Explanation

To maximize the portfolio's risk-adjusted return, the manager should assign the highest relative weight to Security 2.

Key Concepts:

1. Jensen's Alpha: Measures the excess return of a security relative to its expected return based on the Capital Asset Pricing Model (CAPM). A higher alpha indicates better risk-adjusted performance relative to the market.

2. Information Ratio: Measures the active return per unit of active risk (tracking error). It's calculated as:

   $$IR = \frac{\text{Portfolio Return} - \text{Benchmark Return}}{\text{Tracking Error}}$$

   A higher information ratio indicates better risk-adjusted performance relative to a benchmark.

3. Nonsystematic Variance: Represents the idiosyncratic risk specific to a security that can be diversified away in a well-diversified portfolio.

Analysis:

• Security 1 has the highest Jensen's alpha, which is good for absolute risk-adjusted performance.
• Security 2 has the highest information ratio, which is particularly relevant for portfolio managers who are benchmarked against an index. The information ratio directly measures the manager's ability to generate excess returns relative to the benchmark per unit of tracking error.
• Security 3 has the lowest nonsystematic variance, but in a well-diversified portfolio, nonsystematic risk is largely eliminated through diversification, so this characteristic is less important.

Why Security 2 is the Best Choice:

For a portfolio manager seeking to maximize risk-adjusted returns, the information ratio is the most relevant metric because:

1. It directly measures the trade-off between active return and active risk
2. It's particularly important for actively managed portfolios that are benchmarked against an index
3. A higher information ratio indicates more consistent outperformance relative to the benchmark

While Jensen's alpha is also important, the information ratio provides a more comprehensive measure of risk-adjusted performance for portfolio construction, especially when considering the trade-off between active returns and tracking error.

Answer: B (Security 2)