Avoiding fund governance’s mounting risks

03 Sept 2013

Effective fund governance is becoming increasingly important. Following the financial crisis, regulators and investors focused on the conflict of interest between an asset management company’s desire to maximise its own profits, and its duty to maximise fund returns. This scrutiny has since led to a spate of law suits, enforcement actions and new governance codes, significantly increasing the risk for those that do not have strong governance structures and processes.

In the United States, both litigation and SEC enforcement actions have shone a spotlight on governance for Investment Company Act of 1940 funds. And in Europe, some pension funds now require a strong independent board before they will invest in a hedge fund. Illustrating the trend towards tighter governance, the Association of the Luxembourg Fund Industry updated its governance code in July, following the Irish Funds Industry Association’s new code published in late 2012.[1]

Regulators, trade associations and investors alike are concentrating on ways to manage the asset manager’s inherent conflict of interest between profit and fund returns. At the heart of this drive to ensure fair treatment for the investor lies the independence and effectiveness of the fund board and committees. Once in place, these bodies need to look into a number of long-standing and emerging areas where governance dangers are particularly acute.

If funds don’t have strong governance in place across all of these areas, the damage to the asset manager can be substantial. Direct costs include investor compensation following litigation and regulator fines following enforcement action. Indirect costs include the impact of negative publicity on a brand and the loss of prospective and current investors.  And once lost, investor confidence is very difficult to regain.

Four hot topics

  • Fairness of third-party fees
    In the US, the SEC is scrutinising how fund boards review funds’ contracts with service providers, especially the investment adviser and fund distributor. Boards review these contracts annually and have a responsibility to make sure that the quality of services provided, among other things, is aligned with the fees paid by the fund and its shareholders.  Similarly, in Europe, there is a focus on fee arrangements, although more towards transparency and appropriateness of fees charged to the fund.
  • Overseeing risk management (including regulatory and compliance risk)
    In the area of risk management, the board has to strike a delicate balance – it must oversee the investment adviser’s risk management process, including for regulatory and compliance risks, but not get so involved that it’s actually managing risks. What’s more, fund directors need to be confident that management is not only addressing known risks facing the fund industry but also emerging risks, such as fraud, cyber security and, in particular, regulatory change.
  • Valuation processes
    As funds have ventured further into the realms of investing in hard-to-value, illiquid securities, the question of how boards oversee valuation has concentrated the minds of many directors. In broad terms, the board should have a good understanding of the valuation process and organise itself to oversee this process appropriately. It should also review the adequacy of disclosure of valuation processes.
  • Third-party distribution
    Oversight of third-party distributors is a hot topic, and one which our Luxembourg Fund Governance Survey 2012 revealed as an area for improvement. Boards need to make sure that distributors’ marketing materials are accurate and not misleading and comply with regulations, as well as that they’re following sound anti-money laundering procedures. Regulators in the US and Europe are closely scrutinising funds’ conduct in this area.

Putting investors’ interests first

What’s clear is that the importance of sound fund governance is rising. Effective boards or committees acting independently of management are the starting point, followed by oversight of a range of specific areas. Our work with boards, and studies of their activities, shows they’re rising to the challenge, although some areas need improvement.

As fund governance enters a new era, so boards of directors must stay abreast of evolving best practices. They need to monitor emerging investment, operational and regulatory/compliance risks, as well as specific issues such as third-party services and distributors’ activities.  Benchmarking studies of their peer group’s activities are one way to help evaluate leading practices.

Asset management’s inherent conflict of interest is here to stay. But if appropriate structures and processes are in place, the task of fund governance will become easier, and the dangers arising from these inherent conflicts can be effectively mitigated.

[1] ALFI Code of Conduct for Luxembourg Investment Funds, published July 2013; IFIA Corporate Governance Code for Collective Investment Schemes and Management Companies, published December 2012.