Richard Roll, in an article on using the capital asset pricing model (CAPM) to evaluate portfolio performance, indicated that it might not be possible to evaluate portfolio management ability if there is an error in the benchmark used.
a. In evaluating portfolio performance, describe the general procedure, with emphasis on the benchmark employed.
b. Explain what Roll meant by the benchmark error and identify the specific problem with this benchmark.
c. Draw a graph that shows how a portfolio that has been judged as superior relative to a “measured” security market line (SML) can be inferior relative to the “true” SML.
d. Assume that you are informed that a given portfolio manager has been evaluated as superior when compared to the Dow Jones Industrial Average, the S&P 500, and the NYSE Composite Index. Explain whether this consensus would make you feel more comfortable regarding the portfolio manager’s true ability.
e. Although conceding the possible problem with benchmark errors as set forth by Roll, some contend this does not mean the CAPM is incorrect, but only that there is a measurement problem when implementing the theory. Others contend that because of benchmark errors the whole technique should be scrapped. Take and defend one of these positions.