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Asset manager failure - are you prepared ?

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Patrick Kelliher

Invesco’s recent £18m FCA fine [1] has highlighted the conduct risks facing asset managers, but conduct risks are just a subset of a wide range of operational risks run by asset managers. Could these make an asset manager insolvent ? and if so, what would be the impact on their clients such as insurers and pension funds ?

The £18m is one of the largest ever levied by the FCA, but it is not that significant in the context of the Invesco group, which had equity of just under $9bn (/ £5.45bn) at 31/12/2013 [2] i.e. the fine only amounted to 0.4% of group equity. It is unlikely the FCA would levy a fine that would push an asset manager into insolvency, but what is interesting about the fine is the failings that lead to. Invesco failed to communicate changes in risk profile of funds it managed to investors. This failure exposed it to compensation claims, but in this instance Invesco got off lightly with investor compensation of only £5m.

Other asset managers have not got off so lightly in the past. Merrill Lynch Investment Managers (MLIM) reputedly had to pay $110m / £77m to settle a dispute it had with Unilever pension scheme over whether MLIM had properly explained the level of performance risk it was undertaking in managing a $1.4bn mandate for the scheme [3]. The case was settled out of court but nonetheless is an example of what can go wrong in managing assets and communicating risks to clients. Such compensation amounts could spell the end of a smaller asset manager.

Another interesting aspect of this case was the fact it involved an institutional investor. Asset managers have traditionally taken comfort that the institutional and sophisticated individual clients they manage assets for should have a better understanding of the risk and so will find it harder to claim that a product was missold. The MLIM v Unilever case highlights that institutional clients are also more aware of where the asset manager has fallen short, and that they have the deep pockets to pursue the matter in court.

Looking forward, I think the risk of major litigation against an asset manager is increasing as asset management becomes increasingly sophisticated. For example, Liability Driven Investment (LDI) solutions are an increasingly popular offering to pension schemes, but the degree to which a LDI solution hedges risks depends not just on market risks but also risks such as longevity. Rising life expectancy can undermine the degree of hedging. How well this is explained could be a source of contention. LDI solutions also rely heavily on derivatives exposing schemes to counterparty and operational risks associated with derivatives. How well these residual risks are communicated is another source of contention.

Another offering which relies heavily on derivatives is absolute return funds which invest in a range of asset classes with the aim of beating cash benchmarks like LIBOR. The range of strategies can be startling with funds exploiting say differences between the € and Mexican Peso to “alpha” strategies investing in equities while shorting the overall stockmarket. Absolute return funds typically exploit diversification between markets but in stress conditions previously uncorrelated markets can move in tandem and these strategies can unravel. While absolute return fund managers often have sophisticated risk management, if they fail to manage such scenarios, investors could experience significant losses. Combine with the potential for such “cash plus” funds to be misrepresented and confused with deposits and there is a potential for compensation claims.

Asset managers will rarely give direct advice and will generally sell through IFAs and other advisers. However this does not protect asset managers from misselling claims if it can be proven that they were remiss in explaining risks to customers and their advisers.

While not involving an asset manager,  a precedent for product providers to be exposed to IFA misselling claims is Seymor v Ockwell in 2005 where the IFA countersued Zurich over advice on a fund which collapsed. Zurich ended up bearing 2/3rds of the resulting £500,000 compensation claim [4]. More generally, the FSA’s PS07/11 on provider / distributor responsibilities [5] places an onus on product providers like asset managers to ensure their products are suitable for target markets and to ensure that marketing literature and other sales support is sufficient for customers and their advisers to understand risks involved.

So even selling indirectly via IFAs etc., asset managers could be exposed to considerable compensation claims if large investor losses arise and risks are not properly explained. Moreover this is just a subset of the operational risk exposures of asset managers. Asset managers will invariably indemnify clients for operational failings in the management of assets – from “fat fingers” dealing errors to breaches of mandate limits, and from flawed valuations of assets to failure to properly segregate client assets. Increased derivative usage is also increasing operational risk exposure in terms of valuation, adhering to risk limits and managing margin calls.

I believe it is a matter of when, not if, an asset manager suffers a serious operational loss. The question is whether the asset manager would be able to withstand this. Asset managers can be thinly capitalised. For many, their regulatory capital requirement is only 25% of fixed overheads [6]. To put this in context, the average cost base for fund managers is 0.19% p.a. of assets under management (AUM) [7], so 25% of fixed overheads would amount to less than 0.05% of AUM.  By contrast the MLIM loss was nearly 8% of the Unilever scheme assets it managed.

Note the average cost figure masks a wide range: managers focussing on relatively simple index tracking funds will typically have costs < 0.1% p.a., while for managers offering more sophisticated offerings, their fee, cost and capital base will be much higher. Also, many managers will hold considerably more capital than the regulatory minimum. For instance, the largest independent asset manager in the UK, Aberdeen Asset Management had £1,530m of shareholder equity at 31/3/2013, equivalent to nearly 230% of operating costs (though only 0.5% of AUM) [8]. Lastly, for larger managers, a £77m loss on one mandate or fund would be bearable when spread over the AUM they manage and the fee income arising.

The problem may arise with smaller fund managers where a significant loss on one fund or mandate could exceed the manager’s equity base and fee income. Even large managers may be brought down by systematic failings affecting a wide range of funds and mandates, from weaknesses in derivative systems and controls to a poor compliance framework leading to widespread conduct risk failings.

So what would be the impact on clients if a large operational loss bankrupted an asset manager ? Generally client funds should be ring-fenced from those of the manager and its creditors. However these creditors may be clients looking for indemnification of dealing and other errors or for compensation for failures to explain risks. Failure to properly ring-fence client assets could in itself be the trigger for an insolvency event. In general client losses will be what drives insolvency, and an insolvent manager will not be in a position to compensate clients fully for these losses.

There is a particular issue for funds issued through life insurance subsidiaries of asset managers. While cheaper to run than mutual funds, they will not be ring-fenced to the same extent. A life insurer offering links to these funds will be particularly exposed as this will be treated as a reinsurance arrangement and unless a legal charge is put in place, the life insurer will rank behind other investors. Also the insurer’s ability to pass on losses to its unit linked policyholders is constrained by COBS 21.3 [9].

Even if asset manager losses did not affect a client’s assets, there will be practical issues from an asset manager insolvency. The manager may no longer be able to supply up to date information for example, while there may be issues in transferring assets over to another manager. For certain asset classes like UK equities, there is a wide range of managers, so it should be possible to transfer assets to another manager without affecting performance or fees, but for more esoteric classes e.g. loans, it may not be possible to obtain a replacement manager without performance suffering and/or incurring higher fees.

To conclude, I believe there is a good chance that an asset manager will be made insolvent by a large operational loss in the coming years. Increasing sophistication of asset management product offerings increases the risk that these are not properly marketed, exposing asset managers to compensation claims.  Processing risks are also increasing with increased derivative usage. Regulatory minimum capital requirements are not that high as a proportion of AUM, and while most managers have capital well in excess of this, it may not be enough to cover catastrophic operational losses. Clients could find themselves with shortfalls in assets due to losses which the asset manager may not be in a position to indemnify, or have limited recourse in terms of how asset management services were presented. For some asset classes, it may not be possible to replace the manager without performance suffering and/or higher fees.

To mitigate their significant exposure to the operational failings of asset managers, insurers and pension funds should carry out due diligence on the
• financial strength,
• business model and complexity of offerings;
• mix of business and concentrations in respect of individual mandates and funds; and
• systems and controls

…of their managers, and continually monitor developments including any material litigation notified. Lastly they should consider developing contingency plans to manage any failure.

Notes

[1] FCA fine and compensation details: http://www.fca.org.uk/news/invesco-perpetual-fined-186-million-for-failings-in-fund-management with further details in Final Notice: http://www.fca.org.uk/your-fca/documents/final-notices/2014/invesco-asset-management-limited  

[2] Invesco Group accounts and other financial information can be found at http://ir.invesco.com/investor-relations/financial-information/annual-reports/default.aspx  

[3] For details of the MLIM v Unilever case, see for example: http://www.nytimes.com/2001/12/07/business/merrill-to-pay-110-million-to-unilever.html

[4] For more details of Seymour v Ockwell see: http://www.moneymarketing.co.uk/news/court-rules-zifa-must-share-missale-liability-with-adviser/105571.article

[5] FSA PS on provided / distributor responsibilities can be found at: http://www.fsa.gov.uk/pubs/policy/ps07_11.pdf

[6] See Articles 95-97 of the Capital Requirements Regulation (CRR, July 2013) at: http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:02013R0575-20130628  

[7] Average cost as a proportion of AUM taken from the IMA annual survey 2013, p89 – see http://www.investmentuk.org/research/ima-annual-industry-survey/  

[8] See Aberdeen Asset Management’s interim results at 31/3/2014: http://www.aberdeen-asset.com/doc.nsf/Lit/ReportGroupInterim20140331 – noting that the equity figure excludes minorities and hybrid debt instruments; while capital : cost ratio is based on half-year expenses doubled up.

[9] See http://fshandbook.info/FS/html/FCA/COBS/21/3

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