CFP - Investment Planning (17% of the exam) - Section D.29

Market cycles

Bull and bear phases, sector rotation, the link between the economic cycle and asset returns, and behavioural patterns at market extremes. Items ask which stage of the cycle a set of indicators describes and which portfolio posture historically suits it.

Market cycles

Practice question for this objective

Free sampleInvestment Planninghard

Frank Bellamy, aged 61, wants to know whether the manager of one sleeve of his diversified portfolio added value beyond what its market exposure alone would have delivered. Over the measurement period the sleeve returned 12.2 percent a year, the broad market index returned 9.5 percent a year, the risk-free rate averaged 3.0 percent a year, and the sleeve's beta against that index was 1.20. Using the capital asset pricing model to set the required return, and rounding to one decimal place, what is Jensen's alpha for the sleeve?

Aplus 2.7 percent
Bminus 2.2 percent
Cplus 9.2 percent
Dplus 1.4 percent Correct

Compute Jensen's alpha as the return in excess of the capital asset pricing model required return, applying beta to the market risk premium rather than the market return. Jensen's alpha asks how much a manager earned above the return the portfolio's systematic risk alone entitled it to. The required return comes from the capital asset pricing model: risk-free rate plus beta multiplied by the market risk premium, where the market risk premium is the market return less the risk-free rate. Here that is 9.5 less 3.0, which is 6.5 percent, multiplied by a beta of 1.20, which is 7.8 percent, plus the 3.0 percent risk-free rate, giving a required return of 10.8 percent. The sleeve delivered 12.2 percent, so alpha is 12.2 less 10.8, which is a positive 1.4 percent. Applying beta to the raw 9.5 percent market return instead of to the 6.5 percent premium is the error that turns this positive alpha into a negative one.

Why A is wrong: This subtracts the market return of 9.5 percent from the sleeve's 12.2 percent, which implicitly treats beta as 1.00 and so gives the manager credit for the extra return that the sleeve's above-market beta of 1.20 was expected to produce.

Why B is wrong: This applies beta to the whole market return rather than to the market risk premium, giving 3.0 plus 1.20 multiplied by 9.5, which is 14.4 percent, because the 3.0 percent risk-free rate was not subtracted from the 9.5 percent market return.

Why C is wrong: This is the sleeve's excess return over the risk-free rate, 12.2 less 3.0, which is the numerator of Sharpe and Treynor but is not alpha, because nothing has yet been deducted for the return the sleeve's market exposure was expected to earn.

Why D is correct: The capital asset pricing model required return is 3.0 plus 1.20 multiplied by (9.5 less 3.0), which is 3.0 plus 7.8, or 10.8 percent, and the sleeve returned 12.2 percent, so alpha is 12.2 less 10.8, which is 1.4 percent.

See more CFP practice questions, answers explained.

Exam traps in Investment Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

Marcus is correct, because an asset with a 24 per cent standard deviation cannot reduce the standard deviation of a 12 per cent portfolio at any weighting
Why it is wrong: This treats standalone volatility as the whole story, which is the intuition most clients bring to the conversation, but a new holding enters portfolio variance through its covariance with the existing portfolio, so its own standard deviation does not settle the question.
11.52 percent
Why it is wrong: This drops the covariance term altogether, which is the result you get only when the correlation coefficient is 0.00, so it credits the portfolio with more diversification benefit than a correlation of 0.30 actually delivers.
An inversion measures recession conditions that are already present, so the holdings should be moved into short duration bonds until output data confirm that growth has resumed.
Why it is wrong: Tempting because an inversion is genuine information about the market's expectations. It is wrong on timing, because an inversion is a forward looking signal about conditions ahead rather than a measurement of a recession already in progress, and dating the all clear from lagging output data would delay any return for many months.

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