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

A fund of funds is evaluating a manager whose reported annual returns have ranged between 10% and 12% over 20 years, with an annualized standard deviation of 2% and a risk-free rate of 4%. The average return is 11%. What is the Sharpe ratio, and how should it be interpreted in a due diligence context?

The Sharpe ratio is (11% minus 4%) divided by 2%, which equals 3.5. That is far above what equity-related strategies normally achieve, so it signals possible misreporting or fraud and should trigger deeper verification rather than comfort.

  1. A3.5; exceptionally high for an equity-based strategy and a prompt to test whether the returns are genuineCorrect
  2. B5.5; evidence of excellent skill that justifies reduced monitoring
  3. C3.5; normal for a hedged equity strategy
  4. D2.0; moderately attractive and consistent with peers

Explanation

Sharpe = (11% - 4%) / 2% = 3.5. Equity-linked strategies typically have Sharpe ratios well below 1, so 3.5 is implausible and a red flag. The 5.5 option wrongly ignores the risk-free rate (11/2), and the 2.0 option divides by an incorrect volatility.

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