Fundamentals of Financial Management A Report

Question: Mr. Smith is a busy entrepreneur. A financial advisor decides where to invest Mr. Smiths stock portfolio worth several million dollars. After a few years, Mr. Smith hires two consultants to independently evaluate the performance of his stock portfolio. These consultants were given daily data on the total dollar value of portfolio, as well as the data on the episodic infusions of cash from Mr. Smith. I cant trust these guys, says Mr. Smith. It is true they found the same return, but the riskà ¢Ã¢â€š ¬Ã‚ adjustment calculations dont match. Consultant 1 report that Mr. Smiths stock portfolio had an annual Sharpe Ratio of 0.43, and while a broad stock market index had an annual Sharpe Ratio of 0.39. He also found an annual CAPM alpha of 1.54% per year. In contrast, Consultant 2 report annual Sharpe Ratios of 0.41 and 0.40 for Mr. Smiths portfolio and for a market index, respectively, and an annual CAPM alpha of 0.12%. Can both consultants have correct calculations? Explain in detail. Answer: The following report is about scrutinizing about the reports given to Mr. Smith by his two consultants. Sharp ratio is calculated by subtracting risk free return from market return and then dividing by portfolio standard deviation. Higher the value of sharp ratio, more return the investor can expect to earn for extra volatility they are exposed to. Same risky investment should be compensated with same return. For one portfolio there can be only one value of sharp ratio. Two consultants gave two contrasting figures which are not acceptable as the same data and formula should be used to arrive at the figures. The two consultants figures match when they gave their return as they didnt considered the risk factor which is somewhat an inappropriate method to measure portfolio performance. Consultant 1 gave an annual sharp ratio of 0.43 while consultant 2 gave an annual sharp ratio of 0.41 which is contradictory. Since both portfolios gave same value of return, their value of risk should also be same. There also gave conflicting results on broad stock market index (Brigham Houston, 2004). Co nsultant 1 gave an annual sharp ratio of 0.39 while consultant b gave an annual sharp ratio of 0.40.though the differences in less but the value should be equal either of the result would be absolutely correct and hence either of them would be perfectly correct. Alpha is a method of portfolio measurement on a risk adjusted basis. Taking the volatility of a mutual fund into consideration alpha compares its risk adjusted performance to a benchmark index. Alpha is among five technical risk ratios. The other ratio are standard deviation, beta, Sharpe ratio which has explained earlier and r-squared. They are used in modern portfolio theory and are statistical measurement. They are all used to decide risk reward profile of mutual fund. In simplified terms alpha represents the value that a portfolio manager adds or subtracts from a funds return (Paramasivan Subramanian, 2009).they are all risk adjusted way of evaluating a portfolio. Both consultants cannot have the correct calculation. Annual CAPM alpha of less than 0 implies the portfolio has earned too little for its risk while than of more than one implies the investment has earned more than its risk .annual capm value equal to zero implies that they the port folio has earned equal to their value of risk 3. Consultant 1 gave an annual CAPM alpha of 1.54 % while consultant 2 gave an estimate of 0.12%. The two consultants have given two quiet different figures for the alpha and hence either of the two can be correct (Shim Siegel, 2000). They should give the same figure as they have used the same data for calculating the risk. Thus it can be concluded that Mr. Smith should consider choosing either consultant 1 or consultant 2 opinions as it is not possible that both of them are correct. He should arrive at his judgment after seeing how these figures are calculated and after proper scanning as he might be mislead by different results. References Brigham, E., Houston, J. (2004).Fundamentals of financial management. Mason, Ohio: Thomson/South-Western. Paramasivan, C., Subramanian, T. (2009).Financial management. New Delhi: New Age International (P) Ltd., Publishers. Shim, J., Siegel, J. (2000).Financial management. Hauppauge, N.Y.: Barron's.