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FRM Part II · FRM Exam Part II · Case Study: Investor Protection and Compliance Risks in Investment Activities

A fund administrator notes that a hedge fund's reported returns are consistently smooth, its auditor is an unknown one-person firm, and the manager also acts as custodian of assets. Which remedy most directly reduces the compliance and fraud risk seen in these red flags?

Requiring independent custody and a reputable independent auditor most directly reduces the risk. The red flags show missing independent verification, since the manager holds the assets and a tiny auditor signs off. Independent third parties prevent fabricated assets or returns, unlike higher fees, more frequent self-reporting or extra feeders.

  1. ARequire independent custody and a reputable independent auditorCorrect
  2. BIncrease the performance fee to align incentives
  3. CShorten the investor reporting period to weekly
  4. DAdd more feeder funds to diversify investors

Explanation

The red flags are lack of independent verification: a tiny auditor and self-custody. Independent custody and a reputable auditor remove the manager's ability to fabricate assets or returns. Higher fees, more frequent self-reported statements or feeders do not add independent verification.

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