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

An investor notes that a feeder fund's manager refuses to discuss the details of the trading strategy, citing proprietary secrecy, while the strategy is marketed as having low risk and consistent returns. Under good due diligence practice, what is the best response?

The investor should require enough transparency to understand and independently verify the strategy, or decline to invest. Secrecy combined with smooth, low-risk returns is a red flag, and neither reputation, a popular investor base nor a small trial allocation replaces verification.

  1. AAccept the explanation, since secrecy is normal for successful managers
  2. BRequire sufficient transparency to understand and independently verify the strategy, or decline to investCorrect
  3. CAllocate a small amount to monitor performance and revisit the question later
  4. DRely on the manager's reputation and the size of its investor base

Explanation

Investors must be able to understand where returns come from and verify holdings and trades. Opacity paired with strong stable performance is a red flag, and a small test allocation or reliance on reputation does not substitute for verification. The correct step is to demand transparency or walk away.

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