Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration

In our forthcoming Journal of Finance article, Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration, we use the SEC rule adopted on December 2, 2004 that required hedge fund managers to register as investment advisers by February 1, 2006 as an opportunity to test the potential value and materiality of operational risk and conflict of interest variables disclosed by a large number of hedge funds in February 2006. On June 23, 2006, the U.S. Court of Appeals for the District of Columbia Circuit vacated this rule change, with the result that far fewer hedge fund managers have been required to register as investment advisors. As a result, the February 2006 ADV filings by a large number of hedge fund managers present a rare opportunity to examine the fundamental question of whether such disclosure is necessary or warranted.

We find that operational risk indicators are conditionally correlated with conflict of interest variables, indicating a potential value of disclosing such conflicts to investors. Operational risk factors are also correlated with lower leverage and concentrated ownership, suggesting that the 2006 disclosure requirements may have been redundant for lenders and equity investors in hedge funds. In contrast, operational risk factors had no ex-post effect on the flow-performance relationship, suggesting that investors either lack this information or do not regard it as material. The results of our analysis provide a framework for the cost-benefit analysis of regulatory disclosure. Our findings suggest that any consideration of disclosure requirements should take into account the endogenous production of information within the industry, and the marginal benefit of required disclosure on different investment clienteles.

The full paper is available for download here.