CFM Due Diligence & Fund Selection 5 — Questions and Answers
Question 1: A fund manager presents a 5-year track record with a Sharpe ratio of 1.5, but the entire track record was generated at a prior firm. Under GIPS standards, how should this 'portable alpha' track record be treated?
- It is fully valid and must be presented to all prospects
- It may be presented only if the team and process are substantially intact and properly disclosed (Correct answer)
- It cannot be used under any circumstances for marketing purposes
- It is automatically compliant as long as it is audited
Correct answer: It may be presented only if the team and process are substantially intact and properly disclosed
GIPS allows portability of track records from prior firms only if the investment decision-making process is substantially similar and the claim is properly disclosed.
Question 2: Which due diligence finding most directly raises concerns about a fund's valuation independence?
- The fund uses a third-party administrator for NAV calculation
- The portfolio manager has authority to override third-party valuations for Level 3 assets (Correct answer)
- The fund's auditor is a regional rather than Big Four firm
- The fund rebalances quarterly rather than monthly
Correct answer: The portfolio manager has authority to override third-party valuations for Level 3 assets
Allowing portfolio managers to override independent valuations for hard-to-price assets creates a severe conflict of interest and undermines valuation integrity.
Question 3: In the context of hedge fund due diligence, what is the significance of a fund's 'capacity constraint'?
- The maximum number of investors a fund can legally accept
- The AUM level beyond which the strategy's returns may deteriorate due to market impact (Correct answer)
- The fund's regulatory limit on leverage expressed as a ratio
- The maximum allocation any single investor can make to the fund
Correct answer: The AUM level beyond which the strategy's returns may deteriorate due to market impact
Capacity constraints arise because some strategies, especially in less liquid markets, cannot be scaled without the fund's own trading moving prices against itself.
Question 4: During qualitative due diligence, an analyst interviews multiple former employees of a fund who describe a culture of intimidation and suppression of risk concerns. This should be weighted as:
- Anecdotal information with no bearing on investment decision
- A significant governance red flag that may indicate elevated operational and fraud risk (Correct answer)
- Normal competitive culture consistent with high-performing investment teams
- A minor concern that can be offset by superior quantitative performance metrics
Correct answer: A significant governance red flag that may indicate elevated operational and fraud risk
A culture that suppresses risk-raising is a governance failure that historically precedes operational failures and fraud, as seen in cases like Madoff and Amaranth.
Question 5: Which factor would most likely cause an investor to reject an otherwise attractive fund during the final stage of due diligence?
- The fund's benchmark has underperformed the S&P 500 over 3 years
- An unresolved SEC investigation disclosed in the fund's Form ADV (Correct answer)
- The fund's management fee is 10 basis points above the peer average
- The fund's portfolio turnover rate exceeds 100% annually
Correct answer: An unresolved SEC investigation disclosed in the fund's Form ADV
An unresolved regulatory investigation represents material legal and reputational risk that can threaten the fund's ability to operate, making it a potential deal-breaker.
Question 6: What is 'look-through' analysis in the context of fund of funds due diligence?
- Examining a fund manager's personal investment account for conflicts
- Aggregating underlying fund positions to assess true portfolio-level exposures and concentrations (Correct answer)
- Reviewing historic performance by looking through periods of market stress
- Analyzing a fund's fee structure to identify hidden costs beyond the stated management fee
Correct answer: Aggregating underlying fund positions to assess true portfolio-level exposures and concentrations
Look-through analysis consolidates all underlying holdings across manager allocations to reveal the fund of funds' true exposure to specific securities, sectors, or risk factors.
Question 7: A pension fund is selecting between an active equity fund with 2% tracking error and a passive index fund. Which scenario would most justify paying the higher fees for the active fund?
- The pension fund has a long investment horizon and low liquidity needs
- The manager has demonstrated statistically significant alpha net of fees over a full market cycle (Correct answer)
- The active fund has lower absolute volatility than the index
- The active fund invests in the same benchmark securities as the index
Correct answer: The manager has demonstrated statistically significant alpha net of fees over a full market cycle
Active management fees are only justified when a manager can demonstrate persistent, statistically significant net-of-fee alpha across different market conditions.
CFM Due Diligence & Fund Selection 5
A fund manager presents a 5-year track record with a Sharpe ratio of 1.5, but the entire track record was generated at a prior firm.
Under GIPS standards, how should this 'portable alpha' track record be treated?