Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration Stephen Brown, William Goetzmann, Bing Liang, Christopher Schwarz

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

Financial Risk Source: Elton and Gruber 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 Prior month assets under management 1 st quin tile 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% All TASS $US Funds Value weighted returns, Sharpe ratio in italics

Economies of Scale Prior month assets under management 1 st quin tile 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% Funds of Funds 7.45%9.25%8.90%9.54%10.14%9.98% All TASS $US Funds Value weighted returns, Sharpe ratio in italics

Economies of Scale Prior month assets under management 1 st quin tile 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% Funds of Funds 7.45%9.25%8.90%9.54%10.14%9.98% All TASS $US Funds Value weighted returns, Sharpe ratio in italics 26% of Funds of Funds <$25M !!!

Motivation  SEC mandated hedge funds file Form ADV by February 1 st, 2006  Controversial requirement overturned June 23 rd, 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 Available at SSRN:

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 ”  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.”

17 External conflicts Problem fundsNon problem funds With:N% YesN Broker/Dealer Investment Comp Investment Advisor Commodities Broker Bank Insurance Sponsor of LLP

18 Internal conflicts Problem fundsNon problem funds With:N% YesN Trade securities with clients Allow trading on own account Recommend own securities In-house broker dealer Recommends own underwriting service Recommends commission fee items Recommends brokers Use broker provided external research

Problem funds have a more concentrated ownership structure Problem FundsNon-Problem funds MeanMedianMeanMedianDiff Direct Owners Controlling Percent 75% Domestic Entity Indirect Owners Levered? Margin? Person Capital ($mm)

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 All fundsProblemNon problemDiff Leverage ** Avg. Leverage *** Max Leverage *** No FOF Leverage Avg. Leverage *** Max Leverage ** 5% Winsorized Avg. Leverage *** Max Leverage ***

Leverage By Style CategoryADV matched sample(%) Problem sample(% ) Problem leverage Non-problem leverage Convertible Arb Dedicated Short N/A72.22 Emerging Mkts Equity Neutral Event Driven Fixed Income FOF Global Macro Long-Short Managed Futures Multi-Strategy Total100%

Appraisal Ratio Regression Results ProblemNon-problemMatched sample Log Assets0.073***0.047*** Fund Age *** Stdev *** Onshore0.120*0.061**0.151* Incentive Fee ***-0.023** HWM Relationship-0.251*** ** Direct Domestic PercentOwner **-265** Adj. R-squared18.02%6.76%7.08% Num Obs2731,369279

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 TASSADV Previous Returns *** AgencyCrossTra ns 0.06 ** Previous Std. Dev *** RelBrokerDealer 0.28 *** Fund Age *** RelInvestComp 0.24 *** Log of Assets 0.13 *** RelInvAdvisor 0.24 *** Reports Assets 0.12 *** RelPartSponser 0.30 *** Incentive Fee *** BuySellYouOwn 0.08 ** Margin *** BuySellYourClie nt *** Audited *** RecSecYouOwn 0.33 *** Personal Capital *** RecUnderwriter 0.26 *** Onshor *** RecSalesInterest 0.28 *** OpenToInv 0.08 RecBrokers *** Accepts Mgd. Accts *** PercentOwner *** Corr ADV & TASS 0.42 *** DirectDomestic 0.31 ***

Operational risk and the half life of USD funds months Half Life Age of fund (months) Operational Risk  - score

Does the operational risk measure predict leverage? TASS Style DummiesB-G Style Dummies Coefft-valueCoefft-value *** *** *** *** *** *** *** *** *** *** Average *** *** Avg. Adj. R-sq.13.74%2.61% Avg. Obs2279

Does the operational risk measure predict returns? YearOperational risk coefficientt- value %-2.2** % %-4.76*** %-3.71*** ……… %-4.43*** % %-2.45** %-1.31 Average Value-0.92%-2.66** Avg. Adjusted R²40.17% Average Observations 1,027 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?

Coefft-valueCoefft-value Low Rank *** *** Mid Rank *** *** High Rank *** *** Std. Dev *** *** Category Flows *** *** Log Assets *** *** Mgmt. Fees ** *** ω-score Low Rank/ω Mid Rank/ω * High Rank/ω Avg. Adj. R-sq.14.00%14.16% Avg. Obs966 Operational risk does not mediate naïve tendency to chase returns

Conclusion  Important to quantify operational risk

Conclusion  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