Predicting Hedge Fund Lifespan
What is the Omega Score?
Omega Score is an award-winning operational risk score developed by Stephen J. Brown, William N. Goetzmann, Bing Liang, and Christopher Schwarz. Their featured paper which introduced the Omega Score, “Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration”, was published by Journal of Finance, the premiere academic journal in Finance, in 2008. A related paper “Estimating Operational Risk for Hedge Funds: the ω-Score:” won the Graham & Dodd Award in 2009 and was featured on the cover of the Nov/Dec 2010 edition of CFA magazine. The Omega score not only effectively measures hedge fund operational risks, but also answered a challenging question: how can we estimate the life span of a hedge fund?
How is Omega Score Calculated?
Using the SEC filing Form ADV combined with hedge fund TASS data, the Omega Score is calculated via canonical correlation analysis, a statistical methodology that constructs a measure of operational risk. The TASS variables that prior research has shown to be associated with the probability of fund failure are identified and used. Then a linear combination of these variables is constructed that maximally correlated to a variable similarly constructed from weighted set of ADV variables that match the TASS data. This linear combination using the TASS variables is the ω-Score, the proxy for operational risk. This method has the additional advantage of calculating the Omega Score for the time periods beyond availability of ADV data. The ω-Score is related to conflict-of-interest issues, concentrated ownership, and reduced leverage in the ADV data, and related to fund performance, volatility, size, age, and fee structures in the TASS data.