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

A fund-of-funds allocator reviewing a hedge fund that claims a split-strike conversion strategy on large-cap US equities finds that the fund's auditor is a three-person firm with no other significant clients, while the fund reports several billion dollars in assets. Which interpretation best reflects sound due diligence practice?

An auditor with three people covering a multi-billion-dollar fund is a red flag, because it lacks the capacity and independence to verify assets and trades credibly. Good returns or personal familiarity do not replace credible independent verification, so the allocator should treat the mismatch as a serious warning.

  1. AThe auditor's small size is a red flag because it lacks the capacity and independence to credibly verify a fund of that scaleCorrect
  2. BThe auditor's small size is acceptable because the fund's strong reported returns provide sufficient evidence of accuracy
  3. CThe auditor's small size is irrelevant as long as the fund is registered as a broker-dealer
  4. DThe auditor's small size reduces risk because a small firm is more likely to know the manager personally

Explanation

A mismatch between the scale of assets and the resources of the auditor means independent verification is doubtful. Strong returns do not substitute for independent verification, and a close personal relationship undermines independence rather than helping it.

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