John Terry currently has £200,000 invested in Delta Investment
exchange traded fund, a broad-based index fund with an expected
return of 12% and volatility of 10%. He is forty years old and is
saving for his retirement.
John’s broker gives him a call and suggests that he make
an equity investment into Echo Investment, another broad-based
index ETF. This investment has an expected return of 8%, and
volatility of 5%, and a negative correlation with Delta Investment
of -0.50.
The risk-free rate is 2%.
a) Based upon the information above, would you advise John to
invest in Echo Investment? Please justify your answer.
b) Building upon your answer to part a, what is the
optimum combination of investment in Delta Investment and Echo
Investment based upon the above information?
c) Earlier this year, John downloaded the Robinhood app after
hearing it provides commission-free investing. After doing
considerable research, he put a relatively modest amount of his
savings into the stock market. In his first four weeks of actively
investing, he has made himself a total shareholder return of 112%
by picking a small number of ‘meme’ stocks that increased
significantly. Does John generating such high returns directly
contradict the efficient market hypothesis or can such returns be
explained by traditional financial theory in the short run?
d) Why based upon financial theory should it be impossible for
John to generate ‘abnormal returns’ in the long-run?
e) Building upon your answer in part d, if we wanted to
determine whether John has been generating abnormal returns, why
would this need to be done on a risk adjusted basis? How might you
advise that be calculated?
