Question

1. Compare the performance of the two equity funds (Fund A and Fund B), based on the information given below.

Fund	Average Return (%)	Standard deviation of returns (%)	Beta
A B	19.5 15.7	15.5 9.5	1.5 1.2

Additional information:

The risk-free rate is 5% and the return on the market index is 12%. The tracking error is 8.5% for Fund A, and 4% for Fund B.    Evaluate and discuss.

PLEASE SHOW ALL WORING AND FORMULA USED TO ANSWER THIS QUESTION NO EXCEL CALCULATIONS

Answer 1

Comparison of performance of the two equity funds;

1. Based on Average Return

Fund A has higher return when compared to Fund B. Hence an Aggressive investor will select Fund A

2. Based on Standard Deviation

Fund B has lower risk when compared to Fund A. Hence a Conservative investor will select Fund B.

3. Based on Beta

Beta is a measure of non-diversifiable risk (Systematic Risk). It measures the sensitivity of the stock with reference to market index. Beta of 1.50 means the stock is 50% riskier than the market. Beta of 1.20 means the stock is 20% riskier than the market. Hence Fund A is more riskier than fund B.

4. Based on required return as per Capital asset pricing model

Required Return= Rf + b ( Rm – Rf )

Where,

Rf – Risk free return

b – Beta

Rm – Expected return on market portfolio

Required Return for Fund A= 5 + 1.5 ( 12-5 )

= 5 + 10.5

= 15.50%

The average return on Fund A is higher than the required return as per Capital asset pricing model, hence acceptable.

Required Return for Fund B= 5 + 1.2 ( 12-5 )

= 5 + 8.4

= 13.40%

The average return on Fund B is higher than the required return as per Capital asset pricing model, hence acceptable.

4. Based on tracking Error

Tracking error is the difference between a portfolio return and benchmark. Low tracking error means the stock is closely following its benchmark. High tracking error means the fund manager took a greater risk.