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Trust and Delegation

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  • Stephen Brown
  • William Goetzmann
  • Bing Liang
  • Christopher Schwarz

Abstract

Due to imperfect transparency and costly auditing, trust is an essential component of financial intermediation. In this paper we study a sample of 444 due diligence (DD) reports from a major hedge fund DD firm. A routine feature of due diligence is an assessment of integrity. We find that misrepresentation about past legal and regulatory problems is frequent (21%), as is incorrect or unverifiable representations about other topics (28%). Misrepresentation, the failure to use a major auditing firm, and the use of internal pricing are significantly related to legal and regulatory problems, indices of operational risk. We find that DD reports are typically performed after positive performance and investor inflows. We control for potential bias due to this and other potential conditioning. An operational risk score based on information contained in the DD reports significantly predicts subsequent fund failure and statistical performance characteristics out of sample. Finally we find that observed operational risk characteristics do not appear to moderate fund flow.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15529.

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Date of creation: Nov 2009
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Publication status: published as Brown, Stephen & Goetzmann, William & Liang, Bing & Schwarz, Christopher, 2012. "Trust and delegation," Journal of Financial Economics, Elsevier, vol. 103(2), pages 221-234.
Handle: RePEc:nbr:nberwo:15529

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  1. Stephen Brown & William Goetzmann & Bing Liang & Christopher Schwarz, 2008. "Estimating Operational Risk for Hedge Funds: The ?-Score," Yale School of Management Working Papers, Yale School of Management amz2559, Yale School of Management, revised 11 Sep 2009.
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  6. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, American Finance Association, vol. 53(5), pages 1589-1622, October.
  7. Stephen Brown & William Goetzmann & Bing Liang & Christopher Schwarz, 2008. "Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration," Journal of Finance, American Finance Association, American Finance Association, vol. 63(6), pages 2785-2815, December.
  8. Fung, William & Hsieh, David A, 2001. "The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 14(2), pages 313-41.
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  16. K.J. Martijn Cremers & Vinay B. Nair, 2003. "Governance Mechanisms and Equity Prices," Yale School of Management Working Papers, Yale School of Management ysm376, Yale School of Management.
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  18. Nicolas P.B. Bollen & Veronika K. Pool, 2009. "Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution," Journal of Finance, American Finance Association, American Finance Association, vol. 64(5), pages 2257-2288, October.
  19. Liang, Bing, 2000. "Hedge Funds: The Living and the Dead," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 35(03), pages 309-326, September.
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Cited by:
  1. Jorion, Philippe & Schwarz, Christopher, 2014. "Are hedge fund managers systematically misreporting? Or not?," Journal of Financial Economics, Elsevier, Elsevier, vol. 111(2), pages 311-327.
  2. Cao, Charles & Liang, Bing & Lo, Andrew W. & Petrasek, Lubomir, 2014. "Hedge fund holdings and stock market efficiency," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2014-36, Board of Governors of the Federal Reserve System (U.S.).

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