CFM Due Diligence & Fund Selection 4 — Questions and Answers
Question 1: An institutional investor is selecting between two bond funds. Fund A has higher yield but Fund B has better liquidity-adjusted returns. In an adverse market scenario, which consideration should take priority for a pension fund with near-term liabilities?
- Total return maximization regardless of liquidity
- Liquidity management to meet liability obligations (Correct answer)
- Minimizing tracking error to the benchmark
- Maximizing yield to boost income recognition
Correct answer: Liquidity management to meet liability obligations
Pension funds with near-term liabilities must prioritize liquidity to ensure they can meet obligations, making liquidity-adjusted returns more important than raw yield.
Question 2: Which regulatory filing would a due diligence analyst review to identify a U.S. registered fund's largest portfolio holdings on a quarterly basis?
- Form 13F
- Form N-Q or N-PORT (Correct answer)
- Form ADV Part 1
- Form 8-K
Correct answer: Form N-Q or N-PORT
Form N-PORT (formerly N-Q) is filed quarterly by registered investment companies and discloses complete portfolio holdings with position-level detail.
Question 3: During due diligence, you discover a fund manager's personal trading account shows patterns that precede fund trades. This most likely indicates:
- Efficient personal portfolio management
- Front-running, a serious violation of fiduciary duty (Correct answer)
- Disciplined co-investment alongside clients
- Normal rebalancing consistent with published investment policies
Correct answer: Front-running, a serious violation of fiduciary duty
Trading in a personal account ahead of client trades is front-running, which violates fiduciary duty and securities laws by profiting at clients' expense.
Question 4: What does a high 'autocorrelation' in monthly hedge fund returns typically suggest to a due diligence analyst?
- The fund has highly consistent returns with low volatility
- Returns may be smoothed or illiquid assets may be stale-priced (Correct answer)
- The fund employs a momentum-based trading strategy
- Management fees are being applied inconsistently over time
Correct answer: Returns may be smoothed or illiquid assets may be stale-priced
High autocorrelation in returns often signals that a fund is holding illiquid assets that are priced infrequently, making reported returns appear artificially smooth.
Question 5: In fund selection, a 'clawback provision' in a private equity fund's limited partnership agreement primarily protects:
- The general partner against excessive management fee clawbacks
- Limited partners from paying performance fees on returns that are later reversed (Correct answer)
- The fund from investor redemptions during the investment period
- The custodian from settlement fails by the fund
Correct answer: Limited partners from paying performance fees on returns that are later reversed
A clawback requires the GP to return previously paid carried interest if subsequent losses bring cumulative returns below the preferred return threshold.
Question 6: When assessing a fund's risk management framework, which document best reveals the internal governance structure for approving risk limit breaches?
- Monthly investor newsletter
- Risk governance policy and escalation procedures (Correct answer)
- Annual Form ADV amendment filing
- Subscription agreement and lock-up provisions
Correct answer: Risk governance policy and escalation procedures
A fund's risk governance policy defines who has authority to approve exceptions to risk limits, how breaches are escalated, and what remediation actions are required.
Question 7: A fund of funds allocates to 15 underlying managers. Which scenario most undermines the diversification benefit of this structure?
- All managers charge different fee structures
- High positive correlation among underlying managers' strategies (Correct answer)
- Underlying funds have different redemption frequency terms
- Managers are domiciled in multiple jurisdictions
Correct answer: High positive correlation among underlying managers' strategies
If underlying managers are highly correlated, the fund of funds provides little true diversification and investors bear multiple layers of fees for concentrated risk.
CFM Due Diligence & Fund Selection 4
An institutional investor is selecting between two bond funds.
Fund A has higher yield but Fund B has better liquidity-adjusted returns.
In an adverse market scenario, which consideration should take priority for a pension fund with near-term liabilities?