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

A fund of funds allocator learns that a feeder fund's assets are managed by a broker-dealer that also acts as the fund's investment adviser, custodian of securities, and executor of trades, with a tiny, unknown auditor. Which conclusion best reflects sound due diligence applied to the Madoff mechanics?

Concentrating adviser, broker, custodian and execution roles in one firm removes independent verification of assets and trades, which is a serious operational red flag. Combined with a tiny unknown auditor, it meant nobody could confirm the positions existed, making fraud easy to conceal.

  1. AThe arrangement is efficient and lowers fees, so it reduces operational risk
  2. BConcentration of roles removes independent checks and creates a serious operational red flagCorrect
  3. COnly the auditor's size matters, since the other roles are a normal part of hedge fund structure
  4. DThe arrangement is acceptable if the returns are consistently positive

Explanation

Independent administrators, custodians, prime brokers and reputable auditors provide cross-checks on the existence of assets and trades. Madoff combined adviser, broker and custodian roles and used a small audit firm, so nobody independent verified positions. Good returns do not substitute for these controls.

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