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

During due diligence, an allocator notes that a hedge fund's reported monthly returns show strong positive first-order autocorrelation and unusually low volatility, despite holding many illiquid positions. What is the most likely implication and the best response?

Serial positive autocorrelation with low volatility in an illiquid portfolio suggests smoothed returns from stale or discretionary pricing, which understates risk and flatters the Sharpe ratio. The allocator should unsmooth the returns and scrutinize pricing sources rather than accept the numbers or presume fraud.

  1. AReturns are likely smoothed by stale or model-based pricing, so reported volatility and Sharpe ratio are overstated in quality; the allocator should unsmooth returns and review pricing sourcesCorrect
  2. BThe fund is genuinely low risk, so no further review is required
  3. CThe autocorrelation proves fraud and the allocator should redeem immediately without further analysis
  4. DThe pattern shows the manager uses high leverage, so volatility is understated only because of fees

Explanation

Positive autocorrelation with low volatility in illiquid holdings is a classic sign of return smoothing from stale or discretionary marks. This understates risk and inflates Sharpe ratios. The appropriate step is to adjust returns and investigate pricing. It is a red flag, not proof of fraud.

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