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

An investor is performing operational due diligence on a hedge fund that holds mostly exchange-traded equities plus a small sleeve of privately negotiated, thinly traded credit positions. Which valuation practice would be the strongest indicator of a sound control environment?

The strongest practice is independent pricing by the administrator combined with review of illiquid marks by a valuation committee independent of the front office. This removes the portfolio manager's incentive to inflate values, whereas manager-supplied, annual, or selectively higher marks leave conflicts or stale valuations unaddressed.

  1. AThe portfolio manager provides month-end marks for the illiquid positions to the administrator
  2. BThe administrator independently sources prices for all positions and a valuation committee independent of the front office reviews the illiquid marksCorrect
  3. CThe fund's auditor sets the illiquid marks once a year at the audit date
  4. DThe prime broker's marks are used only when they are higher than the manager's marks

Explanation

Independence of pricing from the portfolio manager is the key control. Independent administrator pricing plus an independent valuation committee for hard-to-value assets limits conflicts of interest. Manager-provided marks create an incentive to inflate values, and annual audit pricing is too infrequent. Selecting the higher mark is biased.

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