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

An investor examines a fund's monthly returns. The fund's average monthly return is 1.0% with a monthly standard deviation of 0.5%, and the risk-free rate is 0.25% per month. What is the fund's annualized Sharpe ratio, using square-root-of-time scaling, and how should it be interpreted in a Madoff-style review?

The annualized Sharpe ratio is about 5.2: monthly excess return of 0.75% over 0.5% volatility gives 1.5, multiplied by the square root of 12. Such a figure is implausibly high for an equity-based strategy and should trigger deeper investigation.

  1. AAbout 1.5; modest and unremarkable
  2. BAbout 5.2; implausibly high for the stated strategy and warranting deeper investigationCorrect
  3. CAbout 2.6; typical for an equity long-only fund
  4. DAbout 0.75; indicating weak performance

Explanation

Monthly Sharpe = (1.0 - 0.25)/0.5 = 1.5. Annualized = 1.5 x sqrt(12) = 1.5 x 3.464 = 5.20. Forgetting the scaling gives 1.5, the key distractor. A Sharpe above 5 is far beyond what equity-based strategies sustain, so it is a red flag.

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