Question

Explain what the raw return on an actively managed portfolio tells an investor about the skill of the portfolio manager. What computations one would need to undertake in order to transform the raw return into a measure which is informative about manager skill? Are there any pitfalls or risks associated with these computations that might erode the accuracy of the skill measure that you have proposed?

Answer 1

Raw Return on actively managed portfolio will be reflective of rate of return which has been made by an active fund manager directly from the market and it will not be reflective of any risk which has been undertaken by him.

We will be trying to compute these rate of return through adjustment of risk which has been undertaken by these fund managers and we will be trying to adjust it for risk-adjusted returns by adjusting it for standard deviations and systematic risk through beta so we can say that risk adjusted rate of return of these actively managed funds are very important in order to make a decision about investment into them.

I will be trying to compute it through adjusting the risk of the portfolio by finding out the beta or standard deviation and accordingly adjusting the risk of the portfolio with the return of the portfolio so we can make a better comparison about investment into those funds.

There may be some pitfall associated with adjusting of risk because it is cannot be completely estimated in advance and it can be just predicted and they can be wrong at times because economic forecasts are not always correct.