The perception that regulated, retail funds are free from significant risks is an illusion. 2019 was the year of revelations and 2020 has underscored those worries, so the author of this article argues.

The following article is written by James Newman, co-head, perfORM Due Diligence Services. He addresses an important subject: whether the "veneer" of retail fund regulation draws investors and their advisors into a false sense of security. A run of recent fund suspensions - not all linked to the coronavirus-driven market volatility - raises questions about holding illiquid assets inside funds offering daily liquidity, for example. Way beyond our current pandemic, the issues in this article will be with the financial markets for many years. 

The editors of this news service are pleased to share these views; they invite responses and of course the usual editorial disclaimers remain. Email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

The retail fund market has been tested like never before. The roll call of funds breaching regulatory rules, suspending operations and getting into difficulty is growing at an alarming rate. The COVID-19 pandemic will only generate more negative news headlines. In perhaps a re-run of the unregulated hedge fund failures in the 2000s that became the catalyst for the wide adoption of operational due diligence practices, we expect investors and their advisors in the retail fund market to follow the same route.  

Does regulation provide protection for retail investors?
As investors and their advisors scramble for information on fund performance and liquidity against a backdrop of unprecedented market volatility and losses, there is perhaps a misconception that regulated, liquid retail funds will always be well-governed, well-managed, and trusted investment vehicles because they have a regulated status.

Indeed, it has always been thought that their unregulated cousins registered in far flung jurisdictions are risky, illiquid and need operational due diligence (ODD).

Here lies the problem. There are certainly significant differences between regulated and non-regulated funds but the veneer of regulation is behind an historical over-confidence and complacency by investors in retail funds.  At stake is the management of trillions of dollars of pension funds, ISAs and other such vehicles managing the savings of thousands, if not millions of people. Regulation provides rules on disclosures, governance and fund structure to improve outcomes and support market stability. However, regulation alone is not dependable and investors/advisors need to perform their own due diligence on all funds in order to reduce the risk of being involved in retail fund failures that are becoming increasingly common.

The dawn of operational due diligence on retail funds
ODD is the assessment of non-investment risks: organisational, risk management, liquidity management, governance, business continuity, and much more.  It was created in the 2000s to mitigate the risk of investing in unregulated funds, some of which turned out to be Ponzi schemes, frauds, and a lot more that suffered from poor operational risk practices.  Unsurprisingly retail, regulated funds were less susceptible to these risks and in many quarters remain void of meaningful investor-led ODD.  

Fast forward to 2019, we saw a slew of scandals/bad headlines. For example “Woodford scandal casts long shadow over investment sector (Financial Times, 25 November 2019)”, “Morningstar flags ‘repeated failures’ of risk management at H2O (FT, 11 March 2020)”, “Lindsell Train funds breach UCITS concentration rules (Investment Week, 6 April 2020)” and referring to the liquidity crisis at Woodford led former Governor of the Bank of England, Mark Carney, to claim that these funds were “built on a lie”. This is just the beginning. The inevitable shake out that will come from the current financial maelstrom will lead to many more financial victims.  

And so, as was the case in the 2000s, there will be a response. There has to be. Those in charge of allocating capital will drive improved ODD and manager selection, making the days of ODD sporadic in the retail space a thing of the past.

The dawn of ODD on retail funds is upon us.
Capturing the risks – Fund ODD 101

When establishing an ODD programme for the first time there is the temptation to use a sledgehammer to crack a nut. The managers and their businesses overseeing investment management are often well-established, well-funded, well-known organisations, apart from a notable number that require a closer look. Big is not necessarily beautiful. For the most part, these behemoths carry their own unique set of non-investment risks which need to be part of any repeatable ODD programme. 

ODD should assess these risks through the dual lens of “manager risk” and “fund risk”, ie the risk that the manager’s operations and governance are inadequate and the risk that the fund is not doing what it should be doing. Front and centre in your ODD should be the fund - this is after all what your clients’ or members’ money is directly exposed to. How the fund operates, trades and what it invests in is the fundamental starting point.  

Due diligence should not limit itself to an assessment of past performance, manager investment acumen/pedigree, investment philosophy, and portfolio risk management… the raison d’etre of so many investment due diligence teams. It should extend to trading integrity, trade allocation policies, type and concentration of securities held, frequency of trade errors, robustness of valuation policies, responsibilities for NAV calculation, cash wire policy and integrity, fund expense policy… just to name a few. It also most definitely extends to fund liquidity risk.

It’s not cash… so what is it?
In Europe, the ‘UCITS’ structure allows managers to invest in less liquid securities. Indeed, there are no direct restrictions. And at the same time the manager often structures the fund to allow daily redemptions (like cash withdrawals from a bank) and certainly not limited to every two weeks as perhaps the regulator intended. On the face of it everyone wins from daily liquidity - the fund is set to achieve better performance than an index through careful portfolio management and yet investors can treat the fund like a cash ATM. However, such daily dealing increases the likelihood of liquidity mismatch risks because the underlying asset is not cash, but something less liquid. Fixed income strategies can be associated with crowding issues and exposure to riskier corners of the credit market, and equity funds can invest in small-caps or thinly traded securities and complex modern derivatives.  Should circumstances result where redemption demands increase, for example during financial crises like today, then these liquidity mismatches force fund suspensions and forced selling just at a time when valuations are under pressure. Losses ensue.

An appropriate ODD programme will flush out any funds that have these inherent liquidity risks and/or insufficient liquidity risk management by comparing with best practices and regulatory rules. In the current stressed environment, liquidity risks should be a central part of your ODD.

Manager ODD 101
Upon completing fund level ODD and satisfied with identified risks and associated controls or mitigating factors, the successful execution of the fund’s objective (in other words to make investors money) is predicated on the manager’s operational ability to execute fairly and successfully in all market environments. Large, well funded managers are more susceptible to internal conflicts of interest, for example multiple fund exposures lacking insufficient internal credit controls/limits on the same issuers. The organisational structure, clear segregation of duties, business continuity plans that are credible and tested, cybersecurity testing, and much more all contribute to a manager’s ability to execute multiple fund investment strategies. Or put another way, all have the ability to increase operational risks for every investor.  

For UK OEICs the role of the Authorised Corporate Director (“ACD”) is firmly under the FCA’s microscope who in 2019 launched a review of ACDs following the failings at Woodford. Their role is to ensure that the fund is run competently. Incredibly, they can be set in-house by the same investment houses that are managing the investment of the fund, so major conflicts of interest abound. Or, as in the case of the Woodford Equity Income Fund, delegated to an external provider. The idea of independent oversight is a good one but due diligence on the ACD, once thought unnecessary, is fundamental to ensure that these good intentions flow through to meaningful oversight and accountability. This line of thinking extends to other parts of the fund ecosystem that should all play a part in safeguarding investors’ cash. Issues surrounding depositaries multiple services to the same fund creating conflicts of interest and auditors broad-brush annual reviews are a lost opportunity in assessing a manager’s risk management and operational practices.  

The regulators are coming…
The FCA and the Bank of England recently announced a review into open-ended funds after significant concerns about inadequate liquidity. The FCA is reportedly under pressure for not knowing which funds are having problems. The SEC has already introduced Rule 22e-4 which improves liquidity risk management and caps illiquid securities at a maximum of 15 per cent in mutual funds, and in September 2020 ESMA is introducing new liquidity stress testing policies. However, if the hedge fund chronicles have taught us anything, it is the investors or asset owners who drive and even demand better operational and investment risk management before investing - just as ODD practices began to tackle hedge fund fraud risk in the 2000s, in the 2020s they will benefit the regulated fund world.    

Conclusion
The perception that regulated, retail funds are free from significant risks is an illusion. 2019 was the year of revelations and 2020 reaffirms our fears. Successful performance outcomes cannot be achieved consistently and predictably by faith, pedigree and trust alone. ODD will protect investors by checking iwhether investment managers are managing their funds in accordance with fund terms, best practices and regulatory rules.  

About the author
James Newman is Co-Head, perfORM Due Diligence Services.

Prior to co-founding perfORM alongside Quentin Thom, James developed and led the Global ODD group at Barclays Wealth. During his eight years in the role, he was responsible for passing or failing operational risk assessments across the bank’s retail and non-retail investment product offerings. As a chartered accountant, he has over 20 years’ financial services experience, including managing the UK compliance and operational functions for an investment manager.

perfORM is an innovative, highly flexible and technology driven third-party ODD service. We provide unique, cost-effective support that fuses both practitioner ODD with a smart digital tool across retail (long-only) and alternatives (hedge, private markets).