A Better Grasp of Non-financial Risks

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

2. The Rise of Non-financial Risks in the Fund Industry

The second section of this study explains the rise of non-financial risks in investment funds. The enlargement of available assets is a first explanation. Regulatory certification based on inadequate rules contributed to a rise of risks. The last reason lies in the diverging application of EU regulations and supervisory practices, which can be partly explained by competition between countries. 2.1 The Evolution of Fund Management Techniques Has Increased Non-financial Risks UCITS regulation was originally constructed from country regulations when funds invested mainly in domestic listed securities, and when depositaries could hold all assets in custody. With the increasing sophistication of fund management techniques and number of asset classes, investment funds invested in derivatives and extended their holdings of securities to geographies that required local custody. The legislative framework, as we saw in section one, was unsuited to managing the risks arising from the changes in the investment fund industry. After all, the continuous evolution of funds makes non-financial losses all the more likely. The evolution of financial techniques used in UCITS funds has been acknowledged in the CESR (2007) advice on eligible assets and in the resulting eligible assets directive (or EAD) (EU 2007), which have made tentative clarifications of the use of these new assets, and the recommendation EC/2004/383 (EU 2004) on sophisticated UCITS has clarified the very vague article 21 in UCITS III (EC 2008) that allows member states and

UCITS some leeway in calculating global exposure when investments in derivatives are made. The EAD has allowed investment in indices representative of such ineligible assets as commodities and hedge funds, in non-leveraged collateralised debt obligations, and even in real estate and private equity if the indices comply with liquidity and diversification requirements of UCITS. Derivatives on ineligible assets must naturally be settled in cash (otherwise, the fund would receive ineligible assets directly); in theory, exposure to precious metals is not allowed, but this UCITS requirement is being discussed, if not challenged, by some country regulators. The CESR (2007) has also exempted UCITS funds from incorporating the underlying positions of their investments in financial indices for the calculation of the quantitative restrictions (such as the limitation of concentration risk) of their funds. Along with these increased possibilities for investing, funds have ever more means of investing in other geographies. Exotic geographies usually require sub-custody, so restitution risk increases. In exotic geographies, restitution risk is similar to default risk as it is closely linked to the choice of investment and cannot be fully mitigated by European regulations to which the sub-custodians are not subject. Second, the UCITS framework allows higher leverage for sophisticated UCITS as a result of the authorisation to use Value-at-Risk to measure leverage. The CESR (2009b) advice on sophisticated funds requires that monthly VaR be limited to 20%, a fairly lenient figure, (conventional UCITS, not subject to VAR rules, can be riskier than sophisticated UCITs), which has made possible a wave of such funds.

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An EDHEC-Risk Institute Publication