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

A due diligence analyst reviews a fund that claims to run a split-strike conversion strategy (long equities hedged with collars) and reports only one down month in several years, with returns that are smooth and almost uncorrelated with the equity index in down markets. Which conclusion is most appropriate?

The smooth record is a red flag. A collar strategy retains market exposure between its strike levels, so it should show some losing months and variability in falling markets. Almost no down months is inconsistent with the stated strategy and suggests the reported returns may not be genuine.

  1. AThe track record is a red flag because the stated strategy should show equity-like losses in sharp market declines and some return variabilityCorrect
  2. BThe track record is reassuring because a collar strategy should eliminate all losses
  3. CThe track record is acceptable because low correlation always indicates skilled hedging
  4. DThe track record is irrelevant because performance should not be used in due diligence

Explanation

A collared equity portfolio still has exposure to the market within the band between put and call strikes and gives up upside. Near-constant positive returns with almost no down months are inconsistent with that payoff, so the pattern signals possible misreporting. Option B overstates what collars do, since they limit but do not remove losses.

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