Reference no: EM133121850

You believe that Fund J, Fund K, and a Market index fund will have the following return characteristics over the next several years. You expect T-Bills to earn 0.5%.

a) In which of these 3 funds (Fund J, Fund K, or the Market Index) should you invest your total portfolio if you are (i) completely unconcerned about either total risk or market-wide risk and (ii) unwilling to use leverage of any kind? Show calculations, if any, and briefly discuss.

With no consideration for risk, an investor should maximize expected returns, and without leverage, expected returns cannot be amplified by borrowing. Fund J provides the highest expected return at 6.5%. (The risk premium over T-Bills is rather irrelevant if an investor is not trading off reward for risk.)

b) Calculate (i) M2, (ii) Jensen's alpha and (ii) T2 performance measures for Fund J and Fund K.

M2P = (rP - rF) σM / σP - (rM - rF) = 6% * 18/30 - 4.5% = -0.9% for Fund J

M2P = (rP - rF) σM / σP - (rM - rF) = 4% * 18/12 - 4.5% = +1.5% for Fund K

αP = (rP - rF) - βP (rM - rF) = 6% - 1.0 * 4.5% = +1.5% for Fund J
αP = (rP - rF) - βP (rM - rF) = 4% - 0.6 * 4.5% = +1.3% for Fund K

T2P = (rP - rF) / βP - (rM - rF) = αP/βP = 1.5% / 1.0 = 1.5% for Fund J

T2P = (rP - rF) / βP - (rM - rF) = αP/βP = 1.3% / 0.6 = 2.2% for Fund J

c) In which of these 3 funds should you choose to invest your total portfolio, along with lending or borrowing at the risk-free rate, if you are (i) averse to risk and (ii) willing to use leverage? Show calculations, if any, and briefly discuss.