Operational Risk, Fund Performance and Investors Protection: Evidence From China

This paper investigates the operational risk, fund performance and investor protection in the seven years subsequent to the 2001 liberalization of the Chinese open-end funds market. The empirical results indicate that the fund type and fund manager’s qualification are positively associated with selecting the Big 4 auditing firms, while the size and profitability of open-end funds are not. The results also indicate that the open-end funds audited by the Big 4 firms do not outperform the funds audited by non-Big 4 firms.


Introduction
As the investment fund industry has grown explosively, so too has the list of fund failure. One of the famous examples of hedge fund failure is the Long Term Capital Fund managed by the Long-Term Capital Management (LTCM) 1 . In September 2006, another large hedge fund, Amaranth, reported losses of more than $6 billion apparently incurred in only one month, representing a negative return over that month of roughly 66 percent [1]. A recent example is the Madoff scandal. On December 11, 2008, the Securities and Exchange Commission (SEC) charged Bernie Madoff and his firm, Bernard L. Madoff Investment Securities LLC, with securities fraud for a $65 billion dollar Ponzi scheme 2 .
To better understand why investment funds, including both the hedge funds and mutual funds, fail and how these failures could be avoided, researchers attempt to predict the fraud and other operational risks in financial firms. Brown, Goetzmann, Liang, and Schwarz [2,3] use a contemporaneous cross-section of hedge funds' Form ADV filings with a summary of historical violations to create a measure of operational risk based on the correlations between historically available hedge fund data and Form ADV variables. They then test if this measure is associated with hedge fund death, flows, and returns.
Hedges IV [4] concludes that the primary cause of fund's failure attributed to one of three categories of risk, investment risk, business risk, and operational risk. Operational risks are associated with supporting the operating environment of the fund. The operating environment includes trade processing, accounting, administration, valuation, and reporting. These are the types of risks that investors do not intend to take as part of their investment strategy. For example, it could be the risk that an investment might be fraudulent, or that managers might misrepresent performance. The most common operational issues related to investment fund losses have been misrepresentation of fund investments, misappropriation of investor funds, unauthorized trading, and inadequate resources. The most significant operational issue is the misrepresentation of investments, which is defined as the act of creating or causing the generation of reports and valuations with false and misleading information. This may be due to deliberate deception or to operational errors.
It is widely believed that the internal fraud and operational risk are alleviated by selecting a good external auditor and larger and more prestigious auditors have greater incentives to monitor the firms closely. The auditor selection can be viewed as an indication of firm's willingness to control the operational risk [5,6].
Nevertheless, most of the existing auditor selection literature ignores the financial companies or investment companies because there is no comparability between them and normal companies. In the present study, I investigate the choice of auditor and investor protection in China's open-end fund market over the period 2001-2007. The present study contributes to the literature in a number of ways. First, the 2001 liberalisation of open-end funds market in China provides an environment for the study of auditor selection in the fast-growing investment industry. It is thus possible to investigate which slices of the fund audit market the international firms gained in the booming Chinese funds market. Second, previous studies suggest that highquality auditors provide a source of protection for equity investors in the US and other developed countries 3 . This study sheds light on this issue in an emerging market. In particular it explores the question whether the Big 4 auditors are associated with the open-end funds which have abnormal returns.
In the present paper, I first investigate the determinants of choice of auditor by developing several hypotheses based on characteristics of China's open-end funds, such as fund type, fund manager's qualification, fund size and profitability. In the second step, I study whether the Big 4 auditors protect the open-end funds investors by extending Krishnan [7] and Francis and Wang [8] method.
The rest of this paper is organised as follows. Section "Literature Review" reviews the related literature. Section "Hypotheses Development and Models" develops the hypotheses and models. Section 4 presents the data and empirical results. Conclusion is in the last section.

Literature Review
Early researches on the investment funds have centred on the performance persistence of investment funds 4 and the investor behaviour and cash flows to funds 5 . Operational risk and illegal behaviour by fund managers were ignored in these studies.
Several recent papers examine the returns manipulation of hedge fund manager and illegal behaviour conducted by mutual fund managers. Agarwal, et al. [9,10], Bollen and Pool [10,11] present strong evidence that hedge funds' manipulate their reported returns. Zitzewitz [12] shows that late trading in mutual funds was widespread. Goetzmann, et al. [13] develop pricing rules that prevent investors from late trading. Choi and Kahan [14], Houge and Wellman [15] show that fund families that allowed late trading suffered significant outflows.
A number of other studies investigate the operational risk in lending institutions. The overall conclusion of these papers is that operational risk is a major source of risk for lending institutions and internal fraud is the largest component of operational risk. Chernobai, et al. [16] find financial institutions with weak corporate governance are more likely to have operational events. Perry and de Fontnouvelle [17] test stock price reactions to operational risk events at lending institutions. For internal fraud, the firms' market capitalization drops by double the value of the loss. For other operational losses, the market capitalization only drops by the value of the loss.
It is widely believed that the internal fraud and operational risk can be alleviated by using a good external auditor and larger and more prestigious auditors have greater incentives to monitor the firms. The auditor selection is motivated from three possible sources -client characteristics, audit firm characteristics or the audit environment [5,6]. The existing literature has concentrated on exploring how either auditor or client characteristics determine auditor choice. Auditor section research has been conducted in the U.S. and other developed countries 6 . DeFond [18] summarises the previous literature and concludes that larger companies and those making securities issues are more likely to select larger or higher reputation (as proxied by Big Six) 7 audit firms. DeFond [18] also finds support for the propositions that companies with lower management ownership and those with higher gearing tend to select larger audit firms. Firth and Smith [19] find similar variables significant for the New Zealand companies in the new issue market.
In addition to the choice of auditor, the association between earnings quality and large international accounting firms has also been investigated extensively. DeAngelo [5] documents that higher audit quality is associated with Big six auditors, where audit quality is defined as the joint probability of detecting and reporting material financial statement errors. Francis and Krishnan [20] argue that investor may perceive Big 4 auditors as having higher quality because these auditors have more of the observable characteristics associated with quality, such as specialised training and peer reviews, than non-Big 4 auditors.
There is evidence that earnings of U.S. companies with Big 4 auditors are of higher quality and that the stock market values earnings surprises of Big 4 clients more highly than earnings surprises of firms with non-Big 4 auditors [21,22]. Kinney and Martin [23] analyse nine data sets of audit-related adjustments from more than 1,500 audits across 15 years, and conclude that audit-related adjustments are overwhelmingly negative on pre-audit net earnings and net assets. Another reason investors have greater confidence in the reported earnings of Big 4 clients is that Big 4 auditors are more likely to issue going concern warnings than non-Big 4 auditors for the same set of client circumstances [24].

Hypotheses Development and Models
Auditor selection Theoretical studies have shown that larger or more prestigious accounting firms have greater incentives not to perform a low-quality service at a high-quality price because they have more wealth [25] and more valuable reputations [5]. The fund managers who have obtained the relevant degrees from developed countries or the professional certifications, such as Chartered Financial Analyst (CFA), are deemed to have stronger links with the Big 4 firms. I therefore expect the openend fund with its manager is a Chartered Financial Analyst (CFA) or has an overseas qualification to be more likely to select a Big 4 auditor. This leads to the following hypothesis: There are four types of open-end funds in China. Stock funds are investing heavily on common stocks and the objective of this type of funds is long-term growth through capital appreciation. The other three categories include bond funds, money market funds and hybrid funds. These funds have a more diversified portfolio containing bonds, money market instruments and other assets. Kelley [26] and Granzin [27] compare the value and growth indices based on the behaviour of value and growth funds and report higher volatility of the funds investing heavily on the growth stocks. In the present study, I divide the open-end funds into two groups, stock funds and non-stock funds, which include bond funds, money market funds and hybrid funds. Non-stock funds have lower risk given the nature of the instruments they invested. In the light of the above discussion, I expect that the stock funds tend to Previous auditor selection studies have generally included a client size measure as a control variable [18,19]. These hypotheses are tested by running a binomial logistic regression. It takes the following form:

Investor protection
Subsequent set of hypothesis tests whether the Big 4 firms protect the open-end funds investors in China. It is widely accepted that Big 4 firms in the US impose a high level of earnings quality in order to protect their brand name reputation form legal exposure and reputations risk which can arise from misleading financial reports by clients [5]. However, cross-country comparative accounting studies show that the Big 4 firms' behaviour with respect to client earnings and investor protection varies systematically with the incentives in different institutional environments [28][29][30][31][32][33][34]. A more recent study by Francis and Wang [8] investigates the joint effect of investor protection and Big 4 audits on earnings quality for a large sample of firms from 42 countries. They find that earnings quality increases for firms with Big 4 auditors when a country's investor protection regime gives stronger protection to investors. In the light of the above discussion, I expect that the openend funds audited by Big 4 firm offer higher return to the investors because of investor protection associated with the high-quality audits. This hypothesis is formulated in the alternative form as:

H1e: An open-end fund being a Big 4 firm's client tend to provide higher return to the investors.
Following Krishnan [7] and Francis and Wang [8], I pool the clients of Big 4 auditors and other auditors, and add an additional dummy variable DR it in the regression. This model directly examines whether the contemporaneous association between earnings and negative returns is statistically different for clients of Big 4 firms and clients of other auditors.
Where ∆NAV it is the change of net asset value per share for fund i in year t; R it is annual market return calculated over a 12-month period; and DR it is a dummy variable that equals 1 if R it <0 and 0 otherwise. FIRM it equals 1 for clients of Big 4 firms and 0 for other auditors' clients.    In order to test the significance of the above four determinants in the presence of the others, I run the logistic regression for the pooled data from 2001-2007. The result is shown in Table 4. The regression is statistically significant at 5% level on an overall basis, with one individual variable significant at 5% level and one individual variable significant at 10% level. As expected, there is a positive relationship between the fund manager's qualification and the likelihood of selecting a Big 4 auditor. The fund type is marginally significant at 10% level. However, the empirical result is not able to provide support for the positive relationship between the size and profitability of open-end funds and the likelihood of selecting a Big 4 auditor.

Data and Results
The investor protection analysis is reported in   the funds audited by non-Big 4 firms. Therefore Big 4 firms do not provide any investor protection apart from their high-quality auditing service.

Concluding Remarks
In recent years, the Chinese investment funds market has emerged as one of the fastest growing emerging markets in the world. The investment funds, especially the open-end funds, are becoming the major institutional investors in China's stock and bond markets. There are a few systematic studies, however, on the operational risk, fund performance and investor protection on the investment funds in China.  Note: The heteroskedasticity consistent covariances are estimated using Newey-West method. ***, **, * stand for 1%, 5%, and 10% significance level, respectively Table 5: Regression analysis of investor protection.