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Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration Stephen Brown, William Goetzmann,  Bing L...
Overview <ul><li>The importance of operational risk  </li></ul><ul><li>Analysis of Form ADV filings </li></ul><ul><li>Impo...
Growth of US Hedge Fund Industry Source: Lipper TASS
Institutional concern about risk <ul><li>Fiduciary guidelines imply concern for risk </li></ul><ul><ul><li>Financial risk ...
Financial   Risk Source: Elton and Gruber  1995.  Risk is measured relative to the standard deviation of the average stock
Financial Risk
Funds of Hedge Funds <ul><li>Provides </li></ul><ul><ul><li>Diversification – lower value at risk </li></ul></ul><ul><ul><...
Diseconomies of Scale All TASS $US Funds 1995-2006. Value weighted returns,  Sharpe ratio in italics Prior month assets un...
Economies of Scale All TASS $US Funds 1995-2006. Value weighted returns,  Sharpe ratio in italics Prior month assets under...
Economies of Scale All TASS $US Funds 1995-2006. Value weighted returns,  Sharpe ratio in italics 26% of Funds of Funds <$...
Motivation <ul><li>SEC mandated hedge funds file Form ADV by February 1 st , 2006 </li></ul><ul><li>Controversial requirem...
Data <ul><li>All Form ADV filings in February 2006 </li></ul><ul><li>Hedge fund characteristics from TASS  </li></ul><ul><...
Data (cont.) <ul><li>893 of 1,697 (52.3%) TASS management companies identified. </li></ul><ul><li>2,272 of the 4,019 (56.5...
Form ADV <ul><li>35 pages long. </li></ul><ul><li>General information </li></ul><ul><li>Questions on: </li></ul><ul><ul><l...
Phil Goldstein <ul><li>ADV form asks everything from “your last small pox vaccination to every dirty joke you got on Email...
Tests and Results <ul><li>A “Problem” fund = a fund whose management company answered ‘Yes’ to ANY question on Item 11. </...
External conflicts Problem funds Non problem funds With: N % Yes N % Yes Broker/Dealer 359 73.1 1912 23.7 Investment Comp ...
Internal conflicts Problem funds Non problem funds With: N % Yes N % Yes Trade securities with clients 359 30.7 1912 8.3 A...
Problem funds have a more concentrated ownership structure Problem Funds Non-Problem funds Mean Median Mean Median Diff Di...
Leverage and Problem Funds <ul><li>Can lenders tell the difference (prior to 2006)? </li></ul><ul><li>TASS leverage variab...
Leverage and Problem Funds All funds Problem Non problem Diff Leverage 0.51 0.57 -0.06** Avg. Leverage 52.20 85.31 -33.11*...
Leverage By Style Category ADV  matched sample(%) Problem sample(%) Problem leverage Non-problem leverage Convertible Arb ...
Appraisal Ratio Regression Results Problem Non-problem Matched sample Log Assets 0.073 *** 0.047 *** 0.011 Fund Age 0.009 ...
What have we learned? <ul><li>Factors associated with operational risk </li></ul><ul><ul><li>External conflicts of interes...
A univariate measure of operational risk TASS ADV Previous Returns -0.27 *** AgencyCrossTrans 0.06 ** Previous Std. Dev. -...
Operational risk and the half life of USD funds 0 0.5 1.0 1.5 50 45 40 35 30 25 20 15 10 5 0 90 months 85 80 75 70 65 60 5...
Does the operational risk measure predict leverage? TASS Style Dummies B-G Style Dummies Coeff t -value Coeff t -value 200...
Does the operational risk measure predict returns? Cross sectional return regression on prior operational risk, financial ...
Investor Flows and Problem Funds <ul><li>Operational risk influences ownership and leverage </li></ul><ul><li>Lenders and ...
Operational risk does not mediate naïve tendency to chase returns Coeff t -value Coeff t -value Low Rank 0.596 6.10 *** 0....
Conclusion <ul><li>Important to quantify operational risk </li></ul>
Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of ...
Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of ...
Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of ...
Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of ...
Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of ...
Important implication <ul><li>Hedge funds on average have positive alpha </li></ul><ul><li>Excluding operational risk incr...
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Lessons from Hedge Fund Registration

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  • 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.
  • Transcript of "Lessons from Hedge Fund Registration"

    1. 1. Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration Stephen Brown, William Goetzmann, Bing Liang, Christopher Schwarz www.stern.nyu.edu/~sbrown
    2. 2. Overview <ul><li>The importance of operational risk </li></ul><ul><li>Analysis of Form ADV filings </li></ul><ul><li>Important role of conflicts of interest </li></ul><ul><li>A quantitative measure of operational risk </li></ul><ul><li>Do investors know .. or care? </li></ul>
    3. 3. Growth of US Hedge Fund Industry Source: Lipper TASS
    4. 4. Institutional concern about risk <ul><li>Fiduciary guidelines imply concern for risk </li></ul><ul><ul><li>Financial risk </li></ul></ul><ul><ul><li>Operational risk </li></ul></ul><ul><li>Institutional demand </li></ul><ul><ul><li>Growing popularity of market neutral styles </li></ul></ul><ul><ul><li>Explosive growth of funds of funds </li></ul></ul>
    5. 5. Financial Risk Source: Elton and Gruber 1995. Risk is measured relative to the standard deviation of the average stock
    6. 6. Financial Risk
    7. 7. Funds of Hedge Funds <ul><li>Provides </li></ul><ul><ul><li>Diversification – lower value at risk </li></ul></ul><ul><ul><li>Smaller unit size of investment </li></ul></ul><ul><ul><li>Access to otherwise closed funds </li></ul></ul><ul><ul><li>Professional management / Due diligence </li></ul></ul>
    8. 8. Diseconomies of Scale All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics Prior month assets under management 1 st quintile 2 nd quintile 3 rd quintile 4 th quintile 5 th quintile All Funds t-value (large - small) All hedge Funds (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
    9. 9. Economies of Scale All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics Prior month assets under management 1 st quintile 2 nd quintile 3 rd quintile 4 th quintile 5 th quintile All Funds t-value (large - small) All hedge Funds (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 of Funds 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
    10. 10. Economies of Scale All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics 26% of Funds of Funds <$25M !!! Prior month assets under management 1 st quintile 2 nd quintile 3 rd quintile 4 th quintile 5 th quintile All Funds t-value (large - small) All hedge Funds (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 of Funds 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
    11. 11. Motivation <ul><li>SEC mandated hedge funds file Form ADV by February 1 st , 2006 </li></ul><ul><li>Controversial requirement overturned June 23 rd , 2006 </li></ul><ul><li>Interesting research questions: </li></ul><ul><ul><li>What is the purpose of such mandated disclosures? </li></ul></ul><ul><ul><li>What is the distinction between operational and financial risk </li></ul></ul><ul><ul><li>Does the disclosure provide material information </li></ul></ul><ul><ul><li>To whom? </li></ul></ul>
    12. 12. Data <ul><li>All Form ADV filings in February 2006 </li></ul><ul><li>Hedge fund characteristics from TASS </li></ul><ul><ul><li>management companies matched with ADV forms by both name and address from the “Company” TASS file.. </li></ul></ul>Brown, Stephen J., Goetzmann, William N., Liang, Bing and Schwarz, Christopher, &quot;Optimal Disclosure and Operational Risk: Evidence from Hedge Fund Registration&quot; (January 7, 2007). Yale ICF Working Paper No. 06-15 Available at SSRN: http:// ssrn.com /abstract=918461
    13. 13. Data (cont.) <ul><li>893 of 1,697 (52.3%) TASS management companies identified. </li></ul><ul><li>2,272 of the 4,019 (56.5%) of TASS funds. </li></ul><ul><li>Unmatched TASS Companies: </li></ul><ul><ul><li>22% had assets under $25 million </li></ul></ul><ul><ul><li>2% had lockup longer than 2 years </li></ul></ul><ul><ul><li>73% were foreign based </li></ul></ul>
    14. 14. Form ADV <ul><li>35 pages long. </li></ul><ul><li>General information </li></ul><ul><li>Questions on: </li></ul><ul><ul><li>potential conflicts of interest </li></ul></ul><ul><ul><li>legal or regulatory issues [Item 11] </li></ul></ul><ul><ul><li>ownership structure (both direct and indirect) </li></ul></ul><ul><li>No questions about holdings or strategy </li></ul>
    15. 15. Phil Goldstein <ul><li>ADV form asks everything from “your last small pox vaccination to every dirty joke you got on Email” </li></ul><ul><li>Item 11 </li></ul><ul><ul><li>Felonies </li></ul></ul><ul><ul><li>Investment-related misdemeanors </li></ul></ul><ul><ul><li>Any SEC, CFTC or self-regulatory issues </li></ul></ul><ul><ul><li>Lawsuits </li></ul></ul>
    16. 16. Tests and Results <ul><li>A “Problem” fund = a fund whose management company answered ‘Yes’ to ANY question on Item 11. </li></ul><ul><li>Of 2,272 funds 358 (15.8%) are defined as “problem.” </li></ul><ul><ul><li>128 of 893 (14.3%) management companies. </li></ul></ul><ul><li>Of the 10,295 total ADV registrations, 1,526 (14.8%) had a “problem.” </li></ul>
    17. 17. External conflicts Problem funds Non problem funds 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. 18. Internal conflicts Problem funds Non problem funds 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
    19. 19. Problem funds have a more concentrated 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
    20. 20. Leverage and Problem Funds <ul><li>Can lenders tell the difference (prior to 2006)? </li></ul><ul><li>TASS leverage variables </li></ul><ul><ul><li>Average leverage </li></ul></ul><ul><ul><li>Maximum leverage </li></ul></ul><ul><li>Style controls </li></ul><ul><li>Lenders already understand content of ADV disclosure </li></ul>
    21. 21. Leverage 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***
    22. 22. 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
    23. 23. Appraisal Ratio Regression Results 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
    24. 24. What have we learned? <ul><li>Factors associated with operational risk </li></ul><ul><ul><li>External conflicts of interest </li></ul></ul><ul><ul><li>Internal conflicts of interest </li></ul></ul><ul><li>Operational risk is understood by sophisticated investors </li></ul><ul><ul><li>Problem funds have concentrated ownership </li></ul></ul><ul><ul><li>Problem funds have difficulty borrowing money </li></ul></ul><ul><li>This suggests an important role for due diligence </li></ul>
    25. 25. A univariate measure of operational 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 ***
    26. 26. Operational risk and the half life of USD funds 0 0.5 1.0 1.5 50 45 40 35 30 25 20 15 10 5 0 90 months 85 80 75 70 65 60 55 50 45 Half Life Age of fund (months) Operational Risk  - score
    27. 27. Does the operational risk measure 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
    28. 28. Does the operational risk measure predict returns? Cross sectional return regression on prior operational risk, financial risk and style dummies 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
    29. 29. Investor Flows and Problem Funds <ul><li>Operational risk influences ownership and leverage </li></ul><ul><li>Lenders and hedge fund equity investors already understand risk content of Form ADV disclosures </li></ul><ul><li>Does operational risk modify the flow-performance relationship? </li></ul><ul><li>Do investors care? </li></ul>
    30. 30. Operational risk does not mediate naïve tendency to chase returns 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
    31. 31. Conclusion <ul><li>Important to quantify operational risk </li></ul>
    32. 32. Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of interest </li></ul></ul>
    33. 33. Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of interest </li></ul></ul><ul><li>Operational risk + conflict = low returns </li></ul>
    34. 34. Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of interest </li></ul></ul><ul><li>Operational risk + conflict = low returns </li></ul><ul><li>Operational risk does not mediate the naïve tendency of investors to chase returns </li></ul>
    35. 35. Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of interest </li></ul></ul><ul><li>Operational risk + conflict = low returns </li></ul><ul><li>Operational risk does not mediate the naïve tendency of investors to chase returns </li></ul><ul><ul><li>Either investors do not understand operational risk </li></ul></ul>
    36. 36. Conclusion <ul><li>Important to quantify operational risk </li></ul><ul><ul><li>This risk is associated with conflicts of interest </li></ul></ul><ul><li>Operational risk + conflict = low returns </li></ul><ul><li>Operational risk does not mediate the naïve tendency of investors to chase returns </li></ul><ul><ul><li>Either investors do not understand operational risk </li></ul></ul><ul><ul><li>Or investors know and do not care </li></ul></ul>
    37. 37. Important implication <ul><li>Hedge funds on average have positive alpha </li></ul><ul><li>Excluding operational risk increases alpha </li></ul><ul><li>Due diligence adds value to hedge fund investors </li></ul><ul><li>Suggests a new approach to hedge fund investing </li></ul>
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