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

An allocator performing due diligence on a hedge fund learns that the fund, which reports a multi-billion-dollar strategy, is audited by a three-person accounting firm with one active partner. Which conclusion is most appropriate?

A tiny auditor auditing a very large, complex fund is a significant operational red flag. It lacks the capacity and expertise for independent verification of assets and trades, and good returns or lower fees do not compensate for that weak control.

  1. AThe small auditor is a significant operational red flag because its capacity does not match the fund's size and complexityCorrect
  2. BThe small auditor is acceptable provided the fund's returns are consistently positive
  3. CThe auditor's size is irrelevant because the fund's administrator verifies all trades
  4. DThe small auditor is a strength because it implies lower fees and closer oversight

Explanation

Independent verification depends on an auditor with the resources and expertise to test a large, complex portfolio. A tiny firm cannot credibly do so, which was a core red flag in the Madoff case. Steady returns do not offset the lack of independent assurance, and an administrator is also absent in such structures.

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