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FRM Part II · FRM Exam Part II · Performing Due Diligence on Specific Managers and Funds

A fund of funds reviews a long/short equity manager. The manager reports an annual return of 9% with volatility of 6%, the risk-free rate is 3%, and the manager claims the strategy has no market exposure. The due diligence analyst regresses fund excess returns on market excess returns and finds a beta of 0.5, with market excess return averaging 5% per year. What is the manager's annual alpha implied by this regression?

Alpha is 3.5%. The fund's excess return over the 3% risk-free rate is 6%, and the 0.5 beta to a 5% market excess return explains 2.5%. Subtracting leaves 3.5%. The manager's no-market-exposure claim is contradicted by the regression, which is a due diligence finding in itself.

  1. A3.5%Correct
  2. B6.0%
  3. C1.0%
  4. D4.0%

Explanation

Fund excess return = 9% - 3% = 6%. Beta-explained return = 0.5 x 5% = 2.5%. Alpha = 6% - 2.5% = 3.5%. Using 6% ignores the beta exposure (claim of zero beta), and 1.0% subtracts the full market return incorrectly.

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