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PART A 1. For each of the following following determine determine a benchmark benchmark (from the case) case) and justify justify your your choice choice •
T Rowe Price !lue "hi# $rowth (TR!"%) &
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$oldman 'achs "R/ 0arge "a# $rowth ($0"$%) &
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Russell Russell 1*** 1*** $rowt $rowth h This This inde inde+ + is a stron strong g benchm benchmark ark for for the $0"$% $0"$% fund because the the fund seeks seeks growth com#anies with strong strong and #redictable #redictable cash cash flows and diidends- and the inde+ is made u# of larger com#anies with high #rice2to2 book ratiosratios- strong earningsearnings- and high forecasted forecasted growth growth alues. alues. This This includes includes technology- consumer- discretionary s#ending- and consumer sta#les industry erticals.
3iersified '#ecial /4uity 5n (36P/%) &
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'P ** ** !ecaus !ecausee this this inde+ inde+ re#rese re#resents nts ** ** large largest st com#ani com#anies es by marke markett ca#itali,ation- it re#resents a fair benchmark for a fund built around leading market firms- seasoned management- and strong financial fundamentals.
Russell Russell 7*** 7*** This This inde+ inde+ is the most most common common for mutual mutual funds that identify identify themseles as small ca#. The 36P/% fund does not consider diidends- but instead focuses highly com#anies with a market ca#itali,ation alue of under 87 billion.
Russell Russell 7*** 7*** 6a 6alue 3FA 3FA funds focus on on alue firms and and small ca# stocks. stocks. This This is a #erfect benchmark for 3T96% as it inests in small com#anies with high book2to2market ratios. ratios.
7. !ased on the the chosen chosen benchmark benchmarkss- how did each fund fund #erform in the the #eriod #eriod from ;anuary ;anuary 7*** 7*** through 3ecember 7**<= >ould >ould you recommend buying any of the funds= 5f so- which= •
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!ased on the chosen benchmarks- each fund #erformed as described below from ;anuary 7*** through 3ecember 7**<. 5t seems as though TR!"% and 3T96% out#erformed their benchmark inde+- while while $0"$% and 36P/% did not.
>e would would for sure recommend buying the 3T96% fund due to the strong relatie #erformance and the fact that the return oer this #eriod was #ositie. 5n addition- we would recommend buying 36P/% due to the decent #ositie #ositie return oer this #eriod#eriod- des#ite the fact that it ery ery slightly under#erformed with relation to the inde+.
?. For each of the < mutual funds in (1)- use the "AP9 to ealuate the #erformance of the fund manager for the #eriod from ;anuary 7*** through 3ecember 7**<. !ased on your findingswould you recommend buying any of the funds= •
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>e determined our betas using a one factor linear regression using the market #remium as the + ariable and the fund return minus the risk free rate as our y ariable. >e used monthly alues for our in#uts. >e utili,ed the benchmark inde+ to re#resent the market and long2term goernment bonds as our risk free rates. :sing the "AP9 e4uation and our determined betas- we found e+#ected returns for the funds. As the market was olatile and data aried highly between months- it was ery hard to determine a monthly estimation for returns- and so we annuali,ed all of the returns by finding the #eriod returns and then conerting them to com#ound annual growth rates. >e found that just the T Rowe Price !lue "hi# $rowth (TR!"%) fund out#erformed the e+#ected "AP9 return- and so they had #ositie al#ha alues- while the other three funds had negatie al#ha alues. !ased solely on the com#arison between the funds@ al#ha alueswe would suggest #urchasing the TR!"% fund howeer- during this time frame- we might not hae #urchased this fund and may hae been more attracted to other funds (des#ite under#erforming their #ros#ectie indices) due to the economic enironment faoring certain kinds of com#anies and harming others.
<. 3o the same as in (?)- but now use (a) the Fama French ? Factor 9odel- and (b) the Fama French ? Factor 9odel #lus the 9omentum Factor. !ased on your results- does it look like any of the fund managers hae stock #icking skill= :tili,ing a similar methodology as our construction of the "AP9 e4uation- we estimated e+#ected returns using the Fama French ? Factor 9odel and the Fama French ? Factor 9odel #lus the 9omentum Factor. a) :tili,ing the Fama2French ? Factor 9odel which uses a market factor- a small minus big stock factor- and a high book2to2market minus low book2to2market factor- we found that all four funds out#erformed the calculated e+#ected returns. b) >hen we added the momentum factor to the model we still found that all four funds out#erformed the calculated e+#ected returns. •
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!ased on these results- it seems as if < of the fund managers hae stock2#icking skill.
. "an you think of a way to use the industry #ortfolios to do something like #roblems (?) and (<)= 5f so- how do your results com#are= Bes- you could run regressions on industries that tend to hae com#anies of certain si,es and relatie alues. >e ran the following regressions to see if these industries were a good #redicting measure of fund #erformance •
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T Rowe Price !lue "hi# $rowth (TR!"%) &
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C!lue "hi#D Aerage of "onsumer 3urables- 9anufacturing- and /nergy
$oldman 'achs "R/ 0arge "a# $rowth ($0"$%)
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3iersified '#ecial /4uity 5n (36P/%) &
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C$rowthD Aerage of Ei2Tech and Telecom Eistorically 'mall "a#= "onsumer on23urables (shot in the dark)
3FA Ta+29anaged :.'. 'mall "a# 6alue (3T96%) &
C6alueD :tilities
>e looked the RG7 alue of the results to determine if these industries were correlated
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enough to #redict fund returns. The C!lue "hi#D s. TR!"% and the C$rowthD s. $0"$% regressions had RG7 alues oer .<*- which makes the % ariables relatiely good estimations for a beta that can reasonably #redict fund return. ur growth industry RG7 was our highest at .HI For these two "AP9 e4uations- we got a negatie al#ha. This would conclude that the funds under#erformed their res#ectie markets. PART ! 1. :sing whicheer model(s) you deem a##ro#riate- estimate the cost of ca#ital for Bahoo (BE) and Altria (9) in 3ecember 7**<. At that time- the yield on the 1* year and ?* year :.'. goernment bonds was <.7J and <.KJ- res#ectiely. !oth firms hae o##ortunities to make new inestments that are broadly similar to their e+isting assets and are e+#ected to #roduce an e4uity return of 1*J #er year. The inestments would be financed with the same historical mi+ of debt and e4uity. 5n other words- focusing directly on the cost of e4uity is sufficient. o unleering or releering is necessary. 7. Eow do the costs of ca#ital that you estimate com#are to those of the #rojects= >ould you gie these #rojects the green light= &
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>e ran a regression between recent year #erformance of these stocks- Bahoo and Altria- and their res#ectie industries- Telecom and "onsumer ondurables. >e utili,ed future2looking data by using the 1*2year yield at the end of 7**< for our risk2 free rate and used an industry historical return (using the <* year data) to estimate e+#ected a forward2looking market return (this #roides a smoother- more accurate market #rediction Lthe telecom industry would hae been tainted by the dotcom bubble and there was a recession during this time frame as wellM). >e calculated effectie cost of e4uity for Bahoo to be 7*.NHJ and for Altria- 7?.*J. $ien this high cost of e4uity- unless the com#anies hae ca#ital structures that are leered enough to #roduce an oerall >A"" of less than 1*J- these #rojects would not be #rofitable and should not be taken on.
