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