A Better Grasp of Non-financial Risks

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

3. Risks and Responsibilities in the Fund Industry

Europe. In the United States, there are no regulated alternative funds such as those found in every European country, and investment funds that are not mutual funds are hedge funds. The American regulator, the Securities and Exchange Commission (SEC), is arguably the regulator with the most aggressive oversight of mutual funds. Until recently, however, American hedge fund managers were exempt from requirements to register with the SEC 16 and from the SEC’s oversight. President Obama’s new plan to regulate hedge funds, included in the overhaul of the financial system, will require hedge fund (as well as private equity and venture capital fund) managers to register as investment advisors with the SEC; annual accounting checks at a random date are planned. Mutual funds are required to disclose fees and expenses, as in other common- law countries. But the US regulation of investment funds is very similar to corporate law 17 and thus gives a central

role to the board of directors. Contractually, it is the board that hires the fund manager (called the investment advisor) as well as the custodian to safe-keep the assets (see figure 2). Oversight is the responsibility not of a depositary but of the board. In addition, the US board of directors can discuss the fund’s strategy, seek to reduce expenses, merge funds, or even dismiss the fund manager it has contracted, although it rarely does so. In 2004, the SEC introduced a formal requirement that the chair and 75% of the mutual fund board be independent of the fund advisor 18 to prevent capture of the board. The role of the board, however, remains controversial; Morley, Curtis, and Olin (2010) argue that even independent directors on boards are usually hired by the investment firm, and are no less subject to capture than are chief compliance officers. 19 The SEC, however, always maintained the essential role of the board as a watchdog, and it has refused to implement the contractual form of mutual funds.

16 - These exemptions, provided for in the Investment Company Act of 1940, are for funds with one hundred or fewer investors and funds where the investors are "qualified purchasers". 17 - The board was made mandatory in the Investment Company Act of 1940, despite strong initial opposition from open-ended funds: at the time no investment funds had boards. 18 - This requirement is being challenged by the chamber of commerce. 19 - US regulation requires that a chief compliance officer be responsible for administering the fund's policies and procedures and that designation and compensation of this officer be approved by the fund's board of directors, which has the power to remove him or her from office.

Figure 2: The structure of a (US) mutual fund

SHAREHOLDERS

MUTUAL FUND Board of Directors or Trustees

Oversses the fund's activities, including approval of the contract with the management company and certain other service providers.

INVESTMENT ADVISER Manages the fund's portfolio according to the objectives and policies desribes in the fund's prospectus.

PRINCIPAL UNDERWRITER Sells fund shares, either directly to the public or through other firms ( e.g ., brocker-dealers)

ADMINSTRATOR Oversees the performance of other companies that provide services to the fund and ensures that the fund's operaations comply with applicable federal requirements.

TRANSFER AGENT Executes shreholder transactions, maintains records of transactions and other shareholder account activity, and sends account statements and other

CUSTODIAN Holds the fund's assets maintening therm

INDEPENDENT PUBLIC ACCOUNTANT Certifies the funds financial statements.

separately to protect

shareholder interests and reconciling the fund's

holdings against the custodian's records.

documents to shareholders.

Source: Investment Company Institute

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An EDHEC-Risk Institute Publication