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

During due diligence, an analyst finds that a manager reporting consistently smooth returns refuses to give the allocator direct access to the custodian, citing secrecy of the strategy. Which action best reflects appropriate practice?

The allocator should decline to invest, or keep escalating, until it can independently verify assets directly with a third-party custodian. Manager-prepared statements and offering documents are not independent evidence, and strategy secrecy does not justify refusing asset verification.

  1. AAccept the explanation and invest, since secrecy is common in hedge funds
  2. BInvest a small amount and rely on monthly statements prepared by the manager
  3. CRely on the fund's offering memorandum as evidence that the assets exist
  4. DDecline to invest or escalate until independent verification of assets with the custodian is obtainedCorrect

Explanation

Independent confirmation of assets with a third-party custodian is a basic due diligence requirement. Statements produced by the manager or the offering memorandum are not independent evidence. Strategy secrecy can be respected without blocking asset verification.

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