FRM Part II · FRM Exam Part II · Performing Due Diligence on Specific Managers and Funds
During due diligence, an analyst finds that a hedge fund claims to trade large-cap equity options, but its auditor is a one-person accounting practice, and the fund's custodian is the manager's own brokerage affiliate. Which action best addresses the key operational risk this combination creates?
The best action is to verify assets and trades directly with an independent third-party custodian or prime broker and evaluate the auditor's competence and independence. The problem is missing independent verification, which fee terms, manager-supplied reports or investor references cannot fix.
- ARequest a higher performance-fee hurdle to compensate for the risk
- BIndependently confirm assets and trade records directly with a third-party prime broker or custodian and assess the auditor's capacity and independenceCorrect
- CRely on the manager's monthly performance reports because they are audited annually
- DAsk the manager to supply a reference letter from existing investors
Explanation
The risk is lack of independent verification of existence and ownership of assets. Direct confirmation from an independent custodian and an assessment of auditor competence address it. Fee changes do not mitigate fraud risk, and manager-prepared reports or investor references are not independent evidence.
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