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

An investor reviews a fund that reported monthly returns with a first-order autocorrelation of 0.45, a low reported volatility of 3% annualized, and a large share of illiquid positions marked by the manager. Which interpretation and action is most appropriate?

The pattern suggests return smoothing from stale or manager-influenced valuations, which understates true volatility and inflates the Sharpe ratio. The investor should unsmooth the return series and recalculate risk and performance measures rather than treating the low reported volatility or persistent returns as evidence of skill.

  1. ATreat the low volatility as accurate, because smoothing improves risk-adjusted returns
  2. BConclude the fund has positive alpha because returns are persistent
  3. CSuspect return smoothing from stale or manager-influenced marks, so unsmooth the returns and re-estimate volatility and the Sharpe ratio before relying on themCorrect
  4. DIgnore autocorrelation because it only affects skewness, not volatility

Explanation

High positive autocorrelation in a fund of illiquid assets suggests smoothed or stale valuations, which understates true volatility and overstates the Sharpe ratio. The appropriate step is to unsmooth the series and recompute risk measures. Persistence is not evidence of alpha, and smoothing biases volatility downward.

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