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Estimating Operational Risk for Hedge Funds: The ?-Score

Author

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

Abstract

Using a complete set of the SEC filing information on hedge funds (Form ADV) and the TASS data, we develop a quantitative model called the ?-Score to measure hedge fund operational risk. The ?-Score is related to conflict of interest issues, concentrated ownership, and reduced leverage in the ADV data. With a statistical methodology, we further relate the ?-Score to readily available information such as fund performance, volatility, size, age, and fee structures. Finally, we demonstrate that while operational risk is more significant than financial risk in explaining fund failure, there is a significant and positive interaction between operational risk and financial risk. This is consistent with rogue trading anecdotes that suggest that fund failure associated with excessive risk taking occurs when operational controls and oversight are weak.

Suggested Citation

  • Stephen Brown & William Goetzmann & Bing Liang & Christopher Schwarz, 2008. "Estimating Operational Risk for Hedge Funds: The ?-Score," Yale School of Management Working Papers amz2559, Yale School of Management, revised 11 Sep 2009.
    • Handle: RePEc:ysm:wpaper:amz2559
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    File URL: https://repec.som.yale.edu/icfpub/publications/2559.pdf
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    References listed on IDEAS

    as
    1. Brown, Stephen J & Goetzmann, William N & Ibbotson, Roger G, 1999. "Offshore Hedge Funds: Survival and Performance, 1989-95," The Journal of Business, University of Chicago Press, vol. 72(1), pages 91-117, January.
    2. Edward I. Altman, 1968. "Financial Ratios, Discriminant Analysis And The Prediction Of Corporate Bankruptcy," Journal of Finance, American Finance Association, vol. 23(4), pages 589-609, September.
    3. Stephen J. Brown & William N. Goetzmann & James Park, 2001. "Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry," Journal of Finance, American Finance Association, vol. 56(5), pages 1869-1886, October.
    4. Heckman, James, 2013. "Sample selection bias as a specification error," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 31(3), pages 129-137.
    5. Brown, Stephen J, et al, 1992. "Survivorship Bias in Performance Studies," The Review of Financial Studies, Society for Financial Studies, vol. 5(4), pages 553-580.
    6. Liang, Bing, 2000. "Hedge Funds: The Living and the Dead," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(3), pages 309-326, September.
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    Cited by:

    1. Kuzmina, Olga & Kelly, Patrick & Gorovyy, Sergiy, 2020. "Does Secrecy Signal Skill? Characteristics and Performance of Secretive Hedge Funds," CEPR Discussion Papers 14873, C.E.P.R. Discussion Papers.

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