I spent an interesting morning in Cambridge yesterday along with some other practitioners talking to a postgraduate class at the Judge Business School about risk. At the end of my session I was asked whether all the incoming regulations would improve the risk environment on funds. The answer must be ‘no’ but I have been debating it ever since and indeed our discussions continued afterwards over a sandwich. Why must the answer be ‘no’? After all, the regulations are trying to address how risk might be mitigated and disclosed. Culture however is fundamental to the mitigation of risk. To the extent that there are ways around rules and regulations – people will find them if that is what the culture encourages.
Lets just look at presentations done by financial services practitioners. The rules require authorised firms to have a series of disclosures and warnings on presentations that may be construed as financial promotion. Compliance departments require these disclosures and warnings to appear on presentations. I find it fascinating (sad though it may be) to see how these disclosures and warnings are dealt with by different people.
Should the warnings be at the start of the presentation or at the end? How much time should be given on that warning slide – should you talk to the warnings highlighted or is it enough to just flick through that slide? Does anyone really pay any attention to those disclosures or are they simply ignored and accepted as part of the landscape? Would they really stop an investor from making a decision to invest in a product or strategy?
For example the warning we are all familiar with is that past performance on an investment is not a guide to future performance. We all accept that and generally even understand it. But does that statement really bear further scrutiny? Of course we buy on past performance. It is the whole point of reporting and analysing performance numbers. I don’t know of anyone that has invested in a manager who has consistently reported losses, yet past performance is not a guide to future performance. Such funds would be quietly closed down and buried as no one would invest in them. Why do funds mushroom in size? Because marketing departments trumpet the successes of the fund encouraging others to participate in that success.
So despite the warning which we all accept as being correct, investors generally do invest on past performance as being a pretty good indicator of future performance – because although nobody really knows how a manager will perform in the future – it would take a brave investor to invest with a manager that was reporting consistent losses. Indeed institutional investors will generally not invest with a manager with less than 3 years track record. Perhaps I should rephrase that last sentence more accurately – institutional investors will generally not invest with a manager with less than three years track record of predominantly successful performance – otherwise that manager would not see the light of day – it would be a clever salesman who could achieve sales on a fund with a poor three year track record. Yet past performance we are told – and accept – is not a guide to future performance?
Does that mean the disclosure is wrong? We all accept that it is a reasonable statement, yet investment behaviour does not support it. Does that mean that investors are simply taking a punt on the risk despite the regulatory requirement that highlights that the premise of the decision may not be a safe one? Is it because the measure may be one of the few that are readily understood in what is otherwise extremely uncertain decision making?
Regulation is more often than not a reaction to problems that have occurred. Regulators need evidence of a problem or market failure to justify the introduction of regulations. That often means that risk management is backward looking rather than trying to look ahead at what might still go wrong. The emphasis is to fix what has gone wrong in the past – as there is evidence to justify the stance. That is regulation responding to risk. It is understandable but it does mean that regulation therefore is often two steps behind and risk management a step behind the next real problem that is about to occur. In the meantime all that market participants can take a punt on is that regulation is addressing the risks that have occurred even if none of us can forecast where the next problem lies. Proper risk management requires the right culture to operate in. No amount of regulation can ever change the culture of an organisation unless it is regulated out of existence.
©Jaitly LLP