Trust and Delegation

43 Pages Posted: 17 Aug 2009 Last revised: 20 May 2011

Stephen J. Brown

New York University - Stern School of Business

William N. Goetzmann

Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)

Bing Liang

University of Massachusetts Amherst - Department of Finance

Christopher Schwarz

University of California at Irvine

Multiple version iconThere are 3 versions of this paper

Date Written: April 16, 2011

Abstract

This paper studies operational risk in the hedge fund industry using a sample of 444 due diligence (DD) reports. Many funds suffer from operational problems, ranging from limited disclosure on past legal or regulatory offenses and the failure to use a major auditing firm to the frequent use of internal pricing. We use direct evidence of inadequate or failed internal processes to derive a simple canonical correlation-based measure for operational risk. This measure is consistent with the Basel definition of operational risk and has relevance beyond hedge fund applications. It controls for selection bias and other conditioning factors using an extension of Heckman’s (1979) procedure. Operational risk does not influence investors’ return-chasing behavior, despite the fact that exposure to operational risk increases the likelihood of subsequent poor performance and fund disappearance. Our study emphasizes the importance of information verification in the context of financial intermediation.

Keywords: Hedge Funds, Operational Risk, Due Diligence

JEL Classification: G2, K2

Suggested Citation

Brown, Stephen J. and Goetzmann, William N. and Liang, Bing and Schwarz, Christopher, Trust and Delegation (April 16, 2011). Available at SSRN: https://ssrn.com/abstract=1456414 or http://dx.doi.org/10.2139/ssrn.1456414

Stephen J. Brown (Contact Author)

New York University - Stern School of Business ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0306 (Phone)
212-995-4233 (Fax)

William N. Goetzmann

Yale School of Management - International Center for Finance ( email )

165 Whitney Ave.
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-5950 (Phone)
203-436-9252 (Fax)

HOME PAGE: http://viking.som.yale.edu

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Bing Liang

University of Massachusetts Amherst - Department of Finance ( email )

Amherst, MA 01003
United States

Christopher Schwarz

University of California at Irvine ( email )

Irvine, CA 92697-3125
United States

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