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

A fund of funds analyst examines a manager's monthly returns: the strategy is described as merger arbitrage, and reported returns show a standard deviation of 1.5% per month, with a lag-1 autocorrelation of +0.40. The manager holds some thinly traded securities valued by the manager. Using the common smoothing adjustment, which interpretation is most appropriate?

Positive autocorrelation of 0.40, combined with manager-valued thinly traded holdings, suggests smoothed returns. Reported volatility therefore likely understates true risk and the Sharpe ratio is overstated, so the analyst should unsmooth returns and scrutinize valuation practices.

  1. APositive autocorrelation suggests returns may be smoothed, so reported volatility likely understates true risk and Sharpe ratio is likely overstatedCorrect
  2. BPositive autocorrelation shows the manager has persistent skill, so volatility is overstated
  3. CAutocorrelation has no bearing on volatility estimates
  4. DPositive autocorrelation implies the fund is more liquid than peers

Explanation

Stale or manager-marked prices in illiquid holdings smooth returns and induce positive serial correlation. This biases measured volatility downward and inflates the Sharpe ratio. Unsmoothing would raise estimated volatility. Persistence of this kind is not evidence of skill or liquidity.

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