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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.

Suggested Citation

  • Stephen Brown & William Goetzmann & Bing Liang & Christopher Schwarz, 2009. "Trust and Delegation," NBER Working Papers 15529, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:15529
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    1. repec:eee:jfinec:v:127:y:2018:i:2:p:389-415 is not listed on IDEAS
    2. repec:spr:reaccs:v:22:y:2017:i:3:d:10.1007_s11142-017-9403-5 is not listed on IDEAS
    3. repec:kap:apfinm:v:26:y:2019:i:1:d:10.1007_s10690-018-9258-1 is not listed on IDEAS
    4. repec:bla:eufman:v:23:y:2017:i:2:p:211-253 is not listed on IDEAS
    5. repec:eee:jbfina:v:98:y:2019:i:c:p:212-229 is not listed on IDEAS
    6. Raphael Boleslavsky & Bruce Carlin & Christopher Cotton, 2019. "Disincentive Effects of Evaluation," Working Paper 1410, Economics Department, Queen's University.
    7. Joenväärä, Juha & Kosowski, Robert & Tolonen, Pekka, 2018. "The Effect of Investment Constraints on Hedge Fund Investor Returns," CEPR Discussion Papers 12599, C.E.P.R. Discussion Papers.
    8. Edwin J. Elton & Martin J. Gruber & Christopher R. Blake, 2014. "The Performance of Separate Accounts and Collective Investment Trusts," Review of Finance, European Finance Association, vol. 18(5), pages 1717-1742.
    9. Charles Cao & Bing Liang & Andrew W. Lo & Lubomir Petrasek, 2014. "Hedge fund holdings and stock market efficiency," Finance and Economics Discussion Series 2014-36, Board of Governors of the Federal Reserve System (US).
    10. Andrew J. Patton & Tarun Ramadorai & Michael Streatfield, 2015. "Change You Can Believe In? Hedge Fund Data Revisions," Journal of Finance, American Finance Association, vol. 70(3), pages 963-999, June.
    11. Luca Corazzini & Christopher Cotton & Tommaso Reggiani, 2019. "Delegation And Coordination With Multiple Threshold Public Goods: Experimental Evidence," MUNI ECON Working Papers 2019-02, Masaryk University.
    12. Agarwal, Vikas & Lu, Yan & Ray, Sugata, 2014. "Under one roof: A study of simultaneously managed hedge funds and funds of hedge funds," CFR Working Papers 14-13, University of Cologne, Centre for Financial Research (CFR).
    13. Áron Tóth, 2014. "Reputation Effects In The Market Of Certifiers: Evidence From The Audit Industry," Economic Inquiry, Western Economic Association International, vol. 52(2), pages 505-517, April.
    14. repec:eee:jfinec:v:127:y:2018:i:3:p:417-434 is not listed on IDEAS
    15. Vikas Agarwal & Yan Lu & Sugata Ray, 2016. "Under One Roof: A Study of Simultaneously Managed Hedge Funds and Funds of Hedge Funds," Management Science, INFORMS, vol. 62(3), pages 722-740, March.
    16. Jorion, Philippe & Schwarz, Christopher, 2014. "Are hedge fund managers systematically misreporting? Or not?," Journal of Financial Economics, Elsevier, vol. 111(2), pages 311-327.
    17. Luca Corazzini & Christopher Cotton & Tommaso Reggiani, 2019. "Delegation And Coordination With Multiple Threshold Public Goods: Experimental Evidence," MUNI ECON Working Papers 2019-02, Masaryk University.

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    JEL classification:

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

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