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

Leverage is usually achieved with derivatives since cash borrowings by a UCITS are limited to 10% of its net asset value. On the whole, the pursuit of returns outside the traditional investment scope, naturally increase non-financial risks, as losses in the fund management industry have illustrated. But the duties of depositaries with respect to bookkeeping for derivatives and sub-custody have never been defined with precision at the European level. The EU recommendation that defines sophisticated funds as well as the extension of eligible assets has not been preceded by an impact assessment on back-office and middle-office functions or by reflection on the greater transparency needed by investors. In general, UCITS funds have been able to gather more risks without proper information and monitoring by parties: new instruments such as derivatives or funds of funds give access to risks that investors are unaware of because the true nature of risk is hidden. 2.2 Regulatory Certifications Based on Inadequate Rules Contributed to Adverse Selection and Misselling Regulatory certification based on inadequate rules contributed to the rise of adverse selection and misselling and in the end to an increase in risk. After all, the publicised objective of regulations to create a safe environment for investors and thus to protect unit-holders from non-financial risks leads investors to trust that certified funds will be free of non-financial risks. Adverse selection and misselling are especially worrying in the retail landscape because investors are often unable to make informed decisions (perhaps

because they lack the relevant knowledge or because regulators have not required of investment professionals the necessary transparency). Adverse selection may arise when certification can be obtained by complying with the letter of the law but without truly restricting the fund’s investment strategy or protecting investors. UCITS money- market funds, supposedly the most liquid, have been able to invest in illiquid assets, such as sub-prime securities, which only seemed liquid, as trading volumes were very thin relative to the size of the underlying assets. Investment in structured products can provide the same illusion of liquidity. For such funds, the requirement to have bi-weekly calculation does not mean that fund liquidity will be available when needed by investors, and it creates a false sense of security, especially since regulators and supervisors authorised in UCITS funds suspensions and side pockets typical of illiquid hedge fund strategies. Inadequate prescriptions and misleading certifications also contribute to misselling (inadequate representation of the characteristics of the product and erroneous investment decisions) as well as poor risk management (when regulators state that risks can be neglected). By certifying funds with illiquid assets as very liquid UCITS money-market funds, regulators misled end-investors; distributors and parent companies, which relied on such certifications, were also deceived. Because distributors are responsible for marketing and distributing products that conform to the investor’s profile, they have been sued by retail investors when commercial documents failed to

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An EDHEC-Risk Publication