Investor Protection and Capital Fragility: Evidence from Hedge Funds Around the World

George O. Aragon is associate professor of finance at the W. P. Carey School of Business at Arizona State; Vikram K. Nanda is the O.P. Jindal Distinguished Chair in Finance at the University of Texas at Dallas School of Management; and Haibei Zhao is an assistant professor at Lehigh University. This post is based on their recent paper, forthcoming in the Review of Financial Studies. Related research from the Program on Corporate Governance includes The Elusive Quest for Global Governance Standards by Lucian Bebchuk and Assaf Hamdani; What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen, and Allen Ferrell; and The “Antidirector Rights Index” Revisited by Holger Spamann.

Does weak investor protection exacerbate capital fragility? In this paper, we examine this issue within an important investment vehicle—hedge funds—across countries that differ substantially in the quality of their institutions, as reflected in country-level investor protection. Hedge funds are lightly regulated investment vehicles with minimal disclosure requirements. Consequently, investors may lack relevant information to assess the operational risks of the investment manager. Specifically, the absence of regulatory oversight can increase the risk of management fraud and, in turn, generate large losses for fund investors. In addition, hedge funds’ use of leverage can expose investors to the risk of fund failure and legal risks related to asset recoveries during liquidation proceedings. We contend that, in environments with weak legal rules related to investor protection and poor enforcement of these rules, concerns about operational risks are amplified. Hence, in such environments, funds experience more outflows of investor capital following poor performance and, in this sense, exhibit greater fragility.

Our empirical analysis focuses on a large sample of hedge funds across thirty-five countries over the 1994–2013 period. We construct a score of weak investor protection (WIP) based on the World Bank’s Worldwide Governance Indicators and assign the score to each fund based on where it is located. The figure below plots our capital fragility measure against WIP for each country and highlights our main finding: funds in high WIP countries face a greater sensitivity of investor flows to poor performance (i.e., greater capital fragility) compared to funds in countries with strong investor protection. Our baseline analysis shows that a one-standard-deviation increase in WIP leads to an economically significant 22% increase in flow-performance sensitivity conditional on bad performance. Moreover, following poor fund performance, WIP is positively related to extreme capital outflows as measured by fund liquidation

One potential concern is that investor protection is correlated with other country-level variables that affect capital flows and that these variables, not investor protection, generate capital fragility. We address this concern by exploiting a shock to investor protection in the Brazilian market stemming from the 2014 passage of Brazil’s Clean Company Act (CCA). The CCA is a major anticorruption law that imposes strict liability on Brazil companies for corruption, bribery, and fraud, and grants federal authorities expanded powers of legal enforcement. We expect that such a regulatory shock would attenuate investor concerns about operational risks in the hedge fund marketplace and reduce fragility. We indeed find that the sensitivity of flows to poor performance among Brazilian funds is significantly reduced following the passage of the Act, consistent with stronger protection having a stabilizing force on investor capital. The fact that stronger investor protection leads to less capital fragility within the same country helps address the concern that unobservable country-level variables could drive our results.

Our findings also survive many variations of the baseline analysis, including (1) variables that capture differences in asset liquidity, investor clienteles, fund risk, economic development, education level, religiosity, and democratic rights; (2) alternative measures of investor protection; (3) controlling for cross-country differences in hedge fund regulations; (4) assigning WIP scores to the fund’s domicile country; and (5) market share-adjusted fund flows. Overall, these robustness checks reinforce our conclusion that weak investor protections make hedge fund capital more fragile and prone to investor runs.

Next, we investigate two aspects of operational risks that can explain our findings: first, a misvaluation channel where managers are less concerned about legal jeopardy in weak protection environments and more willing to distort performance figures. In this case, poor returns are regarded as an attempt to hide a far worse performance that managers find difficult to camouflage. Consequently, fund investors may see a first-mover advantage and choose to exit the fund to redeem their shares at inflated net asset values in response to early warning signs of trouble. We indeed observe more returns management among funds managed in weak protection countries, as measured by a greater incidence of suspicious patterns in reported returns, longer reporting delays, and more frequent return revisions. Second, an investor protection channel whereby weak investor protection and legal enforcement can intensify the risk and cost to investors of asset recoveries during fund bankruptcy or liquidation. In these environments, funds would be more prone to runs if enough investors, such as those with little political or economic influence, are concerned about inequitable treatment when funds are liquidated after poor fund performance. We investigate a sample of “twin” funds that are managed in different countries but have nearly identical returns and, hence, control for the effects of misvaluation. We find more outflows after poor performance from funds in weak protection countries compared to their twins in strong protection countries. The fact that our results hold even among twin funds with nearly identical returns and underlying asset holdings helps isolate the effect of misvaluation and supports the investor protection channel.

Our paper contributes to the recent literature on investor runs in open-end funds and more broadly, fragility in the shadow banking system. In the prior literature, investor fragility is a consequence of liquidity transformation services whereby funds hold illiquid assets while offering more generous funding liquidity terms to investors. While the prior literature on investor runs focuses on strategic complementarities emanating from the costly liquidation of fund assets, we uncover a new channel that the risk of fraud and weak legal protection associated with poor investor protection can also induce fragility in the shadow banking system.

This figure plots country-level estimates of capital fragility (y-axis) against country-level measures of weak investor protection WIP (x-axis). A country’s capital fragility is the estimated regression coefficient from the following country-by-country regression of fund flows: where Low is an indicator variable equal to one if fund performance Perf is below its median among all funds within a country during a given quarter, and denote fund and time fixed effects respectively, and Control is a vector of control variables. Larger estimates of  ndicate larger investor redemptions from hedge funds in that country in response to a given level of poor performance and thus signify greater fragility for a country. The asterisks represent the country-level capital fragility measures and their corresponding countries’ average WIP. The letters represent the two-digit ISO 3166 code for the corresponding country. The solid line represents the fitted regression estimate. The estimation result is fragility = –0.325+ 0.111×WIP, and the t-statistic of the slope is 4.19.

The complete paper is available for download here.

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