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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 with USD 800 million in assets. The fund's administrator is a small firm with no other clients of this size, and the fund's auditor is an unknown local practice. Which finding is the most significant operational red flag?

The most significant red flag is that the administrator and auditor are small, unrecognized firms relative to a USD 800 million fund. Such providers lack the capacity and independence to verify assets and valuations, which weakens controls and raises fraud risk. Monthly NAVs, foreign counsel and prime broker financing are normal.

  1. AThe fund uses a prime broker that is also its main source of financing
  2. BBoth the administrator and auditor are tiny, unrecognized firms, weak relative to the fund's sizeCorrect
  3. CThe fund's legal counsel is located in a different country from the manager
  4. DThe fund publishes monthly rather than daily net asset values

Explanation

Service providers that are too small or lack reputation for a fund of this size cannot provide effective independent verification of assets and valuation. This was a central lesson of Madoff-type frauds. The other items are common, acceptable practices and do not by themselves indicate weak controls.

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