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FRM Part II · FRM Exam Part II · Case Study: Financial Crime and Fraud

An investment fund reports steady monthly returns of about 1% regardless of market conditions, uses an unknown tiny audit firm, and its manager acts as custodian and executes all trades through his own affiliated broker-dealer. An allocator doing due diligence should treat which feature as the most serious red flag for potential fraud?

The most serious red flag is the manager acting as adviser, custodian and executing broker, with no independent verification of assets. Without third-party custody and trade confirmation, reported holdings and returns can be fabricated, which is the core enabling feature of Ponzi-type frauds.

  1. AThe manager's combined role as adviser, custodian and executing broker, with no independent verification of assetsCorrect
  2. BThe fund's use of a monthly rather than daily NAV
  3. CThe fund's minimum investment of USD 1 million
  4. DThe fund's preference for large-cap equities

Explanation

Lack of independent custody and trade execution means assets and trades cannot be verified by a third party, the central failure in Ponzi-type frauds. Consistent returns and a small auditor add concern, but the control concentration is what allows fabrication. Monthly NAV, minimums and large-cap focus are ordinary features.

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