CFA Practice Question

CFA Practice Question

A portfolio manager is being evaluated against the rate of return required by CAPM. If the market portfolio used has been mis-identified, the manager's performance is most likely:
A. the question is based on a false premise. Any well-diversified portfolio is a good proxy for the market portfolio.
B. either over or under-estimated.
C. overestimated.
Explanation: This question requires an understanding of what the market portfolio means in the CAPM. The true market portfolio is the one that consists of all the risky assets traded in the entire investment universe available, not just stocks and bonds. It also is the tangency portfolio, having the highest excess-reward-to-risk ratio amongst all portfolios consisting of purely risky assets.

User Contributed Comments 11

User Comment
KD101 So - the incorrect portfolio can still use more or less of risky asset -
"It dependes on what the meaning of "mis-identified" is" -- William Jefferson Clinton
danlan I think "mis-identified" can mean "over" or "under" estimated, so I choose B.
amak This is my interpretation: A market portfolio would have the highest excess reward to risk ratio possible. Hence if the manager misidentified his market portfolio, his market portfolio would have to have a lower excess reward to risk than the 'actual' market portfolio. Hence compared his portfolio with the mis-identified one, then it must be overestimated.
mark98007 It seems to me that this clever question is saying that by definition the market portolio would have to have everything, and would thus be more "conservative" than any other proxy by definition; however, that is not really true; one can imagine him choosing an index that was more conservative than the hypothetical "real" one and underestimating his success... I think it has to be "B"
dimanyc i think amak came closest to explaining this, but I still don't see the link between "lower reward-to-risk" ratio and portfolio being "overestimated".
steved333 I understand amak's explanation, but still, all the question said was mis-identified. This one could have gone either way.
steved333 Okay, well, I see the question asks for the most likely explanation, not what it must be. It can go either way, but more likely the manager's performance would be based against the most conservative portfolio (with the lowest return) available, and thus overestimated.
Kashi2010 I think this is because, for the same given level of risk tolerance (i.e. an an investor's risk tolerance), the return (according to the mis-identified Markowitz frontier) is lower.

As such assuming the same level of portfolio return for the manager, the benchmark is now lower - hence overestimated.

??
Clude good call amak.
zkhan87 if your market portfolio is misidentified, then this misidentified portfolio riskier than the real mkt portfolio...therefore, would require a higher return. so the manager's performance should have been compared to a portfolio that required a higher rate of return...so his performance was overestimated.
shiva5555 fiddlesticks!
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