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MPF intermediaries
MPFMPF Intermediaries ExaminationFund X has an expected return of 16% and volatility of 10%; Fund Y has 10% and 4%. The risk free rate is 2%. Which fund gives the higher return for the same level of risk?
Answer: Fund Y, with a Sharpe ratio of 2.00 against 1.40 for Fund X. Sharpe ratio of X = (16 - 2) / 10 = 1.40; of Y = (10 - 2) / 4 = 2.00. Fund Y earns more excess return per unit of risk.Working:• Fund X: (16 - 2) / 10 = 1.40• Fund Y: (10 - 2) / 4 = 2.00• The higher Sharpe ratio (Fund Y) gives more return per unit of riskWhy not the others:• Fund X, because its expected return is higher: A higher absolute return does not mean a higher return for the same risk; Fund X also carries far more risk.• both funds, as each has the same return per unit of risk: The two Sharpe ratios differ: 1.40 for Fund X and 2.00 for Fund Y.• Fund Y, with a Sharpe ratio of 2.50 against 1.60 for Fund X: These figures divide each return by volatility without first deducting the 2% risk free rate.Watch out: Picking the fund with the higher absolute return; the Sharpe ratio adjusts for risk.Rule: Compare funds on the Sharpe ratio, (expected return - risk free rate) / volatility; the higher ratio gives more return per unit of risk.Source: IA Investment-linked Long Term Insurance Examination Study Notes, 2024 Edition (7th ed., Nov 2024; for exams from 17 Feb 2025), 2.1.5(b), p. 2/7
Picking the fund with the higher absolute return; the Sharpe ratio adjusts for risk.
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