Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration

Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration Stephen Brown, William Goetzmann, Bing Liang, Christopher Schwarz www.stern.nyu.edu/~sbrown

Overview • The importance of operational risk • Analysis of Form ADV filings • Important role of conflicts of interest • A quantitative measure of operational risk • Do investors know .. or care?

Growth of US Hedge Fund Industry Source: Lipper TASS

Institutional concern about risk • Fiduciary guidelines imply concern for risk • Financial risk • Operational risk • Institutional demand • Growing popularity of market neutral styles • Explosive growth of funds of funds

FinancialRisk Source: Elton and Gruber 1995. Risk is measured relative to the standard deviation of the average stock

Financial Risk

Funds of Hedge Funds • Provides • Diversification – lower value at risk • Smaller unit size of investment • Access to otherwise closed funds • Professional management / Due diligence

Diseconomies of Scale All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics

Economies of Scale All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics

Economies of Scale 26% of Funds of Funds <$25M !!! All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics

Motivation SEC mandated hedge funds file Form ADV by February 1st, 2006 Controversial requirement overturned June 23rd, 2006 Interesting research questions: What is the purpose of such mandated disclosures? What is the distinction between operational and financial risk Does the disclosure provide material information To whom?

Data All Form ADV filings in February 2006 Hedge fund characteristics from TASS management companies matched with ADV forms by both name and address from the “Company” TASS file.. Brown, Stephen J., Goetzmann, William N., Liang, Bing and Schwarz, Christopher, "Optimal Disclosure and Operational Risk: Evidence from Hedge Fund Registration" (January 7, 2007). Yale ICF Working Paper No. 06-15 Available at SSRN: http://ssrn.com/abstract=918461

Data (cont.) • 893 of 1,697 (52.3%) TASS management companies identified. • 2,272 of the 4,019 (56.5%) of TASS funds. • Unmatched TASS Companies: • 22% had assets under $25 million • 2% had lockup longer than 2 years • 73% were foreign based

Form ADV • 35 pages long. • General information • Questions on: • potential conflicts of interest • legal or regulatory issues [Item 11] • ownership structure (both direct and indirect) • No questions about holdings or strategy

Phil Goldstein • ADV form asks everything from “your last small pox vaccination to every dirty joke you got on Email” • Item 11 • Felonies • Investment-related misdemeanors • Any SEC, CFTC or self-regulatory issues • Lawsuits

Tests and Results • A “Problem” fund = a fund whose management company answered ‘Yes’ to ANY question on Item 11. • Of 2,272 funds 358 (15.8%) are defined as “problem.” • 128 of 893 (14.3%) management companies. • Of the 10,295 total ADV registrations, 1,526 (14.8%) had a “problem.”

External conflicts 17

Internal conflicts 18

Problem funds have a more concentrated ownership structure

Leverage and Problem Funds • Can lenders tell the difference (prior to 2006)? • TASS leverage variables • Average leverage • Maximum leverage • Style controls • Lenders already understand content of ADV disclosure

Leverage and Problem Funds

Leverage By Style

Appraisal Ratio Regression Results

What have we learned? • Factors associated with operational risk • External conflicts of interest • Internal conflicts of interest • Operational risk is understood by sophisticated investors • Problem funds have concentrated ownership • Problem funds have difficulty borrowing money • This suggests an important role for due diligence

A univariate measure of operational risk

Operational risk and the half life of USD funds Half Life 50 90 months 45 85 40 80 35 75 30 Age of fund (months) 70 25 65 20 60 15 55 10 50 5 45 0 0 0.5 1.0 1.5 Operational Risk  - score

Does the operational risk measure predict leverage?

Does the operational risk measure predict returns? Cross sectional return regression on prior operational risk, financial risk and style dummies

Investor Flows and Problem Funds • Operational risk influences ownership and leverage • Lenders and hedge fund equity investors already understand risk content of Form ADV disclosures • Does operational risk modify the flow-performance relationship? • Do investors care?

Operational risk does not mediate naïve tendency to chase returns

Conclusion Important to quantify operational risk

Conclusion Important to quantify operational risk This risk is associated with conflicts of interest

Conclusion Important to quantify operational risk This risk is associated with conflicts of interest Operational risk + conflict = low returns

Conclusion Important to quantify operational risk This risk is associated with conflicts of interest Operational risk + conflict = low returns Operational risk does not mediate the naïve tendency of investors to chase returns

Conclusion Important to quantify operational risk This risk is associated with conflicts of interest Operational risk + conflict = low returns Operational risk does not mediate the naïve tendency of investors to chase returns Either investors do not understand operational risk

Conclusion Important to quantify operational risk This risk is associated with conflicts of interest Operational risk + conflict = low returns Operational risk does not mediate the naïve tendency of investors to chase returns Either investors do not understand operational risk Or investors know and do not care

Important implication Hedge funds on average have positive alpha Excluding operational risk increases alpha Due diligence adds value to hedge fund investors Suggests a new approach to hedge fund investing

Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration