FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags
Which feature of a hedge fund's reported performance is the strongest strategy-related red flag in a Madoff-type due diligence review?
Steady positive returns in every market environment, with no clear explanation of how the strategy produces them, is the strongest red flag. Genuine strategies show variability and drawdowns consistent with their exposures, so unexplained consistency suggests the numbers may not reflect real trading.
- AReturns that are consistent over time but which can be explained by the disclosed strategy and verified positions
- BReturns that remain steady and positive regardless of market conditions, with no clear explanation of how the strategy generates themCorrect
- CA moderate drawdown during a market crisis
- DReturns that trail the benchmark in strong bull markets
Explanation
Steady positive returns in all environments without a transparent, testable explanation resemble fabricated reporting. A moderate crisis drawdown and lagging a bull market are expected for a hedged strategy. Consistency alone is not a flag when the strategy and verified positions explain it.
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