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. 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?

3. Growth of US Hedge Fund Industry Source: Lipper TASS

4. 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

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

6. Financial Risk

7. Funds of Hedge Funds  Provides  Diversification – lower value at risk  Smaller unit size of investment  Access to otherwise closed funds  Professional management / Due diligence

8. 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%-2.01 0.1070.1330.1280.1220.1170.118 All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics

9. 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%-2.01 0.1070.1330.1280.1220.1170.118 Funds of Funds 7.45%9.25%8.90%9.54%10.14%9.98%2.78 0.0740.1340.1520.1800.2130.139 All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics

10. 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%-2.01 0.1070.1330.1280.1220.1170.118 Funds of Funds 7.45%9.25%8.90%9.54%10.14%9.98%2.78 0.0740.1340.1520.1800.2130.139 All TASS $US Funds 1995-2006. Value weighted returns, Sharpe ratio in italics 26% of Funds of Funds <$25M !!!

11. 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?

12. 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 http://ssrn.com/abstract=918461

13. 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

14. 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

15. Phil Goldstein  ADV form asks everything from “your last small pox vaccination to every dirty joke you got on Email”  Item 11  Felonies  Investment-related misdemeanors  Any SEC, CFTC or self-regulatory issues  Lawsuits

16. 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. 17 External conflicts Problem fundsNon problem funds With:N% YesN Broker/Dealer35973.1191223.7 Investment Comp35950.3191215.8 Investment Advisor35973.9191241.6 Commodities Broker 35953.5191220.3 Bank35940.519129.8 Insurance35939.819129.4 Sponsor of LLP35956.8191221.5

18. 18 Internal conflicts Problem fundsNon problem funds With:N% YesN Trade securities with clients35930.719128.3 Allow trading on own account35984.8191269.3 Recommend own securities35975.5191250.4 In-house broker dealer35931.219122.3 Recommends own underwriting service 35969.4191246.8 Recommends commission fee items 35922.6191215.7 Recommends brokers35946.7191238.0 Use broker provided external research 35981.0191270.5

19. Problem funds have a more concentrated ownership structure Problem FundsNon-Problem funds MeanMedianMeanMedianDiff Direct Owners9.969.007.336.002.63 Controlling8.287.005.975.002.31 Percent 75%0.731.000.50 0.23 Domestic Entity0.801.000.490.000.31 Indirect Owners2.331.001.370.000.96 Levered?0.511.000.571.00-0.06 Margin?0.350.000.490.00-0.14 Person Capital ($mm) 1.260.002.620.00-1.36

20. 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

21. Leverage and Problem Funds All fundsProblemNon problemDiff Leverage0.510.57-0.06** Avg. Leverage52.2085.31-33.11*** Max Leverage96.82140.68-43.86*** No FOF Leverage 0.61 -0.00 Avg. Leverage63.7395.57-31.84*** Max Leverage118.27158.80-40.53** 5% Winsorized Avg. Leverage43.3465.15-21.81*** Max Leverage81.46108.33-26.87***

22. Leverage By Style CategoryADV matched sample(%) Problem sample(% ) Problem leverage Non-problem leverage Convertible Arb4.227.07118.04170.24 Dedicated Short 0.700.00N/A72.22 Emerging Mkts4.222.990.0018.60 Equity Neutral6.265.71185.3161.18 Event Driven11.9213.5951.3051.37 Fixed Income6.053.26287.50415.89 FOF21.3126.096.4736.04 Global Macro3.570.81140.00134.24 Long-Short34.7132.6123.8544.91 Managed Futures 3.484.0819.3491.01 Multi-Strategy3.523.5340.00120.70 Total100% 53.5385.49

23. Appraisal Ratio Regression Results ProblemNon-problemMatched sample Log Assets0.073***0.047*** 0.011 Fund Age 0.009 0.016*** -0.014 Stdev -0.018 -0.040*** 0.010 Onshore0.120*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-squared18.02%6.76%7.08% Num Obs2731,369279

24. 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

25. A univariate measure of operational risk TASSADV Previous Returns -0.27 *** AgencyCrossTra ns 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 *** BuySellYourClie nt -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. Operational risk and the half life of USD funds 0 0.5 1.01.5 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. Does the operational risk measure predict leverage? TASS Style DummiesB-G Style Dummies Coefft-valueCoefft-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. Obs2279

28. Does the operational risk measure predict returns? YearOperational risk coefficientt- 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 R²40.17% Average Observations 1,027 Cross sectional return regression on prior operational risk, financial risk and style dummies

29. 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?

30. Coefft-valueCoefft-value Low 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*** ω-score -0.010-1.610.0251.02 Low Rank/ω -0.019-0.15 Mid Rank/ω -0.202-1.78* High Rank/ω 0.0850.62 Avg. Adj. R-sq.14.00%14.16% Avg. Obs966 Operational risk does not mediate naïve tendency to chase returns

31. Conclusion  Important to quantify operational risk

32. Conclusion  This risk is associated with conflicts of interest

33. Conclusion  Important to quantify operational risk  This risk is associated with conflicts of interest  Operational risk + conflict = low returns

34. 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

35. 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

36. 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

37. 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