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Show how to carry out due diligence on the operational setting of a hedge fund.

FRM® Part II · Risk Management and Investment Management · Performing Due Diligence on Specific Managers and Funds · FRM2.IM.12.e

The idea

Operational due diligence examines the infrastructure around the portfolio, since most failures originate there. The investor checks the independent service providers: an administrator that calculates the net asset value and keeps the investor register, an auditor of suitable size and reputation, prime brokers and custodians, and legal counsel. It reviews the valuation policy, especially for illiquid positions, and whether prices come from independent sources. It tests trade confirmation and reconciliation, segregation of duties between front and back office, and dual authorization of cash movements. It also covers compliance and personal trading rules, information technology, cyber security, and business continuity plans. Service providers affiliated with the manager are a warning sign because they weaken independence. The exam point is verification through direct contact with the third parties, not reliance on the manager's description.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which service provider is normally responsible for independently calculating a hedge fund's net asset value and maintaining the investor register?

  1. The administrator - correct
  2. The prime brokerWhy not: The prime broker provides financing, custody and execution, not the independent NAV.
  3. The auditorWhy not: The auditor gives an annual opinion on the financial statements; it does not strike the periodic NAV.
  4. Legal counselWhy not: Counsel drafts and advises on legal documents and does not calculate NAV.

The administrator strikes the NAV and keeps the register, which makes it a key independent check on the manager's reported values.

A harder one

Which control best reduces valuation risk for a fund holding illiquid positions?

  1. Valuations prepared solely by the portfolio manager, since he knows the positions bestWhy not: The person whose fees depend on the value should not set it.
  2. Valuations set once a year by the auditor at the auditWhy not: Annual audit pricing comes too late to protect monthly NAVs and subscriptions.
  3. An administrator who prices from third-party sources under a written valuation policy, with manager overrides documented and reviewed - correct
  4. Valuations that use the manager's internal model without any sourcesWhy not: A model with no external validation can be tuned to show smooth results.

Independent pricing sources, a written policy and a documented override process limit the manager's ability to influence the NAV.

The hardest tier

A fund's administrator is a subsidiary of an affiliate of the manager, the fund uses a single prime broker that also acts as custodian, and legal counsel is in-house. Which weakness is most serious for the integrity of the reported NAV?

  1. The administrator's lack of independence from the manager - correct
  2. The use of a single prime broker, which concentrates counterparty exposureWhy not: A real risk, but the NAV's integrity depends on who computes it, not on the number of brokers.
  3. The prime broker also acting as custodian, which concentrates safekeepingWhy not: A concentration concern, but it does not itself allow the manager to influence reported values.
  4. The use of in-house legal counsel, which may limit the quality of document reviewWhy not: A weakness for legal protection, not for how NAV is computed.

An affiliated administrator cannot give an independent check on the manager's valuations, which is its main purpose. The other items add risks but do not affect NAV independence.

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