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

A hedge fund firm manages two vehicles: Fund A, a flagship with a 20% incentive fee and large proprietary staff capital, and Fund B, a smaller fund with the same fee. A hot, capacity-limited trade becomes available. Which allocation policy best manages the conflict of interest across the two funds' investors?

Allocate pro rata under pre-established written rules applied consistently and monitored by compliance. This removes discretion that could favor the vehicle benefiting the manager most, and prevents ex post cherry-picking. Favoring the fund with staff capital or choosing after seeing results would disadvantage investors in the other fund.

  1. AAllocate the entire trade to Fund A because it has staff capital invested
  2. BAllocate pro rata based on pre-established written rules applied consistently and monitored by complianceCorrect
  3. CAllocate to whichever fund had worse recent performance to help it recover
  4. DLet the portfolio manager decide ex post after seeing the trade's outcome

Explanation

Preset written pro rata rules, enforced by compliance, remove discretion that could favor the fund benefiting the manager most. Favoring Fund A for staff capital, or choosing after the outcome (cherry-picking), disadvantages Fund B investors. Allocating to the laggard is also discretionary and arbitrary.

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