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

A pension fund's due diligence team reviews a hedge fund manager that reports smooth monthly returns, uses a tiny unknown audit firm, and self-administers its assets. Regulators have examined the manager before without raising concerns. Which lesson from the Madoff case best applies to the team's reliance on the regulatory examination?

Investors should treat regulatory oversight as a supplement to, not a replacement for, their own independent verification. Madoff was registered and examined, yet regulators missed the fraud despite repeated warnings, so allocators must perform their own operational and performance due diligence.

  1. AA prior regulatory examination is a substitute for independent operational due diligence
  2. BRegulatory registration confirms that reported returns are genuine and verified
  3. CInvestors should treat regulatory oversight as a supplement, not a replacement, for their own independent verificationCorrect
  4. DRegulatory examinations are only relevant for managers that are not registered

Explanation

The Madoff case showed that regulators received repeated credible warnings yet failed to uncover the fraud. Investors therefore cannot outsource verification to regulators. Options claiming that examinations substitute for or confirm due diligence repeat the error many Madoff investors made.

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