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FRM Part II · FRM Exam Part II · Risk, Regulation and Organizational Structure

A fund of hedge funds receives a 1% management fee on assets, and its underlying managers charge 2 and 20. The fund of funds manager is considering two potential allocations: a transparent, liquid manager charging 1 and 10, and an opaque manager charging 2 and 20 who offers the fund of funds a rebate of 0.5% of invested assets annually, paid to the fund of funds manager personally. Which assessment is most appropriate?

The undisclosed personal rebate is a conflict of interest because it rewards the allocator for choosing the more expensive, opaque manager rather than the best one for investors. It should be disclosed or passed through to investors; the existence of an existing management fee does not justify it.

  1. AThe undisclosed rebate creates a conflict that biases selection toward the opaque manager and must be disclosed or passed through to investorsCorrect
  2. BThe rebate is acceptable because the fund of funds already charges a management fee
  3. CThe rebate is only a problem if the opaque manager underperforms
  4. DThe rebate reduces risk because it lowers net fees paid by the manager

Explanation

A personal rebate gives the allocator a financial incentive unrelated to investor interest, which biases manager selection toward the costlier, less transparent option. Whether performance later disappoints is irrelevant to the existence of the conflict. Best practice is to disclose such arrangements or pass the rebate to investors, so the stated approach is the appropriate one.

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