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 Schwarz. www.stern.nyu.edu/~sbrown. Overview. The importance of operational risk Analysis of Form ADV filings Important role of conflicts of interest - PowerPoint PPT Presentation

Transcript of Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration

  • Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund RegistrationStephen Brown, William Goetzmann, Bing Liang, Christopher Schwarzwww.stern.nyu.edu/~sbrown

  • OverviewThe 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 IndustrySource: Lipper TASS

  • Institutional concern about riskFiduciary guidelines imply concern for riskFinancial riskOperational risk Institutional demandGrowing popularity of market neutral stylesExplosive growth of funds of funds

  • Financial RiskSource: Elton and Gruber 1995. Risk is measured relative to the standard deviation of the average stock

  • Financial Risk

  • Funds of Hedge FundsProvidesDiversification lower value at riskSmaller unit size of investmentAccess to otherwise closed fundsProfessional management / Due diligence

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

    Prior month assets under management1st quintile2ndquintile3rdquintile4thquintile5thquintileAllFundst-value(large - small)All hedgeFunds(excl. FoF)14.47%14.63%12.87%11.50%11.03%11.28%-2.010.1070.1330.1280.1220.1170.118

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

    Prior month assets under management1st quintile2ndquintile3rdquintile4thquintile5thquintileAllFundst-value(large - small)All hedgeFunds(excl. FoF)14.47%14.63%12.87%11.50%11.03%11.28%-2.010.1070.1330.1280.1220.1170.118Funds ofFunds 7.45%9.25%8.90%9.54%10.14%9.98%2.780.0740.1340.1520.1800.2130.139

  • Economies of ScaleAll TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics26% of Funds of Funds
  • MotivationSEC mandated hedge funds file Form ADV by February 1st, 2006Controversial requirement overturned June 23rd, 2006Interesting 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?

  • DataAll Form ADV filings in February 2006Hedge 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 million2% had lockup longer than 2 years73% were foreign based

  • Form ADV35 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 GoldsteinADV form asks everything from your last small pox vaccination to every dirty joke you got on EmailItem 11FeloniesInvestment-related misdemeanorsAny SEC, CFTC or self-regulatory issuesLawsuits

  • Tests and ResultsA 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

  • *Internal conflicts

  • Problem funds have a more concentrated ownership structure

    Problem FundsNon-Problem fundsMeanMedianMeanMedianDiffDirect Owners9.969.007.336.002.63Controlling8.287.005.975.002.31Percent 75%0.731.000.500.500.23Domestic Entity0.801.000.490.000.31Indirect Owners2.331.001.370.000.96Levered?0.511.000.571.00-0.06Margin?0.350.000.490.00-0.14Person Capital ($mm)1.260.002.620.00-1.36

  • Leverage and Problem FundsCan lenders tell the difference (prior to 2006)?TASS leverage variablesAverage leverageMaximum leverageStyle controlsLenders already understand content of ADV disclosure

  • Leverage and Problem Funds

    All fundsProblemNon problemDiffLeverage0.510.57-0.06**Avg. Leverage52.2085.31-33.11***Max Leverage96.82140.68-43.86***No FOFLeverage0.610.61 -0.00Avg. Leverage63.7395.57-31.84***Max Leverage118.27158.80-40.53**5% WinsorizedAvg. Leverage43.3465.15-21.81***Max Leverage 81.46108.33-26.87***

  • Leverage By Style

    CategoryADV matched sample(%)Problem sample(%)Problem leverageNon-problem leverageConvertible Arb4.227.07118.04170.24Dedicated Short0.700.00N/A72.22Emerging Mkts4.222.990.0018.60Equity Neutral6.265.71185.3161.18Event Driven11.9213.5951.3051.37Fixed Income6.053.26287.50415.89FOF21.3126.096.4736.04Global Macro3.570.81140.00134.24Long-Short 34.7132.6123.8544.91Managed Futures3.484.0819.3491.01Multi-Strategy3.523.5340.00120.70Total100%100%53.5385.49

  • Appraisal Ratio Regression Results

  • What have we learned?Factors associated with operational riskExternal conflicts of interestInternal conflicts of interest

    Operational risk is understood by sophisticated investorsProblem funds have concentrated ownershipProblem funds have difficulty borrowing money

    This suggests an important role for due diligence

  • A univariate measure of operational risk

    TASSADVPrevious Returns-0.27***AgencyCrossTrans0.06**Previous Std. Dev.-0.35***RelBrokerDealer0.28***Fund Age-0.07***RelInvestComp0.24***Log of Assets0.13***RelInvAdvisor0.24***Reports Assets0.12***RelPartSponser0.30***Incentive Fee-0.88***BuySellYouOwn0.08**Margin-0.29***BuySellYourClient-0.08***Audited-0.19***RecSecYouOwn0.33***Personal Capital-0.29***RecUnderwriter0.26***Onshor-0.05***RecSalesInterest0.28***OpenToInv0.08RecBrokers-0.33***Accepts Mgd. Accts.-0.13***PercentOwner750.15***Corr ADV & TASS0.42***DirectDomestic0.31***

  • Operational risk and the half life of USD funds 0 0.51.01.5504540353025201510 5 090 months8580757065605550 45Half Life Age of fund (months)Operational Risk - score

  • Does the operational risk measure predict leverage?

    TASS Style DummiesB-G Style DummiesCoefft-valueCoefft-value2005-18.04-4.04***-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. Obs22792279

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

    YearOperational risk coefficientt-value1994-2.28%-2.2**19950.10%0.121996-3.27%-4.76***1997-2.61%-3.71***2002-1.48%-4.43***2003-0.41%-1.122004-0.67%-2.45**2005-0.11%-1.31Average Value-0.92%-2.66**Avg. Adjusted R40.17%Average Observations1,027

  • Investor Flows and Problem FundsOperational 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 nave tendency to chase returns

    Coefft-valueCoefft-valueLow Rank0.5966.10***0.6347.30***Mid Rank0.9776.89***0.9816.79***High Rank0.90511.69***0.8867.39***Std. Dev.-0.022-5.44***-0.023-5.79***Category Flows0.6859.80***0.6869.63***Log Assets-0.117-6.45***-0.118-6.52***Mgmt. Fees-0.045-3.06**-0.044-2.89***-score-0.010-1.610.0251.02Low Rank/-0.019-0.15Mid Rank/-0.202-1.78*High Rank/0.0850.62Avg. Adj. R-sq.14.00%14.16%Avg. Obs966966

  • ConclusionImportant to quantify operational risk

  • ConclusionImportant to quantify operational risk

    This risk is associated with conflicts of interest

  • ConclusionImportant to quantify operational risk

    This risk is associated with conflicts of interest

    Operational risk + conflict = low returns

  • ConclusionImportant to quantify operational risk

    This risk is associated with conflicts of interest

    Operational risk + conflict = low returns

    Operational risk does not mediate the nave tendency of investors to chase returns

  • ConclusionImportant to quantify operational risk

    This risk is associated with conflicts of interest

    Operational risk + conflict = low returns

    Operational risk does not mediate the nave tendency of investors to chase returns

    Either investors do not understand operational risk

  • ConclusionImportant to quantify operational risk

    This risk is associated with conflicts of interest

    Operational risk + conflict = low returns

    Operational risk does not mediate the nave tendency of investors to chase returns

    Either investors do not understand operational riskOr investors know and do not care

  • Important implicationHedge 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

    ********************Problem funds have a higher number of direct and controlling owners.problem firms are more likely to be structured as a venture or partnership with another institution.percentage of owners that own 75% of the company, is larger for problem funds.**************