mandatory disclosure and operational risk: evidence from hedge fund registration
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Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund
Registration
Stephen Brown, William Goetzmann,
Bing Liang, Christopher Schwarzwww.stern.nyu.edu/~sbrown
Overview
The importance of operational risk
Analysis of Form ADV filingsImportant role of conflicts of
interestA quantitative measure of
operational riskDo investors know .. or care?
Growth of US Hedge Fund Industry
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
$M
illio
n A
ss
ets
un
de
r m
an
ag
em
en
t
Multi-Strategy
Managed Futures
Long/Short Equity Hedge
Global Macro
Fixed Income Arbitrage
Event Driven
Equity Market Neutral
Emerging Markets
Dedicated Short Bias
Convertible Arbitrage
Source: Lipper TASS
Institutional concern about risk
Fiduciary guidelines imply concern for riskFinancial riskOperational risk
Institutional demandGrowing popularity of market
neutral stylesExplosive growth of funds of funds
Financial Risk
0%10%20%30%40%50%60%70%80%90%
100%
0 10 20 30 40 50 60 70 80 90 100
Size of portfolio
Per
cent
of risk
Equities
S&P500 risk
Source: Elton and Gruber 1995. Risk is measured relative to the standard deviation of the average stock
Financial Risk
0%10%20%30%40%50%60%70%80%90%
100%
0 10 20 30 40 50 60 70 80 90 100
Size of portfolio
Per
cent
of risk Equities
Hedge Funds
S&P500 risk
Hedge Fund risk
Funds of Hedge Funds
ProvidesDiversification – lower value at riskSmaller unit size of investmentAccess to otherwise closed fundsProfessional management / Due
diligence
Hedge Fund 1 Hedge Fund 2 Hedge Fund 3
Fund of Funds
Diseconomies of Scale
Prior month assets under management
1st
quintile
2nd
quintile
3rd
quintile
4th
quintile
5th
quintile
AllFunds
t-value(large -
small)
All hedgeFunds
(excl. FoF)
14.47%
14.63%12.87% 11.50% 11.03% 11.28% -2.01
0.107 0.133 0.128 0.122 0.117 0.118
All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics
Economies of Scale
Prior month assets under management
1st
quintile
2nd
quintile
3rd
quintile
4th
quintile
5th
quintile
AllFunds
t-value(large -
small)
All hedgeFunds
(excl. FoF)
14.47%
14.63%12.87% 11.50% 11.03% 11.28% -2.01
0.107 0.133 0.128 0.122 0.117 0.118
Funds ofFunds
7.45% 9.25% 8.90% 9.54% 10.14% 9.98% 2.78
0.074 0.134 0.152 0.180 0.213 0.139
All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics
Economies of Scale
Prior month assets under management
1st
quintile
2nd
quintile
3rd
quintile
4th
quintile
5th
quintile
AllFunds
t-value(large -
small)
All hedgeFunds
(excl. FoF)
14.47%
14.63%12.87% 11.50% 11.03% 11.28% -2.01
0.107 0.133 0.128 0.122 0.117 0.118
Funds ofFunds
7.45% 9.25% 8.90% 9.54% 10.14% 9.98% 2.78
0.074 0.134 0.152 0.180 0.213 0.139
All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics
26% of Funds of Funds <$25M !!!
MotivationMotivation
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 riskDoes the disclosure provide material informationTo 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.)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 million2% had lockup longer than 2 years73% were foreign based
Form ADVForm ADV
35 pages long.General informationQuestions on:
potential conflicts of interest legal or regulatory issues [Item 11]ownership structure (both direct and
indirect)No questions about holdings or
strategy
Phil GoldsteinPhil Goldstein
ADV form asks everything from “your last small pox vaccination to every dirty joke you got on Email”
Item 11FeloniesInvestment-related misdemeanorsAny SEC, CFTC or self-regulatory issuesLawsuits
Tests and ResultsTests 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.”
17
External conflicts
Problem funds
Non problemfunds
With: N % Yes N % Yes
Broker/Dealer 359 73.1 1912 23.7
Investment Comp
359 50.3 1912 15.8
Investment Advisor
359 73.9 1912 41.6
Commodities Broker
359 53.5 1912 20.3
Bank 359 40.5 1912 9.8
Insurance 359 39.8 1912 9.4
Sponsor of LLP 359 56.8 1912 21.5
18
Internal conflicts
Problem funds Non problemfunds
With: N % Yes N % Yes
Trade securities with clients
359 30.7 1912 8.3
Allow trading on own account
359 84.8 1912 69.3
Recommend own securities 359 75.5 1912 50.4
In-house broker dealer 359 31.2 1912 2.3
Recommends own underwriting service
359 69.4 1912 46.8
Recommends commission fee items
359 22.6 1912 15.7
Recommends brokers 359 46.7 1912 38.0
Use broker provided external research
359 81.0 1912 70.5
Problem funds have a more Problem funds have a more concentrated ownership structureconcentrated ownership structure
Problem Funds Non-Problem funds
Mean Median Mean Median
Diff
Direct Owners 9.96 9.00 7.33 6.00 2.63
Controlling 8.28 7.00 5.97 5.00 2.31
Percent 75% 0.73 1.00 0.50 0.50 0.23
Domestic Entity 0.80 1.00 0.49 0.00 0.31
Indirect Owners 2.33 1.00 1.37 0.00 0.96
Levered? 0.51 1.00 0.57 1.00 -0.06
Margin? 0.35 0.00 0.49 0.00 -0.14
Person Capital ($mm)
1.26 0.00 2.62 0.00 -1.36
Leverage and Problem Funds
Can lenders tell the difference (prior to 2006)?
TASS leverage variablesAverage leverageMaximum leverage
Style controlsLenders already understand
content of ADV disclosure
Leverage and Problem FundsLeverage and Problem Funds
All funds Problem
Non problem
Diff
Leverage 0.51 0.57 -0.06**
Avg. Leverage 52.20 85.31 -33.11***
Max Leverage 96.82 140.68 -43.86***
No FOF
Leverage 0.61 0.61 -0.00
Avg. Leverage 63.73 95.57 -31.84***
Max Leverage 118.27 158.80 -40.53**
5% Winsorized
Avg. Leverage 43.34 65.15 -21.81***
Max Leverage 81.46 108.33 -26.87***
Leverage By Style
Category ADV matched sample(%
)
Problem sample(
%)
Problem leverage
Non-problem leverage
Convertible Arb
4.22 7.07 118.04 170.24
Dedicated Short
0.70 0.00 N/A 72.22
Emerging Mkts
4.22 2.99 0.00 18.60
Equity Neutral
6.26 5.71 185.31 61.18
Event Driven 11.92 13.59 51.30 51.37
Fixed Income 6.05 3.26 287.50 415.89
FOF 21.31 26.09 6.47 36.04
Global Macro 3.57 0.81 140.00 134.24
Long-Short 34.71 32.61 23.85 44.91
Managed Futures
3.48 4.08 19.34 91.01
Multi-Strategy
3.52 3.53 40.00 120.70
Total 100% 100% 53.53 85.49
Appraisal Ratio Regression Appraisal Ratio Regression ResultsResults
Problem Non-problem Matched sample
Log Assets 0.073*** 0.047*** 0.011
Fund Age 0.009 0.016*** -0.014
Stdev -0.018 -0.040*** 0.010
Onshore 0.120* 0.061** 0.151*
Incentive Fee 0.003 0.009*** -0.023**
HWM -0.018 -0.056 -0.123
Relationship -0.251*** 0.023 -0.426**
Direct Domestic 0.026 -0.027 -0.049
PercentOwner75 -0.081 -0.075** -265**
Adj. R-squared 18.02% 6.76% 7.08%
Num Obs 273 1,369 279
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 A univariate measure of operational riskoperational risk
TASS ADV
Previous Returns -0.27*** AgencyCrossTrans
0.06**
Previous Std. Dev. -0.35*** RelBrokerDealer
0.28***
Fund Age -0.07*** RelInvestComp
0.24***
Log of Assets 0.13*** RelInvAdvisor 0.24***
Reports Assets 0.12*** RelPartSponser
0.30***
Incentive Fee -0.88*** BuySellYouOwn
0.08**
Margin -0.29*** BuySellYourClient
-0.08***
Audited -0.19*** RecSecYouOwn
0.33***
Personal Capital -0.29*** RecUnderwriter
0.26***
Onshor -0.05*** RecSalesInterest
0.28***
OpenToInv 0.08 RecBrokers -0.33***
Accepts Mgd. Accts. -0.13*** PercentOwner75
0.15***
Corr ADV & TASS 0.42*** DirectDomestic
0.31***
Operational risk and the half life of USD funds
0 0.5 1.0 1.5
5045403530252015
10
5
0
90 months
85807570656055
50
45
Half Life
Ag
e o
f fu
nd
(m
on
ths)
Operational Risk - score
Does the operational risk measure Does the operational risk measure predict leverage?predict leverage?
TASS Style Dummies B-G Style Dummies
Coeff t-value Coeff t-value
2005 -18.04 -4.04*** -6.39 -6.80***
2004 -28.87 -5.85*** -35.16 -8.25***
2003 -24.76 -4.76*** -33.38 -7.19***
2002 -17.36 -3.28*** -26.96 -5.68***
2001 -21.75 -3.96*** -27.21 -5.30***
Average -22.16 -10.33
*** -25.82 -5.04***
Avg. Adj. R-sq.
13.74% 2.61%
Avg. Obs 2279 2279
Does the operational risk measure predict returns?
Year Operational risk coefficient
t-value
1994 -2.28% -2.2**1995 0.10% 0.12
1996 -3.27% -4.76***1997 -2.61% -3.71***… … …2002 -1.48% -4.43***2003 -0.41% -1.12
2004 -0.67% -2.45**2005 -0.11% -1.31
Average Value -0.92% -2.66**Avg. Adjusted R² 40.17%
Average Observations
1,027
Cross sectional return regression on prior operational risk, financial risk and style dummies
Investor Flows and Problem Investor Flows and Problem FundsFunds
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?
Coeff t-value Coeff t-value
Low Rank 0.596 6.10*** 0.634 7.30***
Mid Rank 0.977 6.89*** 0.981 6.79***
High Rank 0.905 11.69*** 0.886 7.39***
Std. Dev. -0.022 -5.44*** -0.023 -5.79***
Category Flows
0.685 9.80*** 0.686 9.63***
Log Assets -0.117 -6.45*** -0.118 -6.52***
Mgmt. Fees -0.045 -3.06** -0.044 -2.89***
ω-score -0.010 -1.61 0.025 1.02
Low Rank/ω -0.019 -0.15
Mid Rank/ω -0.202 -1.78*
High Rank/ω 0.085 0.62
Avg. Adj. R-sq.
14.00% 14.16%
Avg. Obs 966 966
Operational risk does not mediate Operational risk does not mediate naïve tendency to chase returnsnaïve tendency to chase returns
ConclusionConclusion
Important to quantify operational risk
ConclusionConclusion
Important to quantify operational risk
This risk is associated with conflicts of interest
ConclusionConclusion
Important to quantify operational risk
This risk is associated with conflicts of interest
Operational risk + conflict = low returns
ConclusionConclusion
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
ConclusionConclusion
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
ConclusionConclusion
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
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