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

During operational due diligence on a hedge fund, an analyst finds that the fund's administrator, auditor and prime broker are all small, unknown firms, and that the manager's COO also serves as the fund's chief compliance officer. Which conclusion is most appropriate?

These findings are red flags. Sound operational due diligence expects reputable, independent administrators, auditors and prime brokers, plus segregation of duties between operations and compliance. Obscure providers and an overlapping COO and compliance role weaken independent verification and create fraud risk.

  1. AThe arrangement is acceptable because small service providers lower fees and thereby reduce risk
  2. BIndependent third-party service providers of recognized quality and segregation of duties are expected, so these are red flagsCorrect
  3. COnly the auditor's quality matters, so the other findings can be ignored
  4. DThe combination of roles reduces conflict of interest because one person has full oversight

Explanation

Operational due diligence looks for reputable independent administrators, auditors and custodians and segregation of duties. Unknown providers and a combined operations/compliance role weaken controls, as in the Madoff case. Fee savings do not offset control weakness.

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