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

An analyst reviews a hedge fund that claims to run a split-strike conversion strategy (long large-cap stocks, long out-of-the-money puts, short out-of-the-money calls). The fund reports only 3 down months in 15 years, with monthly returns that are smooth and almost uncorrelated with equity market declines. Which observation is the most significant performance red flag?

The key red flag is consistently positive, very smooth returns that stay insulated from major equity drawdowns. A long-equity collar strategy retains market exposure and should show losses in falling markets, so the observed return pattern is inconsistent with the stated strategy and suggests misreporting or fraud.

  1. AThe fund holds large-cap stocks, which are liquid
  2. BThe fund's returns are consistently positive and show very low volatility despite large equity market drawdowns, which the stated collar strategy should not fully avoidCorrect
  3. CThe fund uses options to limit downside risk
  4. DThe fund's returns are reported monthly rather than daily

Explanation

A collar caps upside and floors downside, but it still has equity beta and should lose in sharp market declines. Near-constant smooth gains with very few losing months and little correlation to the market are inconsistent with the stated strategy. The other options describe normal features of such a strategy.

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