A Better Grasp of Non-financial Risks

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

4. Which Possible Protection of Unit-Holders?

involved in collateral management, exercise due diligence with investment firms, and work for several funds. The interests of depositaries may conflict with those of the investment firms 38 that hire them, so one might think that it would be hard for depositaries to disclose the non-financial risks of a fund to other parties, including to end-investors, unless there are clear regulatory guidelines and incentives to do so. All the same, it is in the depositaries’ best interest to disclose the sub-custody risks of the fund to which it provides services. After all, disclosure of this risk should lessen their liability

(as they have not hidden from investors risks they were aware of).

Ratings could also be beneficial to institutional investors, especially if they are produced by the specialist houses that perform due diligence of investment funds for these institutional investors. The costs of due diligence, which makes it possible to choose strategies and to assess the non-financial risks of investment funds, are partly redundant, as they are borne by different investors at the same time, and ratings made available to the public would partly suppress these redundancies.

38 - Depositaries must act only in the best interests of fund investors (UCITS, article 10: “In the context of their respective roles the management company and the depositary must act independently and solely in the interest of the unit-holders”) (EU- 2008). Depositaries, however, are hired and paid by the investment firm, not by the end-investor. Potential conflicts of interest are the result, and the depositary may find it hard to challenge some of the decisions of the asset manager that may not be in the interest of the investors. Thus, additional mechanisms such as disclosures and possibly rating of the quality of the management of non-financial risks would ensure that depositaries and investment firms always act in the best interest of investors.

Box 4: Rating non-financial risks requires new processes Traditional statistical techniques, whereby one attempts simply to model a dependent variable—losses with sub-custodians—as a function of explanatory variables, are expected to perform poorly when there are very few large losses at sub-custodians. One should then rely on knowledge from other fields, on the probability of default of sub-custodians (which can be modelled with credit scoring models using typical variables), and on the exposure to these custodians. The techniques to be used must be further specified, but they are similar in spirit to those used by rating agencies. Rating agencies currently rate investment and securities firms. These ratings are ambiguous. First, bond ratings are regulated, but investment and securities firms ratings are not; for many people, however, the difference is unclear. Second, the rating of investment firms and depositaries provides only a partial idea of the protection offered to unit-holders: “Asset manager ratings reflect an assessment of an fund management organisation’s vulnerability to operational and investment management failures, as reflected by the quality of the organisation’s experience, staffing resources, investment processes, internal control environment, investment administration capabilities, and related technology resources. Asset manager ratings are assigned on a scale from ‘M1’ to ‘M5’, with ‘M1’ being the highest rating denoting the lowest vulnerability to operational and investment management failures” (Fitch 2010). The quality of the processes at the investment firm enables better protection of unit- holders; the strength of the asset manager, however, is not synonymous with unit- holder protection (after all, if an investment firm foists the risk onto its clients, then it becomes financially strong). Last, these ratings do not explicitly quantify sub-custody risk for investors, since this risk depends not on the type of management but on the fund itself; in some cases, sub-custody risk is borne by unit-holders, and it may, to an extent, be independent of the quality of risk management at the investment firm.

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An EDHEC-Risk Institute Publication