Case 007Manager evaluation and attributionWarm up
Pellora Long-Short Fund returned 9% in a year when the market returned 15%. Its average beta was 0.4 and cash earned 6%. Did it underperform?
1The situation
Pellora Long-Short Fund is a long-short equity fund held by a fund of funds. Last year it returned 9% after fees while the broad equity index returned 15%. Over the year its average beta to that index was 0.4: it ran about 40% net long, with longs and shorts of similar riskiness. Cash, the risk-free rate, earned 6%.
An investment committee member calls the result six points of underperformance and wants to redeem. The fund charges 1.5% a year and 15% of gains.
2Your task
Did Pellora underperform, and what is the right benchmark for judging it?
Quick check
What return should a fund with a beta of 0.4 have earned from the market alone?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Pellora underperformed its beta-adjusted benchmark by only about 0.6 points, not the 6 points the committee member sees. A fund with a beta of 0.4 should earn cash plus 0.4 times the market's excess return: 6% plus 0.4 times 9%, which is 9.6%. The fund made 9%. Its alpha was slightly negative after fees, and before fees it was positive.
Step 1Why is the market the wrong yardstick?
A fund that runs 40% net long has chosen to take less than half the market's risk. Judging it against the full market is like judging a driver who kept to 40 on a wet road against one who drove at 100: the second got there sooner, but they were not running the same race. The fair benchmark is what the fund's own market exposure would have earned with no stock picking at all. That is cash, plus beta times the market's return over cash.
| r_f | the risk-free rate, cash at 6% |
| beta | the fund's average sensitivity to the market, 0.4 |
| r_m | the market's return, 15% |
| alpha | the return left over after paying for beta |
Step 2What did the manager actually add before fees?
The 9% is net of fees, so gross it up to see the manager's own work. With a 1.5% management fee and 15% of gains, a 9% net return needs a gross return of about 12.1%. Before fees Pellora earned about 2.5 points of alpha over its 9.6% benchmark, and the fees took all of it and a little more. That is a different conversation from six points of underperformance: the question is whether the fee structure leaves investors enough, not whether the manager can pick stocks.
Step 3What would you check before calling the result?
Three things, each of which can move the answer. First, an average beta hides timing: a manager who was 20% net long before a fall and 60% before a rally shows skill that the average does not credit. Second, one year of alpha is mostly noise; with tracking error of, say, 5% a year, a 0.6 point shortfall is statistically nothing. Third, check that beta is measured against the index the fund actually trades, because a mid cap book measured against a large cap index shows a misleading beta. The committee's judgement should be: not six points behind, roughly flat after fees, and a fee conversation worth having.
Where candidates lose it
The trap is the headline comparison: 9% against 15% sounds like six points of failure. A candidate who does not adjust for beta has told the interviewer they would fire a hedged manager for being hedged.
The second trap is forgetting cash. Beta times the market return, 0.4 x 15% = 6%, ignores that the uninvested capital earns the risk-free rate, and gives an alpha of +3% that is just as wrong in the other direction.
What the interviewer asks next
- Pellora's beta was 0.2 in the first half and 0.6 in the second, when the market did all its rising. What does that say?
- How would you measure alpha if the fund also had a large small cap tilt?
- What alpha, before fees, does a 1.5 and 15 fund need to beat its beta after fees?
Company names and figures are illustrative.