Financial Services have lost a lot of credibility since 2007 some of which can be attributed to their failure to manage conflicts of interest. That failure reflects unfairly on the many in financial services who strive to work decently and fairly and is something senior management in these businesses must take responsibility for.
Conflicts of interest are a fact of life and if recognised and managed properly can avoid many of the problems that have been the cause for criticism. Recent regulatory action against some of the big names in financial services both in the UK and US highlight that just because entities are regulated does not mean that they necessarily behave appropriately. Nor does ‘big’ give any indication of respectable behaviour – indeed the reverse might be a justifiable conclusion.
Yesterday the Financial Times reported on a study on mutual fund families conducted by researchers Goncalves-Pinto and Schmidt at the National University of Singapore and Emory University respectively, which reviews how cross trades occur in funds managed by the same investment manager. Often the ability for such transactions to occur will be of benefit to investors in both the buying and selling funds, but this may not always be the case where the manager is forced to look for liquidity to meet redemption requests when the assets in the portfolio are illiquid (and difficult to value). We have in earlier published Reflections looked at how this can happen in a fund of hedge funds where inflows into one vehicle can be used to meet the liquidity requirements arising from outflows in another vehicle. In such a scenario the cross trade may not necessarily be in the best interests of the subscribing investor but it helps the investment manager preserve its reputation with the redeeming shareholder at the expense of the incoming investor in an unrelated fund.
The evidence on the failures to manage these conflicts of interest continue to mount.
In November this year the UK Financial Services Authority (FSA) published a paper called “Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks.” This looked at a few specific areas that are worthy of examination by any investor looking to invest money with an investment manager:
- How firms identified and controlled conflicts of interest;
- How firms managed the purchase of research and trade execution services on behalf of customers;
- How firms managed gifts and entertainment;
- How firms ensured customers have equal access to all suitable investment opportunities;
- How firms managed personal dealing by employees; and
- How firms allocated the cost of errors between themselves and their customers.
The work done by the FSA was in the form of a thematic review of a selection of asset management firms visited between June 2011 and February 2012. The FSA concluded that “most of the firms visited could not demonstrate that customers avoid inappropriate costs and have fair access to all suitable investment opportunities.” That is a worrying statement given that these firms are obliged to observe rules such as on treating customers fairly. Yet it is not altogether surprising, given the attitudes of some boards in financial services to regulatory fines being nothing more than a cost of remaining in business.
Some of these firms had not even reviewed their conflict of interest arrangements since 2007 which also begs the question as to what their compliance departments had been doing following the credit crisis and the headline regulatory actions that had occurred since? The suspicion that asset managers are reverting back to bad old habits is hard to overcome in the face of such evidence.
The FSA has asked the boards of asset management firms in the UK to discuss the findings of the FSA paper and to then complete and return to the FSA an attestation by 28 February 2013 which confirms that the firm’s arrangements are sufficient to ensure that the firm manages conflicts of interest effectively and in compliance with the FSA rules.
Of course all firms are likely to comply with the FSA requirement. But a regulator’s demands will not change attitudes on their own. A firm’s culture – as the FSA points out – is central to the firm identifying and genuinely managing conflicts of interest. But it also requires investors to actively demand evidence on these matters and to not accept asset managers assurances at face value. That needs institutional investors with some determination to ensure that matters are set right and managed properly.
The standards of control over payments from customers assets are rarely the same as the standards of control asset managers exercise over payments made from the asset manager’s own resources. Investors need to ensure that they understand what is being paid for with their assets.
Personal dealing policies and gifts and entertainment are generally better managed as conflicts of interest.
Investors should question how asset managers allocate trades between different clients and how cross trading is controlled between funds they manage. The FSA has reported that it took enforcement action against a firm that had traded for one fund in order to ease the liquidity problems faced by another fund. My own experience and the university research referred to above indicates that this issue is a lot more widespread than the regulatory action against one firm would suggest.
The FSA also noted the practice particularly amongst hedge fund managers of using contractual limitations for liability to customers from errors in the absence of gross negligence and for not reporting these and collecting information on them. Of course under English law gross negligence is considered a “vituperative epithet”. The FSA note that repeatedly making the same error or similar errors might itself amount to gross negligence. The standard applied in English law to such a test may not be quite what the asset manager thinks they might be able to get away with.
So there is a lot that investors should be thinking about when it comes to their investment manager managing conflicts of interest. Notwithstanding the regulated nature of investment management it is worth investors continuing to monitor how investment managers identify, report and manage these conflicts.
©Jaitly LLP