Due Diligence & Fund Selection Flashcards
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Read the first 7 Due Diligence & Fund Selection flashcards as text
A fund of funds manager is conducting due diligence on an underlying hedge fund. Which factor most directly addresses 'key-man risk'?
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.
In quantitative fund analysis, maximum drawdown is most useful for assessing which risk characteristic?
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.
Which of the following is a 'red flag' in a hedge fund's audited financial statements during due diligence?
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.
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?
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.
During fund selection, a due diligence checklist includes a review of the fund's trade reconciliation process. What specific risk does this address?
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.
What is the primary purpose of a 'side pocket' in a hedge fund?
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.
When comparing two funds with identical Sharpe ratios, which additional metric would best differentiate their downside risk profiles?
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.