Performing Due Diligence on Specific Managers and Funds: formula sheet

Key formulas

Sharpe ratio

Sharpe = (Rp − Rf) ÷ σp

Excess return per unit of total volatility. Use annualised figures consistently. Smoothed returns understate σ and inflate Sharpe.

Alpha from a single-factor regression

Rp − Rf = α + β(Rm − Rf) + ε

α is the return not explained by market exposure. Extend with more factors in multi-factor attribution.

Information ratio

IR = α ÷ tracking error

Active return per unit of active risk against a benchmark.

Maximum drawdown

MDD = (Trough value − Prior peak) ÷ Prior peak

Largest peak-to-trough loss. Compare it with the fund's stated risk limits.

Return decomposition

Total return = Beta return + Factor return + Alpha

Only the alpha part is evidence of manager skill.

Annualised volatility from monthly data

σ(annual) = σ(monthly) × √12

Valid when monthly returns are roughly uncorrelated. Positive autocorrelation from smoothing makes this understate risk.

ODD scope

ODD = people + processes + valuation + service providers + legal/governance + compliance

Use this as a checklist to organise any answer. It is not a numeric formula.

Independence test

Independent check = administrator + auditor + custodian/prime broker not controlled by the manager

If the manager controls or is the same entity as these roles, fraud risk rises sharply.

Segregation of duties

Trade initiation ≠ trade confirmation ≠ cash movement ≠ valuation

One person controlling several of these steps is a control weakness.

Red flag principle

Multiple red flags + weak explanations → reject or escalate

A single flag may be explainable. A cluster is stronger evidence. Unresolved serious flags justify a decline.

Gross exposure

Gross exposure = Long market value + |Short market value|

Gross exposure as a percentage of fund equity (NAV) is a common leverage measure.

Net exposure

Net exposure = Long market value − |Short market value|

Shows directional market risk. A fund can have low net but high gross exposure.

Leverage ratio

Leverage = Gross exposure ÷ Net asset value (NAV)

Define the measure used; notional-based leverage for derivatives can differ from balance-sheet leverage.

Liquidity mismatch test

Days to liquidate portfolio vs. redemption notice period plus payment period

If assets take longer to sell than investors need to be paid, the fund has a mismatch.

Valuation hierarchy

Level 1: quoted prices; Level 2: observable inputs; Level 3: unobservable inputs

Level 3 carries the most model and judgement risk.

Management fee

Management fee = fee rate × assets under management (or NAV)

Charged regardless of performance. Check whether it is based on opening, average or closing NAV.

Incentive fee with high-water mark

Incentive fee = incentive rate × max(0, ending NAV − max(HWM, beginning NAV)) when fees are measured on NAV per unit

Fee is due only on gains above the highest NAV on which a fee was paid. After a loss, the fund must first recover to the HWM.

Hard hurdle incentive fee

Incentive fee = incentive rate × max(0, profit − hurdle amount)

The manager earns the fee only on the excess above the hurdle.

Soft hurdle incentive fee

If profit > hurdle amount, incentive fee = incentive rate × total profit; otherwise 0

Once the hurdle is cleared, the fee applies to the whole profit.

Net return

Net return = gross return − management fee − incentive fee (as a % of starting NAV)

Fees are usually calculated in order: management fee first, then incentive fee on profit after it, unless the documents say otherwise.

Quick revision

• Due diligence has two parts: investment review and operational review. Both are needed.
• Check that strategy is clear, repeatable and consistent with what the manager says it does.
• A track record needs context: length, market conditions, size of assets then and now, and consistency of strategy.
• Style drift means the fund moves away from its stated strategy and is a warning sign.
• Judge returns alongside risk, such as volatility and drawdown, not returns alone.
• Match asset liquidity to redemption terms; illiquid assets with frequent redemptions create a run risk.
• Independent valuation is key; manager-controlled pricing of hard-to-value assets is a red flag.
• Independent administrator, auditor and prime broker or custodian reduce fraud risk.
• Weak controls, key-person dependence and unexplained returns are common fraud and failure signals.
• Check the manager's background, references, past conflicts and any regulatory or legal history.
• Governance includes board oversight, conflicts policy and clear fee and side-letter terms.
• Ask whether some investors get better liquidity or transparency terms than others, and what that means for you.

Common mistakes

• Treating due diligence as only a performance review. Fix: Remember that operational and legal review is a separate, equal pillar. Many failures are operational.
• Believing due diligence ends once you invest. Fix: Include ongoing monitoring and trigger-based re-review, such as key-person loss, style drift or redemptions.
• Treating high past returns as proof of skill. Fix: Always attribute returns to beta, factors and alpha, and ask whether the edge explains them.
• Ignoring capacity when assets have grown. Fix: Compare current assets and position sizes with market liquidity. Expect lower returns if the strategy has outgrown its capacity.
• Treating strong, steady returns as evidence of quality. Fix: Remember Madoff. Returns that are too smooth for the stated strategy are a red flag that needs explanation.
• Accepting that a big-name feeder fund has done the due diligence. Fix: Feeder funds often failed to verify the underlying manager. You remain responsible for checking independence and controls.
• Treating fund liquidity and asset liquidity as the same thing. Fix: Asset liquidity concerns selling positions. Fund liquidity concerns investor redemption terms. Always compare the two.
• Assuming that a fund with low net exposure has low leverage. Fix: Check gross exposure and financing. Leverage is measured against NAV using gross figures.
• Treating a high-water mark and a hurdle rate as the same thing. Fix: The HWM is about prior peak NAV and recovering losses. The hurdle is a minimum return over a period. A fund can have both.
• Charging the incentive fee on the full profit when the hurdle is hard. Fix: Hard hurdle: fee only on profit above the hurdle. Soft hurdle: fee on the whole profit once the hurdle is beaten.

Exam tips

• Questions often ask which source is most reliable. Choose independent third-party verification over manager statements.
• If the stem mentions valuation, fraud or controls, the answer is usually an operational due diligence item.
• Remember both phases: before investing and ongoing monitoring.
• Watch for words like first, best and most important, and rank your options accordingly.
• When a question gives raw returns, look for the hidden step: strip out beta or factor exposure before judging skill.
• Very smooth returns in an illiquid strategy usually point to smoothing or valuation issues, not exceptional skill.
• If assets have grown a lot, think capacity first, especially in small-cap, distressed or niche strategies.
• Between two plausible options, choose the one that requests independent evidence such as position-level data or attribution.