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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

A fund of funds allocates equally to two hedge funds. In stressed markets the funds' correlation rises sharply toward 1, and both impose redemption gates. Which risk is most directly highlighted by this scenario?

The scenario highlights lost diversification as correlations rise in stress, combined with a liquidity mismatch, since underlying funds gate redemptions while the fund of funds may still face investor withdrawals. Neither interest rate risk nor fee savings is the issue described.

  1. ALoss of diversification benefits and liquidity mismatch between FoF investor terms and underlying fund termsCorrect
  2. BPure interest rate risk
  3. CReduction in incentive fee costs
  4. DElimination of manager selection risk

Explanation

Correlations converging in stress reduce diversification, and gates in underlying funds can prevent the FoF from meeting its own investors' redemptions, creating a liquidity mismatch. The scenario does not describe interest rate risk, fee reduction or removal of selection risk.

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