A Better Grasp of Non-financial Risks

The European Fund Management Industry Needs a Better Grasp of Non-financial Risks — December 2010

1. Large Non-financial Risks in Retail Funds Finally Make a Mark on the Regulatory Agenda

MGAM and the importance of external monitoring of compliance In September 1996, dealing in three Morgan Grenfell funds was suspended after the discovery of irregularities. After taking over the management of the funds in 1994, the fund manager started changing the nature of the funds’ investments. Well diversified at first, the portfolios became increasingly concentrated in high-risk holdings of unlisted securities, and the ten-percent cap on unit-trust holdings in unapproved securities (securities not listed in an eligible securities market and issued on terms not calling for an application for listing within twelve months) was soon exceeded; Deutsche Bank, the parent company, injected £180 million into the funds to solve the problem. Both the trustee and the asset manager had failed to verify the compliance of the funds with the contract and with regulation. The verification of compliance was made more complex by investments in opaque structured bonds that hid the nature of the underlying investments. At the time, it was unclear whether the trustee would have had to compensate the investor for losses if MGAM’s parent—Deutsche Bank—had not had pockets deep enough to resolve matters. An undisclosed German investment fund and the lack of checks and balances beyond the monitoring of compliance with regulations An option-type fund, managed by a German firm kept anonymous by the German Federal Court of Justice, had invested exclusively in Japanese options, whose value fell precipitously. The investor sued the depositary for breach of its duty to supervise the investment firm’s adherence to the principle of geographical risk

diversification, even though the fund did not commit to such diversification. The case was dismissed on 18 September 2001 by the German Federal Court of Justice on the grounds that a depositary bank is not responsible for verifying the suitability of investment decisions of the management company, only their legality. The investor’s losses were therefore not compensated for by the depositary. This judgement underscores the importance of transparency and distribution: funds should be distributed to investors capable of fully understanding the risk embedded in funds. It also underscores the absence of independent checks and balances in funds, since depositaries must execute the instructions of the investment firm if they comply with the regulation and with the prospectus, even if they are at odds with the tenets of financial theory. Custodians that are also broker-dealers are subject to conflicts of interests with their clients US regulation requires a custodian to safe-keep assets but entrusts monitoring to the board of directors, not to the depositary. Broker-dealers and securities firms are allowed to act as custodians. Republic Securities was a custodian for Armstrong, an investment firm (and the manager of the fund), improperly certified the accounts of Armstrong and was complicit in falsifying them. Employees of the custodian abetted the fraud. Broker-dealers allowed to act as custodians have potential conflicts of interests with investors since they also trade with the fund. Republic and its parent were able to compensate investors fully.

23

An EDHEC-Risk Publication