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

A fund-of-funds allocator is reviewing a hedge fund that claims a split-strike conversion strategy, yet reports almost no losing months over many years. The fund's auditor is a three-person firm with no apparent experience auditing funds of this size. Which finding is the most significant operational due diligence red flag?

The most significant red flag is an auditor that is too small and inexperienced for the fund's size and complexity. Such an auditor cannot provide credible independent verification of assets and performance, whereas net-of-fee reporting and listed options are ordinary features.

  1. AThe auditor is far too small and inexperienced for the amount of assets and complexity it is attesting toCorrect
  2. BThe fund reports returns net of fees rather than gross of fees
  3. CThe fund's strategy uses listed equity options rather than OTC options
  4. DThe fund's manager is also registered as a broker-dealer

Explanation

An auditor whose capacity is clearly mismatched to the fund's size and complexity undermines the independent verification of assets and performance. Net reporting and use of listed options are normal. A manager also being a broker-dealer is a structural conflict, but the mismatched auditor is the classic independent-verification failure highlighted in the Madoff case.

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