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

mention the risks embedded in funds. In some cases, as with Madoff, the simplified prospectus of UCITS funds failed to mention large concentration or sub-custody risks; structured products and other complex financial products sold by banking networks to retail clients outside the UCITS scope raised numerous complaints—in many cases, structured products offered capital protection but no real guarantee, since stock market falls of more than 20% wiped out any possible protection. Distributors have also been held liable for giving advice at odds with the fundamentals of financial theory. In France, distributors recently made good on investor losses in cash+ funds, as the risk of these money-market funds going illiquid had not been clearly disclosed to investors. On the whole, no certification at all would have been better, as misleading certification also limits the incentives to transparency and risk management (if the fund is certified as a money-market fund by the regulator and perceived as low-risk by the market, what are the incentives to disclose the nature of the risks to investors or to the shareholder of the investment firm?). In the absence of a clear definition of responsibilities for the management of non-financial risks and of clear communication of non-financial risks, the full UCITS universe is at risk of the same adverse selection and misselling practices, which mean, in the end, higher non-financial risks for end-investors. It is clear that, in the responsibility of fund-industry professionals for the non-financial risks of products sold to investors, a subsidiarity principle should prevail. In this framework, it is logical for

the distributor that ultimately sells the products to bear the primary responsibility for disclosing the financial and non-financial risks of the financial instruments it sells. As such, the distributor should ensure that the products offered the client are in keeping with the client’s risk profile and wealth; it should also make every effort to provide the investor the clearest, most accurate, and least misleading information possible. It is, first of all, the distributor that is liable for poor investment choices or for misinforming the client. Of course, if the distributor can prove that the fund manager or the depositary has provided erroneous information or failed to respect contractual or legal terms, the burden of this liability can be shifted or financial compensation for damages can be awarded. It is, as it happens, one of the reasons for which, in application of MiFID, some country regulations defined the relationship between distributor and manager and made it possible for the distributor to have its promotional documents for a product approved by the manager of the product. The UCITS IV directive seeks to harmonise country regulations as well as the distribution of funds in Europe, so the ties between distributors and managers, currently a matter of national law, could be formalised in EU regulations, too.

2.3 Unclear Depositary Obligations and Liabilities Increased Risks

The growing sophistication of funds, as well as their greater use of derivatives and of international assets that require external sub-custody, has made bookkeeping and the monitoring of compliance of the fund ever more important means of protecting investors. Making more assets

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An EDHEC-Risk Publication