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You estimate that a passive portfolio, that is, one invested in a risky portfolio that mimics the S&P500 stock index that represents the stock market, yields an expected rate of return of 13% with a standard deviation of 25%. You manage an active portfolio with expected return 18% and standard deviation 28%. The risk-free rate is 8%.
a. Draw the CML (Capital Market Line) and your funds’ CAL (Capital Allocation Line) on an expected return-standard deviation diagram. Indicate their slopes.
b. Suppose your client ponders whether to switch the 70% that is invested in your fund to the passive portfolio. Explain to your client the disadvantage of the switch.
c.In the context of part b, Show him the maximum fee you could charge (as a percentage of the investment in your fund, deducted at the end of the year) that would leave him at least as well of investing in your fund as in the passive one.)
(Hint: The fee will lower the slope of his CAL by reducing the expected return net of the fee.)

Sagot :

The capital market line with fee will be 0.3771 and the capital allocation line will be 0.24.

How to calculate the slope?

The slope of the capital market line will be:

= (17% - 7% - f)/27

= (10% - f)/27

f = 0.3771

The slope of the capital allocation line will be:

= (13% - 7%) / 25%

= 0.24

The reward to variability ratio will be:

= (17 -7)/27

= 0.3771

The client's reward to variability ratio will be:

= (13 - 7)/25

= 0.25

This shows that the client will be disadvantaged of the switch since it's lower.

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