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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

An investor reviewing a hedge fund notes that the fund reports monthly returns with unusually low volatility and high positive first-order autocorrelation, and that many holdings are Level 3 assets valued by the manager. What is the most likely effect on the fund's reported statistics?

Smoothed valuations of illiquid assets create positive autocorrelation, which biases measured volatility downward and understates market beta. Because the Sharpe ratio divides return by volatility, it is overstated. The fund appears less risky than it truly is.

  1. AReported volatility and Sharpe ratio are understated and overstated respectively, i.e., volatility is biased downward and the Sharpe ratio upwardCorrect
  2. BReported volatility is biased upward and the Sharpe ratio downward
  3. CReported beta to equity markets is overstated, but volatility is unaffected
  4. DReported skewness is overstated and kurtosis is unaffected

Explanation

Smoothed or stale marks create positive autocorrelation, which dampens measured volatility and correlations with markets. Since the Sharpe ratio divides excess return by volatility, it is biased upward. Option B reverses the direction.

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