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

An allocator discovers that a hedge fund's offering documents give the manager broad discretion to value hard-to-price positions using its own models, and the same manager's affiliate sits on the valuation committee. What is the best due diligence recommendation?

The allocator should require independent valuation oversight under a documented policy and review how much of the portfolio is hard to value. Manager-controlled pricing is a conflict of interest, and low volatility or an annual audit does not resolve it.

  1. AAccept the arrangement if the fund's reported volatility is low
  2. BRequire independent valuation oversight, such as the administrator or a third-party pricer applying a documented policy, and review the share of Level 3 assetsCorrect
  3. CAsk for more frequent NAV reporting only
  4. DRely on the auditor's annual opinion alone

Explanation

Manager-controlled valuation of illiquid assets creates a conflict of interest, and low reported volatility can itself result from smoothed marks. Independent valuation with a documented policy and monitoring of hard-to-value holdings addresses the root conflict; frequency or annual audits do not.

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