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

An investor is evaluating a hedge fund that claims a 12% annual return with 5% volatility, versus a peer group average of 9% return with 10% volatility. The investor's due diligence reveals that 40% of the fund's portfolio is in Level 3 illiquid positions valued by the manager, and positions are marked monthly using the manager's own models. Which additional step would most directly address the key risk implied by these findings?

The investor should obtain independent valuation of the Level 3 positions and test the manager's marks against third-party prices and realized sales, while reviewing valuation governance. Manager-modelled prices on illiquid assets can smooth returns and inflate fees, so the apparently high Sharpe ratio cannot be trusted.

  1. AIncrease the allocation because the Sharpe ratio is higher than peers
  2. BObtain independent valuation of the Level 3 positions, review the valuation policy and its governance, and test reported marks against third-party prices or realized sale pricesCorrect
  3. CReduce the review to the fund's fee structure and redemption terms
  4. DRely on the manager's valuation committee since the manager knows the positions best

Explanation

Large illiquid holdings priced by the manager's own models create valuation risk and incentive to smooth returns or inflate performance fees, which may explain the low volatility. The direct remedy is independent valuation review, testing marks against third-party quotes and realized exit prices, and examining valuation governance. A high Sharpe ratio built on subjective marks is not reliable evidence, and relying on the manager's own committee leaves the conflict unaddressed.

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