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 to run 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 other significant clients, and the fund's advisor also acts as its own broker-dealer and custodian. Which feature of this set-up most directly undermines the independent verification of the fund's assets and reported trades?
The most direct problem is that one entity manages the assets, executes the trades and holds custody. With no independent custodian or broker, nobody outside the manager can confirm that trades happened or assets exist, so verification is undermined. Smooth returns are suspicious but do not remove verification.
- AThe fund's reported returns have very low volatility
- BAsset management, brokerage and custody are all performed by the same entityCorrect
- CThe fund charges no incentive fee
- DThe fund is offered only to institutional investors
Explanation
When the advisor also acts as broker-dealer and custodian, no independent third party confirms that trades occurred or that assets exist. This is the core structural red flag in the Madoff case. Low volatility is a performance warning sign, but it does not itself remove independent verification.
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