CFM Due Diligence & Fund Selection 3 — Questions and Answers
Question 1: A fund of funds manager is conducting due diligence on an underlying hedge fund. Which factor most directly addresses 'key-man risk'?
- The fund's leverage limits stated in its offering memorandum
- Whether succession plans exist if the lead manager departs (Correct answer)
- The fund's redemption gate provisions
- The number of prime brokers used by the fund
Correct answer: Whether succession plans exist if the lead manager departs
Key-man risk is mitigated when a fund has clearly documented succession plans and a team-based investment process not solely dependent on one individual.
Question 2: In quantitative fund analysis, maximum drawdown is most useful for assessing which risk characteristic?
- Portfolio concentration in a single sector
- The worst peak-to-trough loss experienced over a period (Correct answer)
- Average annual volatility relative to benchmark
- Correlation to equity market indices
Correct answer: The worst peak-to-trough loss experienced over a period
Maximum drawdown captures the largest cumulative loss from a peak, directly reflecting downside risk and the magnitude of potential loss an investor could face.
Question 3: Which of the following is a 'red flag' in a hedge fund's audited financial statements during due diligence?
- Use of a Big Four auditing firm
- Auditor's qualified opinion on valuation of Level 3 assets (Correct answer)
- Net asset value reconciliation with custodian records
- Timely delivery of financial statements within 90 days
Correct answer: Auditor's qualified opinion on valuation of Level 3 assets
A qualified audit opinion on Level 3 asset valuation suggests the auditor could not fully verify hard-to-price assets, indicating potential valuation risk.
Question 4: A fund charges a 2% management fee and 20% performance fee with a hard hurdle rate of 6%. If the fund returns 10%, what is the performance fee base?
- 10% of total AUM
- 4% of total AUM (returns above the hurdle) (Correct answer)
- 20% of total AUM
- 10% minus management fee on total AUM
Correct answer: 4% of total AUM (returns above the hurdle)
With a hard hurdle rate, performance fees apply only to returns exceeding the hurdle, so 10% - 6% = 4% of AUM is the performance fee base.
Question 5: During fund selection, a due diligence checklist includes a review of the fund's trade reconciliation process. What specific risk does this address?
- Currency hedging efficiency
- Operational errors and unauthorized or erroneous trades going undetected (Correct answer)
- Market timing by investors exploiting NAV lag
- Tracking error versus the benchmark index
Correct answer: Operational errors and unauthorized or erroneous trades going undetected
Trade reconciliation ensures that positions recorded by the fund match prime broker and custodian records, catching operational errors and potential fraud.
Question 6: What is the primary purpose of a 'side pocket' in a hedge fund?
- To segregate liquid assets for rapid redemption
- To isolate illiquid or hard-to-value investments from the main portfolio (Correct answer)
- To hold manager co-investment capital separately from client assets
- To accumulate management fees before quarterly distribution
Correct answer: To isolate illiquid or hard-to-value investments from the main portfolio
Side pockets separate illiquid investments so they are not subject to redemption pressures, protecting both the fund and redeeming investors from forced fire sales.
Question 7: When comparing two funds with identical Sharpe ratios, which additional metric would best differentiate their downside risk profiles?
- Standard deviation
- Beta to benchmark
- Sortino ratio (Correct answer)
- Information ratio
Correct answer: Sortino ratio
The Sortino ratio uses only downside deviation instead of total standard deviation, making it a better measure of downside risk when Sharpe ratios are equivalent.
CFM Due Diligence & Fund Selection 3
A fund of funds manager is conducting due diligence on an underlying hedge fund.
Which factor most directly addresses 'key-man risk'?