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.
Posted by George O. Aragon (Arizona State University), Vikram K. Nanda (University of Texas), and Haibei Zhao (Lehigh University), on Thursday, May 21, 2020
Editor's Note: 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.
