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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 reports steady monthly returns of about 1% with almost no down months over 15 years, attributed to a 'split-strike conversion' strategy on large-cap equities. Which feature of this record is the most important red flag consistent with the Madoff case?

The most important red flag is returns that are too smooth and consistent for the stated strategy. A split-strike conversion on equities should show market-related variability and some sizeable down months, so a near-unbroken record of steady gains signals that the reported results may be fabricated.

  1. AReturns that are too smooth and consistent for the stated strategy and market conditionsCorrect
  2. BReturns that are positively correlated with the equity market
  3. CA fund strategy that uses listed index options
  4. DA manager who charges no performance fee

Explanation

In the Madoff case, the extremely consistent returns, with very few losing months, were inconsistent with a long equity and options collar strategy that should have shown market-related variability. Correlation with equities and use of listed options are expected for such a strategy, and a missing performance fee is a separate structural oddity rather than the key return-based flag.

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