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

An allocator evaluates a manager with these features: a custodian and broker that are the manager's own affiliated entity, a three-person audit firm, and regulatory examinations with no adverse findings. Based on the Madoff lessons, which assessment is most appropriate?

The absence of independent service providers is a structural red flag that clean regulatory examinations do not offset. Affiliated custody and brokerage remove independent checks on trades, and a tiny auditor cannot compensate. Madoff's case shows examinations can miss fraud, and unusually smooth returns add to concern.

  1. AThe lack of independent service providers is a structural red flag that clean regulatory examinations do not offsetCorrect
  2. BThe clean examinations offset the lack of independent providers, so the risk is low
  3. CThe small audit firm is the only concern, because affiliated custody is common for large managers
  4. DThe structure is acceptable if performance has low volatility and consistent returns

Explanation

Self-custody and self-brokerage remove the independent checks that would expose fabricated trades, and an auditor lacking capacity cannot compensate. Clean examinations did not detect Madoff, so they cannot offset this. Smooth returns increase, not reduce, suspicion.

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