Publications
The Financial Supervision Authority reacted to problems cropping up in the risk management of investment funds
28.09.2009
In the wake of the current economic crisis several cases have caught the attention of the media over the last year where the issues of concern arise regarding the offering of investment funds or in taking investment risks on behalf of the fund. It is, to a large extent, a “good times” phenomenon where the focus was on the sale of funds and not too much attention was paid to risk management.
Driven by those recent cases, the Estonian Financial Supervision Authority adopted, on 12 August 2009, two sets of advisory guidelines on the risk management of investment funds. In one of them, titled „Requirements for managing risks related to investing the assets of a fund“, the Financial Supervision Authority elaborates on its expectations regarding the internal risk management procedures to be applied in managing investment funds. In the other one, titled „Revealing of risks in an investment fund prospectus“, the information on the fund’s risk profile to be disclosed to clients upon the offering of an investment fund has been described.
Compliance with the fiduciary obligations is assessed retroactively
A management company must establish clear rules of procedure for concluding transactions on behalf of a fund, which must comply with the type and investment policy of the fund. The required level of detail of such procedures depends on circumstances relating to the fund. In the case of actively managed funds (most of publicly offered funds in Estonia are of this type), the liability of the management company in choosing the investment instruments is more extensive, compared to passive index funds that replicate a benchmark portfolio known to clients. A deeper analysis is expected in the case of more complex OTC-traded instruments (e.g. different structured and unsecured bonds or securitised instruments). If investments are made in listed shares having a representative price, the instrument is more transparent and there is no need for such extensive risk analysis.
The whole risk management process must be sufficiently documented so that, if any dispute should arise later, it would be possible to prove the considerations based on which the investment decision was made. Where necessary specific external expertise should be sought, e.g. for performing legal risk analyses, and the risks discovered in the course of performing such analyses must be properly managed. All this makes it possible to assess the management company’s compliance with its fiduciary duty retroactively.
Obligations must be in compliance with the risk profile
In the case of highly leveraged hedge funds characterised by a high risk profile, but also in the case of other investment funds, it is important to hold a sufficient liquidity buffer. The fact that a fund employs a risky investment policy does not preclude the liability of a management company in the event of insolvency caused by an inadequate liquidity policy.
Liquidity buffers must be managed in accordance with the fund's risk profile to ensure that the management company is able to perform its obligations to both investors and creditors at all times. Therefore, if a fund invests in instruments with a low liquidity (e.g. in unlisted shares or bonds or real property), this should be reflected in the fund’s redemption policy. Signing loan agreements not compatible with the fund’s liquidity policy should be deemed as transactions damaging the interests of the fund. In such an event it should be determined whether the management company has complied with its due diligence requirement in signing the agreement.
The management company must, considering the fund’s risk profile, ensure that only such obligations are assumed on behalf of the fund that can be performed. A change in the economic situation cannot, as a rule, be viewed as an event of force majeure that would excuse the failure to perform obligations.
Greater awareness means greater liability
Thus far prospectuses have often included only a standard warning against risks involved in investing, which does not take a specific fund’s risk profile into account to a sufficient extent. Consequently, the investor’s knowledge of the real and likely risks entailed in investing has not been guaranteed.
According to the advisory guidelines prepared by the Financial Supervision Authority, a prospectus as a sales document should stress the material risks arising from the peculiar features of a specific fund. In deciding whether a risk is material, the possible effect of the risk on investments and the likelihood of its occurring should be considered. Moreover, a management company is required to submit a description of a typical investor for whom the risks involved in investing in a particular fund should be suitable. For that purpose, having the experience necessary for evaluating the risks entailed in investing and sufficient economic capability to make the investment as well as the short- or long-term objectives pursued by the investor should be taken into account among other things.
Only a precise and appropriate description of the risks involved will result in sharing the liability with investors. If a risk occurs of which the client should have been aware when making the investment, it is inappropriate to blame the asset manager alone. However, part of the liability shifts from the management company to the investor only if the respective investments have been made in compliance with the fund’s risk profile and the professional fiduciary duty.
Stricter supervision next year
The above advisory guidelines prepared by the Financial Supervision Authority will take effect from 15 November 2009. Therefore, market participants were given enough time to review their current procedures and prospectuses and to make the necessary amendments to bring them into compliance with the recommendations of the Financial Supervision Authority.
Although the guidelines prepared by the Financial Supervision Authority are, strictly speaking, only advisory in nature, they should be treated as something more than mere recommendations given that they interpret mandatory requirements established by law and reflect the current market practice.
As sufficient time was given to apply the guidelines and market participants were able to submit their comments when the guidelines were being prepared, it is likely that the implementation period of the guidelines will be followed by a period of stricter supervision by the Financial Supervision Authority and, if any violation is discovered, it is also likely that sanctions will be applied. Thus market participants should apply the requirements imposed by the guidelines, taking account of the peculiarities of their business, or should be ready to provide reasonable justifications for not applying certain requirements.
