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

An allocator is conducting operational due diligence on a hedge fund that holds mostly Level 3 securities. Which of the following is the strongest indicator that the valuation process is independent and reliable?

A valuation committee that includes people outside the front office, combined with an independent administrator using third-party pricing sources, is the strongest sign of reliable valuation. It separates pricing from the portfolio manager, who has an incentive to inflate marks and so earn higher performance fees.

  1. AThe portfolio manager sets month-end prices, and the administrator records them without challenge
  2. BA valuation committee including members outside the front office reviews prices, and an independent administrator uses third-party sourcesCorrect
  3. CThe fund's prime broker provides the only marks, and these are never compared to other sources
  4. DThe fund's auditor reviews valuations once a year, with no checks during the year

Explanation

Independence requires that pricing is not controlled by those who earn performance fees. A valuation committee with non-front-office members, plus an independent administrator using third-party sources, separates valuation from portfolio management. Manager-set prices create a conflict of interest, and a single source or annual-only review is weaker.

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