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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 stated strategy (liquid global macro futures) with its audited financials. The fund holds 40% of NAV in Level 3 assets, has side pockets, and has gated redemptions twice in three years, while offering monthly liquidity. The manager says all positions are priced by an in-house committee. Which is the most significant concern for the allocator?

The key concern is the mismatch between the stated liquid macro strategy and 40% Level 3 holdings, together with manager-controlled valuation. This signals style drift, liquidity mismatch evidenced by gates, and risk that NAV and fees are inflated. Side pockets and committees are not inherently improper if disclosed and independent.

  1. AA mismatch between strategy description and holdings, combined with manager-controlled valuation of illiquid assets, raising style drift, liquidity and NAV integrity risksCorrect
  2. BThe use of a pricing committee, because committees always produce biased valuations
  3. CThe monthly liquidity term, because longer lock-ups are always preferable to investors
  4. DThe existence of side pockets alone, because they are prohibited under standard hedge fund practice

Explanation

A liquid macro futures strategy should not hold large Level 3 assets. The gap indicates style drift, and in-house valuation of illiquid holdings lets the manager influence NAV and fees, while gates show liquidity mismatch. Side pockets are permitted tools when disclosed, and committees can be acceptable if independent, so those options overstate.

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