If we find a mutual fund with a higher Sharpe ratio than the S&P 500 Index...

If we find a mutual fund with a higher Sharpe ratio than the S&P 500 Index we should discard the CAPM. Agree or Disagree? Explain

Expert Solution

Higher sharpe ratio is reflection of outperformance of the mutual fund in respect to the index rate of return and it is reflecting that Mutual Funds are creating Alpha in comparison to the index and they are beating the rate of the Return of the index but we should still not discard the Capital Asset pricing model because Capital Asset pricing model is a different model than Sharpe ratio as Sharpe ratio will only be considering the excess of the rate of the return of any mutual fund in regards to the index but Capital Asset pricing model will be Accounting in for the systematic risk which is associated with the performance of the mutual fund and it will be calculating risk adjusted return rather than normal rate of return.

Capital Asset pricing model will be adjusting the performance of the mutual fund in respect to the market with beta which is a reflection of the volatility and the systematic risk and they will be determining how much risk the mutual fund is taking in order to beat the rate of the return of the index and hence they will be reflecting a different rate of return than the Shape ratio, so we should never discard Capital Asset pricing model as it will be including the risk associated with earning the rate of return.

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