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

A fund of funds reviews a manager reporting very smooth monthly returns with only 2 negative months in 10 years, while claiming a strategy with option-selling exposure in volatile markets. Which analytical step best tests for possible fabricated or misvalued returns?

The best step is to compare returns with peers, look for implausibly low volatility and serial correlation, and verify against independent prime broker statements. Overly smooth returns for an option-selling strategy suggest smoothing, misvaluation or fabrication, so third-party verification is needed rather than trusting reported figures.

  1. ACompare reported returns with those of the strategy's peers and check for implausibly low volatility and serial correlation, then verify against prime broker statementsCorrect
  2. BIncrease the allocation, since low volatility implies low risk
  3. CRely on the manager's own marketing material for the Sharpe ratio
  4. DConfirm the fund has a high-water mark provision

Explanation

Returns that are too smooth for the stated strategy, or that show positive serial correlation, suggest stale or smoothed pricing or fabrication. Independent verification with third-party records such as prime broker statements tests this. The other options accept the numbers without challenge or address fees.

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