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Implementing a Risk-Based Approach to Investment Fund Governance

Creating a Risk-Based Oversight Framework to Protect Investment Fund Investors

While much of the scrutiny in the aftermath of the global financial crisis focused on 'corporate' board structures' practices and processes, there has been less discussion on the fundamental differences and requirements from an 'investment fund' governance perspective.

Protecting investors is a key component of fund management, but it cannot be accomplished without first understanding the nature of risks associated with an investment fund. Those responsible for the governance of investment funds (e.g., fund promoters, investment fund boards, management company boards and service provider organizations), all have crucial roles to play in determining and accounting for risk. Successful oversight of investment fund risk must start with a thoughtful and cohesive framework.

Key Insights

  • Asset managers must align their objectives and share a common ‘language of governance’
  • The ultimate goal of any governance framework should be investor protection
  • The only way to create this framework is to understand the risks to the fund
  • Adopting a risk-based oversight framework enhances the fund’s ability to respond to change
  • The board of directors and management of an investment fund are responsible for effecting the fund’s enterprise risk management process

A group of industry experts who took part in the Investment Fund Governance discussion sponsored by RBC Investor & Treasury Services, in partnership with the Certified Investment Fund Director Institute (CIFDI), and the Chartered Alternative Investment Analyst (CAIA) Association, examined how to create and implement a risk-based oversight structure that:

  • has investor protection at its core
  • understands and is guided by the unique characteristics of investment funds versus companies
  • reconciles the objectives of investment fund governance with investment fund board oversight
  • allows for risk management that is appropriate to the fund industry

Peter Spinelli, Managing Director and Head of Asset Management Investment Banking at RBC Capital Markets, noted that it is a fascinating time in the asset management industry. Markets, he observed, are at or near all-time highs, but morale and earnings trajectory at most investment managers does not match that market sentiment. The disparity between the two creates an immense amount of pressure on fund managers, and an even greater need for a clearly defined risk management structure.

Dr. Margaret Cullen, CEO of the CIFDI, and Dr. Masao Matsuda, Independent Fund Director with Lainston International Management, explained the importance of establishing an effective governance framework to protect the interests of fund investors and to enable boards of directors to make risk-intelligent decisions and discharge their fiduciary duties.

Drawing on the unique characteristics of investment funds, Cullen explained that asset managers must align their objectives and share a common "language of governance" in order to establish a successful oversight framework. This is not always easy, as global asset managers may have funds distributed across a number of jurisdictions with different regulatory approaches. What is universal, however, are: the unique characteristics of investment funds; the notion of making investor protection a key focus; preventing fraud; and minimizing and managing conflicts of interest. Cullen stressed the importance for boards to define their investor protection objectives. Investment fund boards need to ask the question: What does investor protection mean to us?

The ultimate goal of any governance framework should be investor protection, which does not equate to protecting investors from market-related losses. The objective, according to Cullen, is to provide transparency, enabling investors to understand the risks attached to investment fund products, and then to prevent misleading practices and potential losses due to the negligence of fund promoter organizations and other service providers. It is important to define and understand what this means from a practical perspective.

Steps for Successful Risk Oversight

In order to implement a risk-oversight based approach, Cullen and Matsuda recommend creating and then adhering to a carefully crafted framework for effective governance practice.

Cullen, whose organization, the Certified Investment Fund Director Institute, has as its core objective raising professional standards in investment fund governance, says many asset managers are stuck in a “one size fits all regulatory compliance approach" to investment fund governance. This approach she says cannot lead to a successful risk-based oversight framework and can obfuscate investor protection objectives. While funds may have mitigation strategies across a similar range of risks, generic frameworks should be avoided, according to Cullen.

Dr. Margaret Cullen

Dr. Margaret Cullen

It is important to understand the operation of the fund, or what she calls its "DNA," by asking and clearly answering basic questions:

  • Who will be involved?
  • What is the fund trying to achieve?
  • What components of investor protection are unique to this fund?

Essentially, as Cullen explained, it requires “coming to grips" with the way the fund will operate. The only way to create this framework is to understand the risks attached to the fund.

Once the framework is complete, the next step is to "risk profile" the fund. This involves identifying all of the risks specific to the fund (e.g., micro and macro, strategic, market, credit, legal, fiduciary, reputational, operational, organizational, industry, tax, political and competitive). Here is where risk is defined, and then assigned to the appropriate owner, says Cullen. Identification ensures that appropriate ownership and accountability of risk is established and understood by everyone involved.

Once risk is identified, a governance framework can be determined. It should include the operating policies unique to the fund, escalating and reporting procedures, accurate contractual agreements, service level agreements, and compliance with regulation and legal documentation.

Implementation of the framework requires ongoing oversight of the fund and active reporting of that oversight, making sure change control procedures are in place. Management procedures need to be ready if escalation is necessary.

One of the most important aspects of fund governance is to avoid becoming complacent. Operating and escalation procedures should not be static. They need to adapt to change. Adopting a risk-based oversight framework enhances the fund's ability to respond to change. As Cullen explains, protecting the investor also protects the asset manager's reputation. It is about creating a process with investor protection at its core. A risk-based oversight framework for investment funds can be implemented by investment fund boards and/or those charged with fund product governance within asset managers and should be flexible in its application and take into account specific local regulatory fund requirements.

Enterprise Risk Management for Fund Governance

As Dr. Masao Matsuda, an Independent Fund Director at Lainston International Management explained, unlike oversight of regular corporations, fund oversight is not exclusive to one organization. Instead, its stewardship and supervision involve many different service providers: from investment advisors, fund administrators and accounting/audit firms to data providers, prime brokers, distributors, and others.

Without a properly implemented framework across these service providers, the result is 'silo by silo' risk management, says Matsuda, where each party conducts their own risk management of the fund. This siloed approach to risk management endeavors can cause potential gaps in risk coverage to emerge.

Dr. Masao Matsuda

Dr. Masao Matsuda

To boost comprehensive oversight, Matsuda advises that it is key for fund leadership to incorporate an enterprise risk management (ERM) structure for their funds. The board of directors and management of an investment fund are responsible for effecting the fund's ERM process. This process should identify potential events that may affect the fund. Risk should then be managed in accordance with the fund's appetite, and finally, provide reasonable assurance regarding the achievement of fund objectives.

What is critical here is the “tone at the top," says Matsuda. In the case of a corporation, the corporate board sets the culture of risk awareness. Similarly, the fund board has to emphasize its intention to pursue risk-based oversight.

By selecting directors who create an environment where risk management is imperative, investors are put exactly where they should be—at the centre of the fund's priorities. Understanding risk, creating bespoke oversight goals, and ensuring all governance participants understand and have ownership over their roles all combine to support the development of an effective and well organized risk-management framework.