FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags
An investment committee is evaluating a feeder fund that places all of its assets with a single master manager who also acts as prime broker, custodian and executing broker for the strategy. Which risk is most directly heightened by this arrangement?
The main heightened risk is weak segregation of duties. When one manager is adviser, broker and custodian, no independent party can confirm that assets and trades exist, so fabricated holdings or fictitious trading could continue undetected. Cost, basis and currency issues are not what this arrangement mainly creates.
- ABasis risk between the feeder fund's benchmark and the master fund's benchmark
- BReduced operational segregation of duties, so fabricated trades or assets would go undetected by independent partiesCorrect
- CHigher transaction costs due to multiple brokerage relationships
- DCurrency mismatch between the feeder fund's share class and the master fund
Explanation
When one entity performs advisory, custody and execution, there is no independent third party to confirm that securities exist or trades occurred. This removes the checks that would reveal fraud. The other options are not driven by the concentration of functions.
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