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

A due diligence team compares a hedge fund's monthly returns with those of its stated strategy peers. The fund reported 60 positive months out of 60, with monthly volatility of 0.4% and an average return of 0.9%. Peers with similar strategies show volatility near 2.5% and several negative months each year. What is the most appropriate response by the team?

The team should treat the unusually smooth returns as a red flag and investigate valuation, strategy and possible misreporting. Sixty positive months with very low volatility are inconsistent with peers of similar strategy, which suggests smoothing, hidden risk or fraud rather than superior skill.

  1. AAccept the record as evidence of superior skill and recommend allocation
  2. BTreat the unusually smooth returns as a red flag and investigate valuation, strategy description and possible misreporting before proceedingCorrect
  3. CConclude the fund is low risk and therefore apply leverage to its allocation
  4. DIgnore the comparison because peer groups are not meaningful for hedge funds

Explanation

Returns far smoother than strategy peers with no losing months are inconsistent with the strategy's risk and suggest smoothing, stale pricing, hidden risk or fraud. The proper step is to investigate valuation, trading records and independent confirmation. Accepting the record as skill or levering it repeats the mistake made by Madoff investors.

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