Trust and Delegation

This paper studies operational risk in the hedge fund industry using a sample of 444 due diligence (DD) reports. Many funds suffer from operational problems, ranging from limited disclosure on past legal or regulatory offenses and the failure to use a major auditing firm to the frequent use of internal pricing. We use direct evidence of inadequate or failed internal processes to derive a simple canonical correlation-based measure for operational risk. This measure is consistent with the Basel definition of operational risk and has relevance beyond hedge fund applications. It controls for selection bias and other conditioning factors using an extension of Heckman's (1979) procedure. Operational risk does not influence investors' return-chasing behavior, despite the fact that exposure to operational risk increases the likelihood of subsequent poor performance and fund disappearance. Our study emphasizes the importance of information verification in the context of financial intermediation