FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags
A fund of funds compares a feeder fund's returns with its stated benchmark, the S&P 500. Over 60 months the feeder's regression on the index gives a beta of 0.05 and an R-squared of 0.02, while the manager describes the strategy as fully invested in large-cap US equities with option overlays. What is the best interpretation?
The result is inconsistent with the stated strategy. A long large-cap equity portfolio with option overlays should retain substantial market sensitivity, yet a beta of 0.05 and R-squared of 0.02 show returns almost unrelated to the index, suggesting the reported returns may not come from the claimed holdings.
- AConsistent with the strategy, since option overlays remove all market exposure
- BConsistent with the strategy, since low R-squared implies strong alpha
- CInconsistent with the strategy, because a long equity portfolio with an overlay should retain substantial market sensitivity, so the returns may not come from the claimed holdingsCorrect
- DUninformative, because regression analysis cannot be applied to hedge funds
Explanation
A portfolio of large-cap stocks with collars still has meaningful beta, typically around 0.3 to 0.6, and meaningful R-squared. A beta of 0.05 and R-squared of 0.02 mean returns are nearly unrelated to the market, which contradicts the description. Low R-squared does not demonstrate alpha; it signals a mismatch between the claimed holdings and the actual return source.
Did you get it right without looking?
One question tells you little. A timed set on Madoff: A Riot of Red Flags shows your real accuracy, how long you take and where you lose marks.
More Madoff: A Riot of Red Flags questions
- A risk manager at an allocator reads that regulators examining Madoff's firm accepted documents supplied by the firm itself and did not inde…
- Which feature of a hedge fund's governance would an investor most reasonably view as a red flag in the context of the Madoff case?
- A pension fund's investment committee is reviewing lessons from the Madoff fraud. Which feature of the Madoff case best illustrates a failur…
- A fund of funds is evaluating a manager whose reported annual returns have ranged between 10% and 12% over 20 years, with an annualized stan…
- A pension fund's investment committee is reviewing why the SEC failed to uncover Bernard Madoff's fraud despite several examinations and tip…
- A fund of funds is evaluating a manager who says the strategy trades equity index options with a notional that the due diligence team estima…