Large institutional investors

Question 2
Part (a)
(i) Please state/briefly explain the Roll critique of the CAPM (3 points)
(ii) Explain, based on the Roll critique, why might we expect that large institutional investors (such
as the Yale Investments Office) will be able to achieve higher gross Sharpe ratios than small, individual
investors. In the context of this question, “gross Sharpe ratio” indicates that the excess return in the
numerator is computed gross of any fees charged by fund managers.
(2 points)
(iii) Explain why we might expect large institutional investors to benefit from allocating to alternative asset classes, even if we completely ignore benefits that might arise from mechanisms related to the
Roll Critique. Why do we expect these benefits to be largest for institutions that use an organizational
structure in which direct investment decisions are delegated to specialized managers?
(2 point)
4
Part (b)
The CAPM does not fully explain the systematic variation in the cross-section of returns for the S&P
500 stocks. We can think of the CAPM as a one-factor asset-pricing model. How many factors do we
need in order to fully explain the systematic variation in the cross-section of returns for the S&P 500
stocks? Please explain your answer, and please include brief empirical justifications where appropriate.
[Hint: think about upper and lower bounds, and how tight we can make these bounds.]
(4 points)