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

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1.
What is alpha?
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The difference between a fund's expected returns based on its beta and its actual 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.
Which measurement is most useful to investors?
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A Sharpe ratio of 1.7 for a fund with a standard deviation of 12%. Alphas aren't meaningful unless the fund's R-squared is greater than 75. Sharpe ratios, meanwhile, are always useful, because they involve standard deviations rather than betas.
4.
Alpha _______ distinguish between underperformance caused by incompetence and underperformance caused by fees.
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Does not. Alpha does not distinguish between these two.
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.