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?

Ratings of securities firms suffer the same drawbacks as ratings of investment firms; they may simply help small investment firms shortlist the depositary banks they want to interview. We must emphasise that there are ratings of funds (Fitch ratings), but that they are more ambiguous again than ratings of investment firms and inappropriate as such for our purpose. They are the result of the blend of the financial risks 39 and the operational risks associated with the processes at the investment firm and at its service providers. Yet they do not measure explicitly what can best be defined as the risk of default of an investment fund, the risk of disappearance of assets (as in sub-custody risk), or the risk of unit-holders finding themselves unable to redeem their units. Ratings rely heavily on the credit risk of the instruments held in a fund, even though the average ratings of the instruments in a fund are not a good representative of financial risk; ratings take into account risk management and operational processes, but the risk of disappearance of assets at a sub-custodian, like the risk of default, is also independent of the processes and linked to amounts in sub-custody and to the ratings of sub- custodians. Last, derivatives hide the true nature of the risk (if the asset underlying a derivative disappears, the derivative instruments loses market value, a loss that hides the non-financial risk of the investment), but for the sake of transparency it would be of interest to have an assessment of the true extent of the non-financial risks of a fund.

39 - Rating agencies, unlike firms such as Morningstar and EuroPerformance, have access to fund positions, and are thus in a better position to assess extreme financial risks. 40 - See: http://www. fool.com/investing/ mutual-funds/2008/06/06/ dont-trust-the-mutual-fund- industry.aspx And: www.caceis.com/ fileadmin/pdf/newsletters_en/ caceisnews18_EN.pdf

4.3 Transparency versus Insurance In contrast to the aforementioned notion of insurance against non-financial risks, a notion that, in spirit, responds to the assumptions, as formulated in civil law and as implicit in European regulation, of total protection of the retail investor, is the notion, dear to common law, of informed and consenting parties and thus of transparency. Transparency creates incentives to manage risks because informed investors may turn away from poorly managed, risky funds. Furthermore, there may be higher demand for transparency to restore trust, which, as anecdotal evidence suggests, is currently missing in the mutual fund industry. 40 We thus recommend that ratings of non-financial risks be reported together with fund rankings and the financial risk

indicator currently present in the KID (CESR 2009a). Aboulian (2010) notes correctly that “the risk and reward indicator methodology has been widely criticised for failing to truly present all risks to investors”, a failure that explains why the required contents of the KID were not defined as of December 2010. Even now, in theory, the distributor must provide all relevant information about the products being sold. After all, distributors are subject to MiFID. As retail investors are considered relatively uninformed, distributors must provide them with all relevant information. Distributors should be required to inform retail clients of the non-financial risks involved in specific fund structures. For instance, a retail investor should be aware that funds that invest in exotic locations involve sub-custody and

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An EDHEC-Risk Institute Publication