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

An allocator is reviewing a hedge fund manager that has recently reported strong, unusually smooth returns. During operational due diligence, which finding is the most significant red flag for potential fraud?

The mismatch between fund size and complexity and an obscure, inexperienced auditor is the biggest red flag. Independent oversight is a key fraud control, and a weak auditor undermines it. Reputable administrators, standard fees, and regular investor letters are normal and do not indicate fraud.

  1. AThe fund uses a well-known prime broker and an independent administrator that strikes the NAV
  2. BThe fund's auditor is an unknown, very small firm with no experience auditing funds of this size and complexityCorrect
  3. CThe manager charges a 1.5% management fee and 20% performance fee
  4. DThe manager publishes monthly investor letters with commentary on positioning

Explanation

An unqualified, tiny auditor for a large and complex fund is a classic service-provider red flag, as seen in major fraud cases. Independent administrators and prime brokers reduce risk, and standard fee levels and regular letters are normal practice.

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