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

An analyst reviewing a hedge fund that claims to run a split-strike conversion strategy on large-cap US equities notes that the fund has reported only 3 down months in 15 years and that its returns show very low correlation with the equity market during sharp market declines. Which conclusion is most consistent with the red flags discussed in the Madoff case?

Returns this smooth, with very few down months and little link to market declines, conflict with a strategy that holds equities and options. This mismatch between stated strategy and observed performance is a red flag that calls for deeper independent verification, not reassurance.

  1. AThe consistency is plausible evidence of superior manager skill and should lower the due diligence burden
  2. BThe returns are inconsistent with the stated strategy's expected equity exposure and warrant deeper independent verificationCorrect
  3. CThe low correlation proves the fund is a successful market-neutral strategy
  4. DThe smoothness is typical of any long-biased equity strategy that uses options

Explanation

A collar-type strategy holding equities and options should still have meaningful market beta and show losses in market downturns. Persistently smooth returns that do not move with the market contradict the stated strategy, which is a key performance red flag. Treating the smoothness as skill is the error the case warns against.

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