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Trust and Delegation

Author

Listed:
  • 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.

Suggested Citation

  • Stephen Brown & William Goetzmann & Bing Liang & Christopher Schwarz, 2009. "Trust and Delegation," Yale School of Management Working Papers amz2545, Yale School of Management, revised 13 Nov 2009.
    • Handle: RePEc:ysm:wpaper:amz2545
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    References listed on IDEAS

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    More about this item

    Keywords

    Hedge Funds; Operational Risk; Due Diligence;
    All these keywords.

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • K2 - Law and Economics - - Regulation and Business Law

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