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?

severe negative effects on the portfolio. Redemptions triggered by a fall in asset prices mean that the fund manager (and other stakeholders, such as the more static investors and the sponsor) are short a put option, much as banks with very liquid liabilities but less liquid assets are; the assumption that investors will redeem if their capital is insufficiently protected makes the case for a dynamic strategy drawing on constant proportion portfolio insurance (CPPI). 43 The management of sub-custody risk Regulatory guidelines for the management of sub-custody risk may be necessary to protect end-investors. In the AIFM directive (EP 2010), barring contractual exemptions, the depositary is responsible for sub-custodianship. In investments in foreign developed countries, the depositary will choose the sub-custodian, and no contractual exemptions will be drafted. Depositaries will then monitor the credit risk of sub-custodians closely and could be expected to take assets away from these sub-custodians if the risk of bankruptcy increases. Moreover, should all depositaries retrieve their clients’ assets from a weak sub-custodian, the sub-custodian, deprived of its source of revenue, is unlikely to survive. Last, funds may seek to arrange potential buyers of illiquid assets.

43 - The measure proposed by De Souza and Smirnov (2004) attempts to incorporate the liquidity of each asset in the fund by measuring its liquidity-adjusted VaR. The liquidity cycle, or the possibility that investors need to redeem their funds because they are facing liquidity constraints in other

funds, is not taken into account in their model.

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An EDHEC-Risk Institute Publication