In this Opalesque.TV interview, Professor Stephen Brown describes how his recent research reports into operational due diligence have shown that operational risk is the “disease” that plagues hedge funds and funds of funds, and accounts for low market-adjusted returns along with many of the fund failures that occurred in 2008. While financial risk is a “symptom” of the disease, operational risk is more predictive of fund failure than is financial risk. Prof. Brown’s evidence points to his conclusion that due diligence is a source of alpha.
By analyzing the operational characteristics of funds, Prof. Brown’s research proves that managers and investors did not take due diligence processes very seriously leading up to 2008. Focusing on the central role of funds of funds as the primary conduit for institutional investing into the hedge fund space, Stephen argues that the traditional question of how much diversification a fund of funds should utilize is the wrong question. What is most significant is not the number of hedge funds that a fund of funds invests in, but the affordability of appropriate due diligence.
In addition, learn about the following:
• Analyzing all Form ADV data to determine operational risk characteristics
• Are legal and regulatory action against hedge funds predictive of operational risk?
• How are Leverage, Ownership Structure, and Conflicts of Interest used as indicators of operational risk?
• How 444 private investigator reports explain funds of funds' failures in operational due diligence
• Why diversification in funds of funds actually magnifies left-tail risk?
• What is the minimum due diligence investment a fund of funds must make?
• Why can only 25% of funds of funds afford to do the necessary due diligence?
Stephen Brown’s most recent research reports:
Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration, with William Goetzmann, Bing Liang and Christopher Schwarz, Journal of Finance 2008
Trust and Delegation, with William Goetzmann, Bing Liang and Christopher Schwarz, Journal of Financial Economics 2012 (forthcoming)
Is it Possible to Overdiversify? The Case of Funds of Hedge Funds, with Greg Gregoriou and Razvan Pascalau, Review of Asset Pricing Studies 2012 (forthcoming)
Stephen J. Brown is David S. Loeb Professor of Finance at the Leonard N. Stern School of Business, New York University. He graduated from Melbourne High School and Monash University in Australia and studied at the University of Chicago, earning an MBA in 1974 and a Ph.D in 1976. Following successive appointments as a Member of Technical Staff at Bell Laboratories where he spent time on assignment as District Manager in the AT&T Pension Fund, and Associate Professor at Yale University, he joined the faculty of New York University in 1986. In December 2002 he was appointed to the honorary position of Professorial Fellow with the title of professor at the University of Melbourne, and in 2007 was elected Academic Director, Financial Management Association. He has served as President of the Western Finance Association and Secretary/Treasurer of that organization, has served on the Board of Directors of the American Finance Association, and was a founding editor of the Review of Financial Studies. He is a Managing Editor of The Journal of Financial and Quantitative Analysis and has served on the editorial board of The Journal of Finance and is on the board of the Pacific-Basin Finance Journal and other journals. He has published numerous articles and five books on finance and economics related areas. He is currently a member of the Academic Advisory Board of Russell Investments, is retained as an advisor to MIR Investment Management Ltd in Sydney, and has served as an expert witness for the US Department of Justice and has testified on his research before a Full Committee Hearing of the U.S. Congress House Financial Services Committee in March 2007. In 2010 he served as a member of the Research Evaluation Committee of the Excellence in Research Australia initiative on behalf of the Australian Government.
