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

A hedge fund reports monthly returns with a standard deviation of 1.0% and a first-order autocorrelation of +0.50 that the due diligence team suspects stems from smoothed pricing of illiquid holdings. Relative to the true economics, which statement best describes the reported figures?

Positive autocorrelation from smoothed valuations typically understates reported volatility, which in turn overstates the Sharpe ratio. Prices of illiquid assets adjust slowly, dampening measured variance while leaving average returns unchanged, so risk-adjusted performance looks better than the true economics.

  1. AReported volatility and Sharpe ratio are likely understated and overstated respectivelyCorrect
  2. BReported volatility is likely overstated and the Sharpe ratio understated
  3. CReported volatility is unaffected, but the Sharpe ratio is overstated because of skewness
  4. DReported correlation to equities is likely overstated, with volatility unaffected

Explanation

Smoothing produces positive serial correlation and dampens measured variance, so volatility is biased downward. With the same mean return in the numerator, the Sharpe ratio is biased upward. Correlations to market factors are also typically understated, not overstated.

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