Case Study:

An investor wishes to outperform a cap-weighted equity index. The investor knows that Modern Portfolio Theory suggests that the market portfolio is a cap-weighted portfolio and will be best portfolio (once risk free asset is included as an investment) in an efficient market. In the absence of an efficient market, the investor feels that they are able to outperform a cap-weighted benchmark.

The investor feels that an equal weighted dollar portfolio (each asset is allocated equally in dollar terms) is a better portfolio construction technique to outperform a cap-weighted benchmark.

The investor will invest in the same assets as in the index but the assets will be allocated according to the portfolio construction technique.

Question 2

(i) Explain the resulting active weights of large cap firms and small caps of the equal dollar weighted portfolio against a cap-weighted index? Active weight of an asset is the difference between allocation in the portfolio and the benchmark (allocation in portfolio less allocation in benchmark).

(ii) Explain if the volatility of an equal dollar portfolio will be higher or lower than the volatility of a cap-weighted index.

(iii) Explain if the beta of an equal dollar portfolio will be larger than 1 or less than 1 against a cap weighted index.

Question 3

(i) Explain if an equal dollar portfolio will be able to generate higher returns against the cap-weight index (Active Returns)

(ii) Explain if an equal dollar portfolio will be able to generate higher risk adjusted returns against the cap-weight index (Jensen's Alpha).