FRM Part II · FRM Exam Part II · Performing Due Diligence on Specific Managers and Funds
A fund of funds analyst reviews a hedge fund whose monthly returns show unusually low volatility and almost no down months for six years, despite a strategy trading illiquid credit positions. The fund is administered by a small firm owned by the manager's relative and audited by a one-person practice. What is the most appropriate conclusion in the due diligence process?
The analyst should treat smooth returns that do not fit an illiquid strategy, combined with a related-party administrator and a tiny auditor, as a serious red flag and escalate before allocating. Independent, competent service providers are essential, and an audit by a weak firm provides little assurance.
- AThe smooth track record is strong evidence of skill, so operational concerns are secondary
- BTreat the combination of implausible returns and weak independence of service providers as a serious red flag requiring escalation before any allocationCorrect
- CRely on the audit opinion because audited returns are verified by definition
- DReduce the proposed allocation slightly and proceed without further work
Explanation
Returns inconsistent with the strategy's liquidity profile, together with related-party administration and a tiny auditor, are classic red flags (as in Madoff). Independence and capability of service providers are core ODD checks, and a small auditor cannot give comfort on its own. Proceeding with only a smaller allocation ignores the unresolved risk.
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