active funds. 3 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 L ECTURE 9 – E FFICIENT MARKET HYPOTHESIS B ACKGROUND A financial market is said to be efficient if asset prices respond to relevant information instantaneously and accurately so that no-one is able to use information that is already known by the market to earn abnormal returns net...
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