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Funds 205: Gauging Risk and Return Together: Alpha and the Sharpe Ratio

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1.
The higher a fund's Sharpe ratio, _______.
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The greater its returns given the amount of risk it's taking on. The Sharpe ratio is based on the relationship between a fund's risk as measured by standard deviation and its returns.
2.
The Sharpe ratio uses _______ to measure a fund's risk-adjusted returns.
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Standard deviation. Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories.
3.
A fund's alpha is dependent on the legitimacy of its beta measurement.
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True. After all, it measures performance relative to beta.
4.
What allows us to use the Sharpe ratio to compare risk-adjusted returns of funds in different categories?
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Its use of standard deviation. Standard deviation is calculated the exact same way for any type of fund, be it stock or bond.
5.
Funds A, B, and C each return 15%, while the SP 500 returns 10%. Relative to the SP 500, which fund has the highest alpha?
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Fund C, which has a beta of 0.8. With its beta, you'd expect Fund C to gain 8% (10% x 0.8 = 8%). It made almost twice that. Fund A should have gained 10%, so it earns a lower alpha than Fund C. Fund B should have returned 17%, so the fund has a negative alpha.