Stephen Brown, NYU William Goetzmann, Yale Bing Liang, U Mass Christopher Schwarz, UC Irvine

 Is SEC registration useful?  What correlates to operational risk?  Can we predict operational event?

 Form ADV Item 11: legal and regulatory problems.  A “Problem” fund = a fund whose management company answered ‘Yes’ to ANY question on Item 11 of Form ADV.  Past Suspension  Past Fine  Other Legal or Regulatory issue

% 20% 40% 60% 80% 100% Hedge FundsAll Advisers Problem Non-Problem

"Problem" Funds"Non-Problem" Funds No. Funds% YesNo. Funds% Yes Broker/Dealer Investment Comp Investment Adviser Commodities Broker Bank Insurance Sponsor of LLP **, * significant at one and five percent respectively Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration, Stephen Brown, William Goetzmann, Bing Laing, Christopher Schwartz, Not for reproduction or citation or quotation without authors’ permission

"Problem" Funds "Non-Problem" Funds No. Funds% Yes No. Funds % Yes Buy Sell Your Own Buy Sell Yourself Clients Recommend Sec You Own [Rec] Agency Cross Trans Rec Underwriter Rec Sales Interest Rec Brokers Other Research

**, * significant at one and five percent respectively From Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration, Stephen Brown, William Goetzmann, Bing Laing, Christopher Schwartz, Draft: October 11, Not for reproduction or citation or quotation without authors’ permission Log(Assets)Fund Age (Years) Std DevOnshoreIncentive FeeHigh Water Mark RelationshipDirect Domestic Percent own 75% t-value

 We need PAST ADV problems  Difficult to get from SEC  Instead, we can use observables  “Rotation” of Lipper-TASS variables and “Rotation” of ADV characteristics that are most highly correlated.  Canonical correlation.  Use this model with historical data.

 A propensity score for “problem”  Uses TASS data (widely available)  As good as we can do without a research and due diligence team  A linear factor model  Does it predict fund disappearance?  Back-test

From Estimating Operational Risk For Hedge Funds, The Ω-Score, Stephen Brown, William Goetzmann, Bing Laing, Christopher Schwarz. Not for reproduction or citation or quotation without authors’ permission.

 Is the half-life of the fund related to the omega score?  Other factors – age.

months Half Life Financial risk (prior monthly  ) Operational Risk  -Score 0.8

 Market alternative to regulation  Not all funds register  Due diligence before investing

 445 DD funds over past decade  DD decision endogenous  Past returns.  Different thresholds for problems based on returns.  Focus on honesty

Database MatchesAll Funds CoefChi SqCoefChi Sq Log Assets ** ** Management Fee * ** Incentive Fee ** ** High Water Mark ** ** Leveraged Red Notice Period ** ** Lockup Period ** ** Return Mean ** ** Return Std. Dev ** ** Ret Autocorrelation Year DummiesYY Style DummiesYY Clustered by FundYY Fund Year Observations 26,12726,219 Number of Funds9,0019,093 R-Squared0.25

DD Funds Non-DD Matched Funds Differencep-value Flows Problem Flows Non-Pro Flows Appraisal ratio Problem A ratio Non-Pro A ratio

Model 1Model 2 coefficientChi-sqcoefficientChi-sq Return mean Return Std. Dev Return Autocorr Log(assets) Fund age Management fee Incentive fee Lockup period Notice period Non-Verification ** * Signature Self-Pricing * * Big 4 auditor ** * # Ind Board Lambda Style DummiesYY

Model 1Model 2 coefficientChi-sqcoefficientChi-sq Return mean Return Std. Dev Return Autocorr Log(assets) Fund age Management fee Incentive fee Lockup period Notice period Inconsistency Signature IQ Pricing Big 4 auditor * ** # Ind Board Lambda Style DummiesYY Num Obs

All FundsNon-Problem FundsProblem Funds Coeff.t-valueCoeff.t-valueCoeff.t-value Lawsuit Regulatory Misrepresentation Return Mean ** Return Std. Dev Return Autocorr Log(assets) ** * ** Fund age Management fee Incentive fee Lockup period Notice period Non Verification Signature IQ * Pricing Big 4 auditor Lambda * Style DummiesYYY Adjusted R-squared Num Obs

All FundsNon-Problem FundsProblem Funds Coeff.t-valueCoeff.t-valueCoeff.t-value Lawsuit Misrepresentation * Regulatory Log(assets) Fund age * Autocorrelation Management fee Incentive fee * * Lockup period Notice period * * Inconsistency Pricing * ** Signature IQ Big 4 auditor Lambda * * Style DummiesYYY Adjusted R-squared Num Obs

 Hedge fund opacity demands trust  Problem funds have:  Verification problems  Minor auditors  More likely to self-price