Enhancing fund governance for sustainable growth

While the fund industry witnessed a sharp fall following the financial tsunami in 2008, the impact of the global financial crisis (GFC) seems to have abated. In April this year, the custodian business recorded a historical high in asset under custody of about USD120 trillion, according to Global Custody. But beneath the promising signs of growth lurks mounting pressure on the industry with regulators tightening rules and both investors and regulators demanding greater transparency.

What fund industry practitioners are facing is a shift in economic paradigm – an increasingly accepted belief that the financial market should be more regulated. Ready examples include UCITS IV, AIFMD, which have already brought about significant impact on fund management service providers. Global regulatory regimes in future will put more effort to enhance investor protection: on the one hand through supervision of industry participants and on the other investor education and active participation.

Some might consider the term “Regulatory Tsunami” in describing the current environment an overstatement, but the fund management industry around the globe is facing unprecedented regulatory changes.

In fact, the GFC did highlight certain areas and risks that need to be addressed through drastic changes and enhanced disclosure, such as complexity of structured products, various risks relating to counterparties and availability of total exposure of components in the investment portfolio, etc.

To ensure the best interest of investors is served, investment management has to adhere to requirements of fund governance, which covers end-to-end operation of a fund to each process is managed in a sustainable manner and risks are mitigated.

Cost for Quality Investment Operations

For fund managers, while focusing on their core competence of investment management, resources should also be allocated to monitor their in-house middle and back office functions to ensure not only compliance – legal and regulatory – but also different stages / aspects of the trade process including timely issuance of settlement instructions, prompt handling of corporate actions, best execution, investment compliance and no churning of portfolio, among others elements of sound fund governance.

For those who have outsourced the middle- and back-office functions to a third party provider, monitoring the provider’s operational performance, risk management and control is of utmost importance.

While the cost of investing in people and systems to deliver quality middle and back office services can be considerable (ranging from 40% – 60% of total costs depending on regions according to different surveys), middle office operations are generally less differentiable than front office operations and tend to be conducive to economies of scale. From the standpoint of operational efficiency, outsourcing of investment operations is worth considering if the cost of running it in-house is relatively high.

What’s more, with the increasing focus on emerging markets, outsourcing can be a business-savvy option for asset managers who are entering into new markets; as with offshore funds, it can make a vital difference with the middle office’s ability to adapt to local needs and cross-border regulatory requirements.

The same is true of ETFs, which requires accurate, up-to-date information as fast as technologically possible – if not in real time. With the time-sensitive nature of ETFs, administrators should be able to leverage the web as a powerful platform for effective information provision, and handle exceptions (short-settlement requests and other one-time situations) without disrupting core business processes.

Outsourcing not the end of the Story

Before contracting a custodian or fund administrator to carry out the investment operation functions for enhanced governance, there are risk factors to consider such as the mission and values of the external party, the possibility of reduced agility and inadequacy in the control environment. One useful way of finding and monitoring the level and scope of services available in the market is the use of RFPs, which can be a good exercise for benchmarking purposes.

Once the middle and back office functions are outsourced, monitoring and oversight of providers should be in place as part of strong fund governance, taking into account the validation processes for ensuring compliance, generation of reports that meet the increasing regulatory and compliance requirements, system stability, flexibility and robustness, etc.

Site visits should be conducted to look at internal controls of providers and, in particular, sub-custodians for their capability in supporting product development and service enhancements (instruments such as hedge funds, OTC derivatives, private equity ETFs, property and REITs, inflation linked assets, longevity linked assets and commodities), because the third party provider is expected to contribute to developing solutions around client needs.

Sound fund governance entails the monitoring of the entire investment operation value chain through an effective compliance framework with qualitative and quantitative controls (pre-trade, execution, post-trade and back to portfolio administration and asset monitoring and reporting) to provide best possible protection to investors.

When the best interest of investors is served – with enhanced protection and transparency accompanied by effective investor communications all made possible by strong governance – favourable conditions can be created for the fund management industry to continue to thrive globally.