I know this is a long post but I was wondering if you could help me out with this question.
Do you think this is something they will ask? The LOS says contrast. I am not about the division the made for manager 2.
Manager 1: cumulative annualized return for the first four years at CAM was 3.4% above that of the benchmark. In the fifth year, return was 2.2% below that of the benchmark, so the manager was fired.
Manager 2: cumulative annualized return for the first 10 years at CAM was 2.1% above that of the benchmark. In the 11th year the cumulative annualized return dropped to 1.9% above that of the benchmark, so the manager was fired.
With regard to the two managers Dzagoev described to Salvio, assuming a null hypothesis of zero or negative value added, it is most likely that CAM committed:
The answer puts type II error to both and the explanation was:
A Type I error occurs when CAM retains a manager who adds no value and a Type II error occurs when CAM fires a manager who adds value.
CAM’s first rule – firing a manager for a single year’s performance that is more than 2% below the benchmark – makes it more likely that CAM will commit Type II errors: a manager generally adds value but has one bad year.
The Sharpe ratio is:
(4×3.4%)−2.2%
of the benchmark ( 5 = 2.28%), so it appears that, on average, they add positive value.
CAM’s second rule uses a constant 2% threshold above the benchmark regardless of the number of years of returns being evaluated, when it should have a threshold that decreases with the square root of the number of years of returns. It, too, makes it more likely that CAM will commit a Type II error.
In the case of Manager 1, their 5-year cumulative annualized return was still likely more than 2% above that
In the case of Manager 2, although the 11-year cumulative annualized return is not above the 2% threshold, it more appropriately should be compared with a lower threshold (such as 2% = 0.603%) and would likely be above that lower threshold.