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

A due diligence team reviews a fund reporting steady monthly returns with annual volatility of 2% and an average annual return of 12%, using a supposedly split-strike equity strategy, with a risk-free rate of 3%. What is the Sharpe ratio, and how should it be interpreted?

The Sharpe ratio is (12% minus 3%) divided by 2%, which equals 4.5. That is implausibly high for an equity-linked strategy and is a classic fraud warning sign, so it calls for forensic review of the returns and trading records.

  1. A1.5, which is plausible and consistent with a typical equity strategy
  2. B4.5, which is unusually high for the stated strategy and warrants forensic scrutinyCorrect
  3. C6.0, which is unusually high because the risk-free rate is ignored
  4. D0.75, which shows poor risk-adjusted performance

Explanation

Sharpe = (12% - 3%) / 2% = 4.5. Such a figure for an equity-linked strategy is implausibly high and is a classic red flag, as in Madoff. 6.0 ignores the risk-free rate; 1.5 and 0.75 are arithmetic errors.

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