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

A fund of hedge funds offers quarterly redemptions with 45 days notice. It plans to invest in a hedge fund with annual redemptions, a 2-year initial lock-up, and the right to impose a gate of 25% of fund NAV per redemption date. Which is the most important risk the due diligence team should highlight?

The key risk is a liquidity mismatch. The fund of funds offers quarterly redemptions, but the underlying fund has a lock-up, annual redemption dates and gates. In stress it may be unable to meet redemptions from the underlying holding, forcing sales of other assets and harming remaining investors.

  1. AAsset-liability mismatch between the fund of funds' liabilities and the underlying fund's liquidity termsCorrect
  2. BHigher management fees than typical for the strategy
  3. CLack of diversification in the underlying fund's benchmark
  4. DExposure to counterparty credit spreads

Explanation

The fund of funds promises quarterly liquidity to its investors but would hold an asset with lock-up, annual redemption and gates. In stress, it could not meet redemptions without selling other holdings, hurting remaining investors. The other items are not the issue raised by the terms given.

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