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

A feeder fund invests all of its assets with a single master manager and tells its own investors that it performs extensive due diligence on that manager. In a post-mortem after the master fund is revealed to be fraudulent, which finding would best show that the feeder's due diligence was inadequate and not merely unlucky?

The strongest evidence is that the feeder simply accepted the manager's statements and never independently verified trading, custody or the auditor. Good due diligence tests claims against independent sources. Investor losses, fees or positive returns describe outcomes or features, not a failure of process.

  1. AThe feeder's investors suffered losses when the fraud was exposed
  2. BThe feeder relied on the manager's own statements and never independently verified trading, custody or the auditorCorrect
  3. CThe master fund's reported returns were positive in most years
  4. DThe feeder charged a management fee on assets invested

Explanation

Adequate due diligence requires independent verification of operations, custody, trade existence and service providers. Relying on the manager's own assertions fails this. Investor losses and fees are outcomes, not evidence of process failure, and positive returns do not show inadequacy.

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