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

An investor in a feeder fund relies on the feeder's own due diligence, which concluded that the underlying manager was sound because other sophisticated institutions had invested. Which flaw in this approach best describes the problem?

The flaw is substituting peer reputation for independent verification. If every investor assumes the others did the diligence, nobody verifies assets or processes, creating herding and delegated diligence failure that lets fraud persist.

  1. AReliance on peer reputation substitutes for independent verification, so the investor is exposed to herding and delegated diligence failureCorrect
  2. BThe approach overweights quantitative analysis
  3. CThe approach ignores the time value of money
  4. DThe approach assumes the feeder fund has leverage

Explanation

Relying on the presence of other well-known investors is not verification; each party assumes others did the work, so no one verifies. Quantitative overweighting, discounting and leverage are not what the scenario describes.

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