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

A fund of funds' operational due diligence team assesses a manager who reports a split-strike conversion strategy, refuses to give position-level transparency, and says the strategy is proprietary and cannot be explained further. The team's best course of action is to:

The team should treat the opacity as a major red flag and insist on enough access to verify positions and strategy, or decline to invest. Proprietary secrecy prevents independent verification, and reputation or past returns cannot substitute for it.

  1. AAccept the explanation because secrecy is normal for successful strategies and invest with a smaller allocation
  2. BRely on the manager's reputation and the long track record in place of transparency
  3. CTreat the lack of transparency as a significant red flag and require sufficient access to verify positions and strategy, or decline to investCorrect
  4. DReplace due diligence with a performance analysis of historical returns against the S&P 500

Explanation

Investors need enough transparency to verify that reported positions and returns are consistent with the stated strategy. Secrecy blocks that verification, so the proper response is to obtain access or walk away. Reputation and return history cannot replace verification.

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