Question

17) An investor has a choice of investing in one of two different mutual funds. a portfolio A and the second fund has a portfolio B comprised of the same stoc different weights. If the risk free rate of return is 2% and the expected mal which portfolio(s) would you advise the investor to accept? nerent mutual funds. The first fund has prised of the same stocks as A but with mnd the expected market return is 12%, Asset 1 1 T L 3 L 4 5 Total Asset Beta Portfolio A Portfolio B Weights (%) Weights (%) 1 .30 15 30 0.70 25 1.25 12 35 1 .10 LE18 23 0. 9030 ban 5 10021100 DIESER inline

Answer 1

As the portfolio Beta is the weighted average of the individual stock's Beta

$\beta _{A}$    = 1.3*0.15+0.7*0.25+1.25*0.12+1.1*0.18+0.9*0.3

=0.195+0.175+0.15+0.198+0.27

=0.988 and

$\beta _{B}$ = 1.3*0.3+0.7*0.07+1.25*0.35 +1.1*0.23+0.9*0.05

=0.39+0.049+ 0.4375+ 0.253+0.045

=1.1745

Therefore , the Expected return on A and B as per CAPM is

R_A = Risk free rate +$\beta _{A}$ * (market return - risk free rate)

= 2% +0.988* (12%-2%) =11.88% &

R_B = Risk free rate +$\beta _{B }$ * (market return - risk free rate)

= 2% +1.1745* (12%-2%) =13.75%

In terms of Risk and return A is less risky (low beta) and has less expected return

wheras B has higher risk (high beta) and higher return

To advise one of A and B , we have to look at the risk appetite of the investor, If the investor is risk averse, investing in A can be advised else investing in B can be advised if the investor is relatively risk seeking.

If a choice has to be made without the information of Investor's risk appetite, I would recommend B because A is very similar in risk (measured by beta) and expected return with the market portolio (with beta = 1) . The same can be easily achieved with an Index fund with much lesser cost. So an index fund is much better than portfolio A and hence I would Advise investment in B.