Question

Use the following information to answer Problems l2–16:

Primo Management Co. is looking at how best to evaluate the performance of its managers. Primo has been hearing more and more about benchmark portfolios and is interested in trying this approach. As such, the company hired Sally Jones, CFA, as a consultant to educate the managers on thebest methods for constructing a benchmark portfolio, how best to choose a benchmark, whether the style of the fund under management matters, and what they should do with their global funds in terms of benchmarking.

For the sake of discussion, Jones put together some comparative two-year performance numbers that relate to Primo’s current domestic funds under management and a potential benchmark.

As part of her analysis, Jones also takes a look at one of Primo’s global funds. In this particular portfolio, Primo is invested 75% in Dutch stocks and 25% in British stocks.

The benchmark invested 50% in each—Dutch and British stocks. On average, the British stocks outperformed the Dutch stocks. The euro appreciated 6% versus the U.S. dollar over the holding period, while the pound depreciated 2% versus the dollar. In terms of the local return, Primo outperformed the benchmark with the Dutch investments but underperformed the index with respect to the British stocks.

Question: If Primo decides to use return-based style analysis, will the R² of the regression equation of a passively managed fund be higher or lower than that of an actively managed fund?

Short answer

Higher

Step-by-step solution

Definition of return based style analysis

A statistical technique used in finance to deconstruct the returns of investment strategies using many exploratory tools is known as returns based style analysis.

Explanation on the R2 of the equation regression

Since the previously managed fund mimics the benchmark, the R² of the regression should be very high, probably higher than the actively managed fund.