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

A fund of funds allocated to a manager after reviewing the manager's reported returns, which showed only 4 down months in 15 years and low volatility, with the claimed strategy being a split-strike conversion on large-cap equities. Which due diligence step would best expose a fundamental inconsistency?

The best step is to test feasibility by comparing the option volume the strategy would require with total listed option market volume and by matching reported trade prices and timing to exchange data. This exposes whether the claimed strategy could actually produce the reported returns.

  1. AComparing the manager's fee schedule with peers
  2. BChecking that the reported returns match the manager's marketing brochure
  3. CConfirming the manager's office location and staff headcount
  4. DCross-checking the volume of options the strategy would need against total listed option market volume and the reported trade timing against exchange dataCorrect

Explanation

A strategy of that size would require option volume that dwarfs the market's open interest, and reported trades at prices inside the daily range should be verifiable against exchange records. Such feasibility testing reveals that the stated strategy cannot produce the reported results. Fee comparison, brochure matching, and headcount checks do not test strategy feasibility.

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