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CFA Level I · CFA Level I Exam · Alternative Investment Features, Methods, and Structures

During operational due diligence on a hedge fund, which finding would a prospective investor most likely view as the greatest red flag?

The greatest red flag is an administrator owned by the fund's manager. This removes independent verification of valuations and records, creating a conflict of interest and fraud risk. A foreign prime broker and a high-water mark performance fee are not inherently problematic and the latter favors investors.

  1. AThe fund uses a prime broker located in a different country from its manager
  2. BThe fund's administrator is a small firm that is also owned by the fund's managerCorrect
  3. CThe fund charges a performance fee subject to a high-water mark

Explanation

An administrator owned by the manager lacks independence, so net asset value calculation and record keeping could be manipulated. A foreign prime broker is not itself a concern, and a high-water mark protects investors.

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