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

Which action is the most effective operational due diligence step for a prospective investor in a hedge fund whose administrator, custodian and prime broker are all named in the offering documents?

The best step is to contact the named administrator, custodian and prime broker directly and confirm the relationships and the existence of assets and trades. Independent third-party confirmation tests the manager's claims, whereas written assurances, marketing materials or peer return comparisons all depend on manager-supplied information.

  1. ARequest the manager's written confirmation that the service providers are reputable
  2. BContact the named administrator, custodian and prime broker directly to confirm the relationships and the existence of assets and tradesCorrect
  3. CCompare the manager's returns with a peer-group average
  4. DReview the manager's marketing presentation for a description of controls

Explanation

Independent confirmation directly from third parties tests whether the stated relationships and assets really exist. Manager assurances, marketing material and peer return comparisons all rely on or describe information supplied by the manager and do not verify existence.

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