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FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags

A due diligence analyst notes that a manager is also its fund's sole general partner and that the fee structure pays the manager only a commission on trades, with no performance or management fee. Which interpretation is most consistent with the Madoff reading?

The unusual fee arrangement is a warning sign. Madoff took only commissions while feeders earned the big fees, which is economically odd for a truly profitable strategy and signals that the real structure and incentives need scrutiny. Lower fees do not reduce operational risk.

  1. AThe structure aligns incentives well because the manager earns nothing unless trades occur
  2. BThe unusual fee arrangement is a warning sign: the manager may be forgoing visible fees while feeders collect them, raising questions about who is really being paid and whyCorrect
  3. CThe structure is a positive because lower fees increase the investors' net returns
  4. DThe structure removes operational risk because the manager is not paid on performance

Explanation

Madoff charged only commissions while feeder funds collected the large management and performance fees. Such an arrangement is economically odd for a genuine, highly profitable strategy and should prompt questions about the real economics. It does not reduce operational risk.

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