Question

You are invested in the mutual fund "MF." MF has a volatility of 24%. You wish to know if investing in MF is better than investing on the Capital Market Line (CML). The market volatility is 20%. The risk-free rate is 2% and the market risk premium is 7%.

a. (7 points) To figure out whether MF beats a passive investment on the CML, you wish to compare the performance of MF to the performance of a particular portfolio on the CML. What is the relevant CML portfolio that you should compare MF to (Calculate the weights y and 1-y)?
b. (8 points) What should be the expected return of the CML portfolio that you calculated in a.?
c. (5 points) The MF fund considers a fundamental change in its investment strategy. It will expand into emerging markets to increase its returns and reduce its risk exposure. It considers an emerging market ETF which has a correlation of 0.1 with MF’s assets and a standard deviation of 75%. MF will sell 20% of its assets to buy the ETF. What will be the new volatility of MF?

Answer 1

The comparison between investing in the mutual fund 'MF' and the Capital Market Line involves calculating the appropriate weights for a CML portfolio with equivalent volatility to 'MF', determining its expected return, and evaluating the impact of incorporating an emerging market ETF into 'MF's strategy.

Step-by-step explanation:

The question revolves around determining if investing in the mutual fund 'MF' is more advantageous than investing on the Capital Market Line (CML). To answer this, a comparison is needed between the performance of 'MF' and a comparable portfolio on the CML which we calculate by finding the correct weights (y and 1-y).

Firstly, we need to find the portfolio on the CML that has the same volatility as 'MF', which is 24%. The equation for the CML is E(R) = risk-free rate + (portfolio volatility / market volatility) * market risk premium. We can find y by equating the volatility of 'MF' to that of an equal-volatility portfolio on the CML, using the market volatility of 20%.

After calculating y, the expected return of the CML portfolio can be found using the same CML equation. To assess the impact of a change in 'MF's investment strategy, we consider the introduction of an emerging market ETF to the portfolio and calculate the new volatility after selling 20% of 'MF's assets to buy the ETF. The new volatility must account for the correlation of 0.1 between MF’s assets and the emerging market ETF, along with their respective standard deviations.