Alpha (and the Low-Risk Anomaly)

1)The performance parameters of two fund managers (measured against the same benchmark)
in an investment firm is shown in the table below:

Parameter Fund Manager 1 Fund Manager 2

Return 12.35% 13.00%
α 2.35% 3.00%
Tracking error 25% 34%

Which of the following statements is correct?

A
Fund manager 1 deviated more from the benchmark index

B
Fund manager 2 deviated more from the benchmark index

C
Fund manager 1 generated a higher excess return

D
Fund manager 2 has a higher information ratio

The correct answer is: B).

The tracking error is the standard deviation of the excess return. It measures how disperse the
fund manager’s return is relative to a benchmark. A larger tracking error implies a greater
deviation from the benchmark index. As observed from the data, the tracking error of manager 2
> manager 1, hence manager 2 deviated more from the benchmark.

The information ratio is calculated as:

Information Ratio(IR)= α / σ

Using the above formula:

IRFund Manager 1 = 0.940

IRFund Manager 2 = 0.0882

Therefore, the information ratio of fund manager 1 is higher than that of fund manager 2.

2) A large investment management firm intends to launch a new hedge fund for its retail
investors.  The firm is in the process of identifying a benchmark which its fund would try to
replicate. During a meeting of the investment management committee, the following remark is
made:

Fund manager 1: “Our firm has multiple active funds tracking different benchmarks. We must
include the benchmark with the highest return as the benchmark for our new fund as this will also
help us to attract new investors.”

Which of the following is correct with respect to the statement made by Fund manager 1?
A
The benchmark with highest return will help the firm to attract new investors

B
The firm cannot have the fund with highest return as its benchmark as it is not well-
defined

C
The firm cannot have the fund with highest return as its benchmark as it is not risk-
adjusted

D
The firm cannot have the fund with the highest return as its benchmark as it is not
tradable

The correct answer is: B).

The fund with highest return cannot be taken as a benchmark as it is not well-defined. One of the
characteristics of a sound benchmark is that it must be well-defined and free of ambiguity about
its contents. As the fund with highest return changes each time, its content remains ambiguous.
Thus, due to this ambiguity, the fund with the highest return cannot be considered as a
benchmark.

3) A large investment management firm intends to launch a new hedge fund for its retail
investors.  The firm is in the process of identifying a benchmark which its fund would try to
replicate. During a meeting of the investment management committee, the following remarks are
made:

Fund manager 1: “Our firm has multiple active funds tracking different benchmarks. We must
include the benchmark with the highest return as the benchmark for our new fund as this will also
help us to attract new investors.”

Fund manager 2: “My research reveals that the returns for XYZ fund have been above the
market return for several consecutive periods. I would, therefore, recommend the use of the
market return as our benchmark, as it will clearly help us attract new investors.”
Which of the following is correct with respect to the statement made by Fund manager 2?
A
As the returns of hedge funds are generally higher, the hedge fund must be considered
as the benchmark

B
Hedge funds have a higher risk profile, hence XYZ must not be used as the benchmark

C
Hedge funds are not easily replicable, hence XYZ must not be used as the benchmark

D
Hedge funds are usually not diversified, hence XYZ must not be used as a benchmark

The correct answer is: C).

The composition of a hedge fund is generally not disclosed publicly. Each hedge fund manager
employs a unique strategy to generate a return and most of them do not disclose their
investment strategy. This makes it very hard to replicate such a hedge fund. Therefore, a hedge
fund cannot be considered as a benchmark.

4) A large investment management firm intends to launch a new hedge fund for its retail
investors.  The firm is in the process of identifying a benchmark which its fund would try to
replicate. During a meeting of the investment management committee, the following remarks are
made:

Fund manager 1: “Our firm has multiple active funds tracking different benchmarks. We must
include the benchmark with the highest return as the benchmark for our new fund as this will also
help us to attract new investors.”

Fund manager 2: “My research reveals that the returns for XYZ fund have been above the
market return for several consecutive periods. I would, therefore, recommend the use of the
market return as our benchmark, as it will clearly help us attract new investors.”

Fund manager 3: “There are many absolute return funds in the market which have consistently
beaten the market. We must take one of those funds as the benchmark.”

Which of the following is correct with respect to the statement made by Fund manager 3?

A
Absolute return funds generate positive returns irrespective of market conditions and,
therefore, it would be in order to use one of them as the benchmark

B
Absolute return funds take excessive risks, a characteristic which effectively nullifies
them from being used as benchmarks

C
Absolute return funds employ different strategies which are usually not replicable, and
hence one of them must not be used as the benchmark

D
Absolute return benchmarks are usually not diversified, and hence one of them must not
be used as the benchmark

The correct answer is: C).

An absolute return fund tries to generate positive returns irrespective of the market returns.
These fund do not try to replicate any indices and, hence, cannot be replicated themselves.

5) The composition an index (ABC) is given below:

Assets Proportion
Exotic Stones 10%
Real Estate 75%
Art 15%

Which of the following statements is accurate?

A
 ABC can be an ideal benchmark for real estate

B
ABC can be an ideal benchmark for hedge funds

C
ABC cannot be used as a benchmark index

D
ABC cannot be used as a benchmark for alternative investments

6) The composition an index (ABC) is given below:

Assets Proportion
Exotic Stones 10%
Real Estate 75%
Art 15%

Which of the following statements is accurate?

A
ABC can be an ideal benchmark for real estate

B
ABC can be an ideal benchmark for hedge funds

C
ABC cannot be used as a benchmark index

D
ABC cannot be used as a benchmark for alternative investments

The correct answer is: C).

All the assets included in the index are illiquid in nature. Hence, the index formed from such
assets cannot be traded with ease and may also require high transaction costs. Therefore, ABC
cannot be used as a benchmark.

7) An investment management firm recruits multiple fund managers to manage its funds. In
order to have some control over transaction costs, the firm allows each manager to make a
maximum of 100 transactions per year.

One of the fund managers wants an information ratio of 0.75. Assuming the “fundamental law”
applies, her information coefficient must be equal to:

A
0.75

B
0.0075

C
0.075
D
7.5

The correct answer is: C).

Information Ratio = IC × √BR

IC = Information Coefficient
BR = Breadth of the strategy
IC = 0.75/√100 = 0.075

8) An investment management firm recruits multiple fund managers to manage its funds. In
order to have some control over transaction costs, the firm allows each manager to make a
maximum of 100 transactions per year.

One of the fund managers alternatively calculates her information ratio by computing the excess
return and the tracking error from the actual observed values. She uses the following formula:

Information Ratio = α / σ

After computation, the fund manager observes that the information ratio is less than 0.75. This is
most likely due to the:
A
Correlation between the different bets of the fund manager

B
Cap on the number of transactions per year

C
Differences in portfolio weights

D
Differences in the number of transactions from one manager to another

The correct answer is: A).

The information ratio of a fund manager depends on the number of transactions carried out,
which is defined as the breadth of the strategy (BR). In the present case, the firm’s management
caps transactions at 100 per year. But in reality, the 100 transactions carried out by a fund
manager may not all be different. For instance, the fund manager may be investing in growth
stocks and perform 20 transactions in that regard. We may view these as 20 distinct transactions
but the fact is all of them are correlated. As a result, the IR reduces.

9) An investment management firm recruits multiple fund managers to manage its funds. In
order to have some control over transaction costs, the firm allows each manager to make a
maximum of 100 transactions per year.

The assets under management for the above fund increase from $1million to $20 million in 5
years. How does this affect the information ratio (IR)?

A
It increases
B
It remains unchanged

C
It decreases

D
It moves towards a value of 1

The correct answer is: C).

The information coefficient is a measure of the opportunities generated by the fund manager to
increase the fund’s returns. As the assets under management increase, the ability to generate a
stronger information coefficient decreases. This, in turn, decreases the information ratio.

10) A fund manager tracks the monthly return of ABC Corporation – an asset management
company. She regresses the monthly return of ABC against the market returns for the past 5
years. The regression output is given in the table below:

Parameter Coefficient
Alpha 0.82%
Beta 0.69
Asset under management $10 million

The stock generates a yearly excess return of:

A
0.82% with approximately 70% of market risk

B
8.20% with approximately 30% of market risk

C
9.84% with approximately 70% of market risk

D
0.82% with approximately 30% of market risk

The correct answer is: C).

The monthly excess return generated by the stock = 0.82%

Yearly Return = 0.82% × 12 = 9.84%

As Beta = 0.69, the stock carries approximately 70% of market risk.

11) A fund manager tracks the monthly return of ABC Corporation – an asset management
company. She regresses the monthly return of ABC against the market returns for the past 5
years. The regression output is given in the table below:

Parameter Coefficient
Alpha 0.82%
Beta 0.69
 Asset under management $10 million

The assets under management (AUM) of ABC Corp increase to $100 million. How does this
impact the value of alpha?
A
Alpha increases

B
Alpha decreases

C
Alpha remains unchanged

D
Alpha = 1

The correct answer is: B).

As the assets under management increase, the ability to generate excess returns decrease.
Thus, alpha decreases.

12) A fund manager tracks the monthly return of ABC Corporation – an asset management
company. She regresses the monthly return of ABC against the market returns for the past 5
years. The regression output is given in the table below:

Parameter Coefficient
Alpha 0.82%
Beta 0.69
Asset under management $10 million

An investor wants to replicate the ABC Corporation's stock returns but she does not intend to
hold the stock of ABC Corp. Which of the following portfolios mimics the stock of ABC Corp?
A
25% of T-Bills and 75% of the market portfolio

B
35% of T-Bills and 65% of the market portfolio

C
31% of T-Bills and 69% of the market portfolio

D
33% of T-Bills and 67% of the market portfolio

The correct answer is: C).

If we ignore alpha and apply the CAPM model, the return of stock ABC Corp. can be illustrated
as:

RABC Corp. = rf + 0.69 (rm – rf)

Where:

RABC Corp. = Return of ABC Corp.stocks

 rf = Risk-free return

rm = Market return

The relationship above can also be indicated as:

RABC Corp. = 0.31rf + 0.69rm

This interpreted means that the return of stock ABC Corp. is equivalent to a portfolio with 31% of
T-Bills and 69% of the market portfolio.

13) A fund manager has a corpus of $10 million. She short sells T-bills with an aggregate value
of $2m and invests all the proceeds plus her stock of capital in a market index. The effective beta
of her portfolio is:

A
1.2

B
0.2

C
1.4

D
0.8

The correct answer is: A).

The composition of the fund manager’s portfolio is such that T-bills decrease by 20% while the
market portfolio increases by a similar percentage.

The above portfolio in terms of CAPM can be shown as:

rportfolio = –0.2rf + 1.2rm

rportfolio = –0.2rf + 1.2rm
rportfolio = rf + 1.2(rm – rf ) 
Thus, β = 1.2

14) A large investment management firm manages multiple funds. It re-launches one of its best
performing funds to attract new investors. John Grey, a prospective investor in the fund, goes
through the fund factsheet. In the factsheet, the investment management firm states that the fund
invests in large value stocks. To verify the correctness of this assertion, Grey plans to leverage
the skills he’s learned from his Finance undergraduate classes.

Grey regresses the fund return against the market and a few other factors. The results areas
presented below:

rfund – rf = 0.82% + 0.74(rmkt – rf ) + 0.32 SMB + 0.54 HML + serror

Which of the following statements is correct?

A
The fund has more exposure towards large stocks

B
 The fund has more exposure towards small stocks

C
The fund has equal exposure towards both small and large stocks

D
The fund has 100% exposure towards large stocks

The correct answer is: B).

The regression equation given above is basically the Fama-French regression model with SMB
as the size factor. In the Fama-French model, the size factor is created by going long on small
companies and short on large companies. A positive SMB indicates that the fund has more
exposure towards small companies as compared to large companies.

15) A large investment management firm manages multiple funds. It re-launches one of its best
performing funds to attract new investors. John Grey, a prospective investor in the fund, goes
through the fund factsheet. In the factsheet, the investment management firm states that the fund
invests in large value stocks. To verify the correctness of this assertion, Grey plans to leverage
the skills he’s learned from his Finance undergraduate classes.

15) Grey regresses the fund return against the market and a few other factors. The results areas
presented below:

rfund – rf = 0.82% + 0.74(rmkt – rf ) + 0.32 SMB + 0.54 HML + serror

Which of the following statements is correct?

A
The fund has more exposure towards value stocks

B
The fund has more exposure towards growth stocks

C
The fund has equal exposure towards both value and growth stocks

D
The fund is concentrated with growth stocks

The correct answer is: A).

Since the HML coefficient is positive, the fund has more exposure towards value stocks as
compared to growth stocks.

16) A large investment management firm manages multiple funds. It re-launches one of its best
performing funds to attract new investors. John Grey, a prospective investor in the fund, goes
through the fund factsheet. In the factsheet, the investment management firm states that the fund
invests in large value stocks. To verify the correctness of this assertion, Grey plans to leverage
the skills he’s learned from his Finance undergraduate classes.

Grey regresses the fund return against the market and a few other factors. The results areas
presented below:

rfund – rf = 0.82% + 0.74(rmkt – rf ) + 0.32 SMB + 0.54 HML + serror

The fund factsheet indicates that the investment strategy of the fund is investing in large value
stocks.

The statement is:

A
True, as the coefficient of the SMB factor is positive

B
False, as the coefficient of the HML factor is positive

C
False, as the coefficient of the SMB factor is positive

D
True, as the coefficient of the HML factor is positive

The correct answer is: C).

The positive SMB factor indicates exposure towards small stocks while the positive HML factor
indicates exposure towards value stocks. Hence, the fund primarily has exposure towards small
value stocks. Therefore, the statement that the fund invests in large value stocks is false.

17) You have been given the following information for a portfolio:

Portfolio return 10%

Beta 1.2
Standard deviation of the portfolio 5%
Benchmark return 8%
Tracking error 10%
Risk-free rate 3%

Calculate the Sharpe and the information ratios for the portfolio.
A
Sharpe ratio: 1.4; Information ratio: 0.2

B
Sharpe ratio: 1.4; Information ratio: 0.7

C
Sharpe ratio: 0.4; Information ratio: 0.2

D
Sharpe ratio: 0.4; Information ratio: 0.7

18) You have been given the following information for a portfolio:

Portfolio return 10%

Beta 1.2
Standard deviation of the portfolio 5%
Benchmark return 8%
Tracking error 10%
Risk-free rate 3%

Calculate the Sharpe and the information ratios for the portfolio.
A
Sharpe ratio: 1.4; Information ratio: 0.2

B
Sharpe ratio: 1.4; Information ratio: 0.7

C
Sharpe ratio: 0.4; Information ratio: 0.2

D
Sharpe ratio: 0.4; Information ratio: 0.7

The correct answer is: A).

Sharpe Ratio = (Rp − Rf )/σ

Sharpe Ratio = (10 – 3)/ 5

Sharpe Ratio = 1.4

Information Ratio = (Rp − Rb)/(Tracking error)

Information Ratio = (10 – 8)/10

Information Ratio = 0.2

19) A portfolio manager invested $1 million in a portfolio of equities. At that time the benchmark
index against which the performance of the portfolio was to be tracked stood at 2000 points. One
year later the value of the portfolio was $1.12 million while the benchmark index was 2180 points.
Calculate the information ratio for the portfolio if the tracking error is 4%.

A
0.75

B
0.60

C
0.83

D
1.00

The correct answer is: A).

Information Ratio = Alpha/Tracking error

Alpha = Return on the portfolio – Return on the benchmark 

Alpha = (1.12/1 - 1) – (2,180/2,000 – 1)
Alpha = 3%

Information Ratio = 0.03/0.04 

= 0.75

20) Which of these managers will have the highest information ratio based on Grinold’s law of
active management?

A
 A manager with an information coefficient of 0.5 and a breadth of 20

B
A manager with an information coefficient of 0.05 and a breadth of 200

C
A manager with an information coefficient of 0.1 and a breadth of 100

D
A manager with an information coefficient of 0.8 and a breadth of 10

The correct answer is: D).

According to Grinold’s law the maximum attainable information ratio can be calculated using the
following formula:
IR = IC x √BC

The four managers will have IRs of:

IRA = 0.5 x √20 = 2.24
IRB = 0.05 x √200 = 0.71
IRC = 0.1 x √100 = 1.00
IRD = 0.8 x √10 = 2.53

21) James Dunn is a retail investor who expects his stock portfolio to return 21.2% in the
following year. If the returns on risk-free Treasury notes are 11.6%, and the portfolio carries a
standard deviation of 0.09, then which of the following is closest to the Sharpe ratio of Dunn’s
portfolio?

A
1.5403

B
2.9873

C
1.0667

D
2.4543

The correct answer is: C).

Recall that the Sharpe ratio is given as:

SharpeRatio=SR=¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯rt−rftσSharpeRatio=SR=rt−rft¯σr =0.212, r =0.116, σ=0.09 
t ft

Therefore:
SharpeRatio=SR=0.212−0.1160.09SharpeRatio=SR=0.212−0.1160.09SR=1.0667SR
=1.0667This means that for every point of return, you are shouldering 1.0667 "units" of risk.
22) Tradability is one of the properties of a sound benchmark. Which of the following best
explains the link between tradability and a sound benchmark?

A
If alphas are not evaluated relative to a tradable benchmark, the implementable returns
on investment strategies are not a representation of the calculated alphas
B
Both the asset owner and the fund manager are supposed to display the ability to trade
the benchmark

C
Produced by an independent asset provider, a tradable benchmark should be verifiable
and not ambiguous about its contents

D
Alphas must not be measured in relation to a tradable benchmark because if so, the
computed alphas will not give the returns on investment strategies that can be
implemented

The correct answer is: A).

The measure of alpha should be relative to tradable benchmarks or else the calculated alphas
will not be a representation of the implementable returns on investment strategies.

23) The expected return of the market portfolio, E(rm ),is 6.2% and the risk-free rate, rf, is given
as 3.9%. Let’s also assume that the beta of the asset is given as 1.3. What is the asset’s
expected return,E(ri )?

A
4.96%

B
2.99%

C
11.96%

D
6.89%

The correct answer is: D).

Recall that:

E(ri ) − rf = βi (E(rm) − rf )

Therefore: 

E(ri) = βi (E(rm) − rf ) + rf

E(ri) = 1.3(6.2% − 3.9%) + 3.9%

= 6.89%