The Surprising Benefits of Mandatory Hedge Fund Disclosure

Regulators have long disagreed whether regulation would reduce hedge funds’ financial misreporting. On the one hand, critics have stated that hedge funds are unlikely to misreport because their investors are highly sophisticated financial players who can detect and deter financial misconduct. On the other hand, recent changes in the composition of hedge funds’ investors have led many to question this argument. In this paper, I test whether hedge fund regulation reduces misreporting by using a quasi-natural experiment in which a subset of hedge funds was regulated, deregulated, and then regulated again. Unique features of the setting permit me to study not only whether hedge fund regulation reduces financial misreporting—but, if so, why the regulation reduces misreporting. The results show that regulation reduces misreporting at hedge funds and that the imposition of disclosure requirements, even without other concurrent changes in regulation, can reduce hedge funds’ misreporting. The result seems surprising, because hedge funds’ investors are commonly thought to have access to far more information than is required by disclosure rules. Further inquiries suggest that disclosure requirements led funds to make changes in their internal governance, and that these changes in governance induced funds to report their financial performance more honestly and accurately.