Two investment advisers are comparing performance. One averaged a 19% return and the other a 16% return. However, the beta of the first adviser was 1.5, while that of the second was 1.

a. Can you tell which adviser was a better selector of individual stocks (aside from the issue of general movements in the market) ?

First Investment Advisor

Second Investment Advisor

Cannot be determined

b. If the T-bill rate were 6% and the market return during the period were 14%, which adviser would be the superior stock selector?

First Investment Advisor

Second Investment Advisor

Cannot be determined

c. What if the T-bill rate were 3% and the market return 15%?

First Investment Advisor

Second Investment Advisor

Cannot be determined

a. Cannot be determined

b. Second Investment Advisor

c. Second Investment Advisor

Explanation:

a. Since all the information is not given in the question so we are not able to give advise. As abnormal return is calculated from subtracting the expected return from the return. But no such information is provided in the question.

b. We know that

Abnormal return = Return - expected return

Expected rate of return = Risk-free rate of return + Beta * (Market rate of return - Risk-free rate of return)

In case of First Investment Advisor:

The return is 19%

And, the expected return equal to

= 6% + 1.5 * (14% - 6%)

= 6% + 1.5 * 8%

= 6% + 12%

= 18%

So abnormal return = 19% - 18% = 1%

In case of Second Investment Advisor:

The return is 16%

And, the expected return equal to

= 6% + 1 * (14% - 6%)

= 6% + 1 * 8%

= 6% + 8%

= 14%

So abnormal return = 16% - 18% = 2%

So, Second Investment Advisor should be accepted as it has high abnormal return then first investment Advisor

c. In case of First Investment Advisor:

The return is 19%

And, the expected return equal to

= 3% + 1.5 * (15% - 3%)

= 3% + 1.5 * 12%

= 3% + 18%

= 21%

So abnormal return = 19% - 21% = - 2%

In case of Second Investment Advisor:

The return is 16%

And, the expected return equal to

= 3% + 1 * (15% - 3%)

= 3% + 1 * 12%

= 3% + 12%

= 15%

So abnormal return = 16% - 15% = 1%

So, Second Investment Advisor should be accepted as it has high abnormal return then first investment Advisor