Financial Services Authority Financial Services Authority Authorit Financial Risky Outlook Financial Ser ices Asset Management

Sector vDigest Authority 2010 Financial Services

Delivering financial stability Delivering market confidence Delivering consumer protection Delivering a reduction of financial crime

 Financial Services Authority 2010 25 The North Colonnade Canary Wharf London E14 5HS Telephone: +44 (0)20 7066 1000 Fax: +44 (0)20 7066 1099 Website: www.fsa.gov.uk All rights reserved

Contents

Asset management sector leader introduction Overview of the operating environment for asset management firms
Buyers of asset management services Providers of asset management services Delivery of asset management services: (i) Funds Delivery of asset management services: (ii) Operations

3 4
4 6 6 7

Priority risks for the asset management sector

Controls over client money and assets Valuation of assets in funds Alternative Investment Fund Managers Directive (AIFMD) Platforms

8
8 8 10 12

Key messages

13

The Financial Services Authority invites comments on this Sector Digest. Comments may be sent to AssetManagementEnquiries@fsa.gov.uk

Financial Risk Outlook 2010 Asset Management Sector Digest

Asset management sector leader introduction

Dan Waters The Asset Management Sector Digest is published alongside the Financial Risk Outlook 2010 (FRO). The FRO sets out the main risks facing the UK financial services industry and this Digest highlights specific risks that impact the asset management sector.
Demand for asset management services rose in 2009, most noticeably in the UK retail segment. Investors made large changes to asset allocation, which tested the product portfolio strategy of many firms. In 2009, asset managers developed more complex investment strategies and some managers offered these to retail investors via the UCITS fund format. 2009 highlighted the crucial role systems play in the industry, with fund platforms accounting for over 50% of retail sales in the UK.1 More generally, rising volumes and additional complexity exposed weaknesses in key processes and controls, such as the handling of client monies, the valuation of client assets and the management of liquidity. On the regulatory front, in April 2009 the EU published the draft Alternative Investment Fund Managers Directive (AIFMD) which proposes fundamental changes to how the industry operates. In light of these developments, we would remind firms that they must design, characterise and communicate products in a manner appropriate for the end client. We also remind firms to ensure they possess the systems, controls and capital to manage the investment strategies offered to clients. Finally, we urge firms to fully consider the impact of the AIFMD and to highlight any concerns about its impact on their business with policy makers.

1 Platforms continue to grow and now hold about 110 billion in assets according to a recent report which also estimates that about half of all new investment business is being placed through platforms. Source: Platform Survey, Money Management, February 2010. The report surveyed 15 platforms.

Financial Risk Outlook 2010 Asset Management Sector Digest

Chart 1: Assets held by buyers of asset management services by geographical region (December 2009)
45 40 35 30
US$bn

25 20 15 10 5 0 North America Europe Japan Emerging Markets Asia ex. Japan Middle East

Wealthy individuals Source: FSA calculations

Occupational pension funds

Retail investors

Sovereign wealth funds

Insurance funds

Overview of the operating environment for asset management firms

Buyers of asset management services
Asset management is a global business... The market for asset management services currently operates on a global basis, with buyers able to choose service providers from across the world. North America remains the largest market for asset management services (see Chart 1), while the growing wealth of Asia and the Middle East is boosting demand from wealthy individuals and sovereign wealth funds. Long-term demand for asset management services is driven by trends in economic growth, savings rates and demographic profiles. Rising savings rates in the UK and North America, and continued economic growth in Asia, will increase demand for asset management in these markets. Although subject to ongoing debate, the draft AIFMD presently contains restrictions on the ability of asset managers based outside the European Economic Area (EEA) to market Alternative Investment Funds (AIFs) to EEA investors. This proposal may exclude some current product providers from the EEA, reducing investor choice and increasing their costs. In the long term, there is a risk that other countries may retaliate and exclude EEA-based providers of asset management services from growth markets. In the medium to long term, unjustified barriers to the international flow of investment capital are damaging to the development of sustainable economic growth and prosperity. The occupational pension schemes and retail funds segments in the US and the UK are key players in the market. In both the US and the UK, the number of defined benefit occupational pension schemes is declining, as there is a shift towards defined contribution schemes. One major consequence of this trend is to highlight the importance of systems platforms to support both defined contribution and retail investment schemes. During 2009 occupational pension funds in the US and the UK continued to diversify assets and strategies. Pension funds are replacing large holdings of domestic equities often managed by one or two firms with overseas assets and alternative investment strategies, a move which benefits smaller, specialist asset management companies. Tactical switches between different asset classes also have a considerable impact on demand for the services of individual firms.

but the AIFMD may reduce investor choice.

Retail demand is growing

Financial Risk Outlook 2010 Asset Management Sector Digest

Chart 2: Net sales of UK domiciled unit trusts / OEICs by type of asset invested
10,000 8,000 6,000 4,000
mn

2,000 0 -2,000 -4,000 -6,000 -8,000

Q1 2008
Equity

Q2 2008
Bond

Q3 2008

Q4 2008
Money market

Q1 2009
Balanced

Q2 2009

Q3 2009
Property

Q4 2009
Other

Source: IMA, FSA calculations

In 2009, investors partially recovered their appetite for financial risk. In the UK, on the back of low interest rates and changing perceptions of value, retail investors bought record amounts of investment funds, particularly those offering strategies in bonds and alternative investments (see Chart 2). Net retail sales reached 25.8 billion in 2009 with purchases of corporate bonds and absolute return funds amounting to 6 billion and 2.5 billion respectively.2 We are concerned, however, that the promotion of complex investment strategies to retail investors creates the potential for consumer detriment if the risks creating risks are not adequately understood or are poorly communicated to investors or their advisers. We also expect in product design asset managers to manage liquidity in these funds in a manner consistent with the expectations created when the funds were marketed to investors, especially if cash inflows reverse in response to changing and liquidity economic conditions. management. with producers offering complex products

Key messages
Innovation can develop new products to meet consumers changing needs. But innovation presents significant problems if the inherent risks are not adequately understood by the product provider, or are not properly communicated to investors and their advisers. Firms should ensure that products are designed and characterised appropriately, and take reasonable steps to ensure investors are not offered inappropriate products. Firms must ensure they treat customers fairly and that product communications are clear, fair and not misleading (especially where intermediaries make extensive use of these communications). Consumers should be aware that if an investment fund provides higher returns/yields than similar funds, they should examine the reasons why (or ask their adviser) as higher returns/yields may indicate greater levels of risk than they are willing to accept. We expect firms to manage redemptions in a manner consistent with the expectations created when they marketed the funds to investors. Investors in less liquid instruments need to understand any lock-in periods or limits on redemption rights, as well as the associated valuating and pricing issues that may arise in respect of such investments. In managing cash inflows and outflows, firms must treat all customers fairly.

2 IMA Investment fund statistics 2009 summary.

Financial Risk Outlook 2010 Asset Management Sector Digest

Providers of asset management services

There has been recovery in profits at asset managers The majority of asset management firms saw profits increase in 2009, although the profitability of individual businesses depended heavily on the performance of the asset classes in which they invested. The global recovery in markets benefitted most firms, while specialist equity managers and some hedge funds experienced a particularly sharp rebound. After strong performance from bond markets over the last two years, specialist managers of bond funds face a more difficult outlook. The private equity sector, which relies on bank loans to support investments in businesses and IPOs to realise value, had a more difficult year, as bank lending and the IPO market remained muted. Merger and Acquisition (M&A) activity within the sector increased during 2009. One noticeable trend in the UK was the withdrawal of banks from the asset management sector. For example, Barclays sold Barclays Global Investors (BGI) to Blackrock, and both Royal Bank of Scotland (RBS) and Credit Suisse sold part of their asset management businesses to Aberdeen Asset Management. The industry continued to expand the use of derivatives in investment strategies and the complexity of products offered to investors. The growing complexity of strategies and products based on the use of derivatives requires firms to have more sophisticated controls over investment risk and operations. Firms must consider whether complex strategies are appropriate for their clients. There is a risk that firms pay insufficient attention to these questions as they seek to exploit rising demand for innovative products. In the UK, asset managers have traditionally been able to develop investment strategies without regulatory intervention. However in 2009, politicians expressed concern over whether unfettered investment strategies are in the public interest, with growing concern about the amount of leverage in investment strategies. Meanwhile, the sale of products to retail investors based on high-risk investment strategies has led to questions over whether product design and characterisation requires further regulatory intervention.

and increased M&A activity.

The wider use of complex strategies

Key messages
Asset managers who widen their range of investment techniques and instruments need to have adequate expertise, operating processes, and risk controls.

Delivery of asset management services: (i) Funds

Funds and fund structures enable asset managers to deliver their investment strategies to clients. Until 2009, authorities seemed willing to allow institutional investors to negotiate the terms and conditions governing their funds while regulatory attention focused on the regimes governing funds sold to retail investors. The Madoff fraud, perpetrated against institutional investors among others, along with growing concern about the role that offshore funds play in the shadow banking system, has called this policy into question. The provisions in the AIFMD regarding equivalence requirements on depositaries and the subcustodians of assets outside the EU, and particularly in emerging markets, could have material impacts on the investment strategies offered by asset managers. It may encourage them to consider regulated fund formats, such as UCITS. and growth of their use in UCITS funds ...compound risks on product design and characterisation. The growing sophistication of investment strategies, combined with the move to adopt regulated fund formats, has led to considerable growth in UCITS funds. There are now more than 200 hedge funds complying with UCITS guidelines, with assets of more than $35 billion, according to Hedge Fund Research.3 The European Commissions work on Packaged Retail Investment products seeks to examine the effectiveness of regulation of retail investment products across the banking, insurance and fund sectors. It has a particular focus on the rules around selling processes and pre-contractual consumer disclosures. Although there are significant differences in the requirements across Europe, we see clear benefits to consumers of a more uniform approach, and encourage continued engagement by firms on these proposals.

3 UCITS III Hedge Fund Offerings proliferate as new industry model gains traction, Hedge Fund Research, February 2010.

Financial Risk Outlook 2010 Asset Management Sector Digest

Key messages
We are concerned that in some cases, asset managers are relying on the classification of a fund as a UCITS fund to justify its promotion to retail investors rather than ensuring the investment strategy is appropriate for the target customer, and remind firms of their obligations under UCITS III.

Delivery of asset management services: (ii) Operations

Operating systems are crucial. Complex operating systems provide the backbone of the asset management industry and it is encouraging to see the UK industrys systems appeared to operate well during the crisis. Ensuring systems and controls operate effectively remains a key priority for the FSA and we have identified a number of areas where systems may be less effective than we wish them to be.

There is increased Platforms represent a major interface between retail investors and the asset management industry, with around 110 billion invested through platforms. The Retail Distribution Review (RDR) proposals may reliance on have a significant effect on the sale and distribution of funds and investment products. Some platforms platforms. may find reaching or sustaining profitability challenging, particularly as they require substantial investment to meet rising standards of service. We are concerned that some systems and procedures to control the holding of client money and assets fall Controls over client money and short of our requirements. assets The systems and procedures used to value client assets perform a critical role in areas such as the calculation of performance, the setting of prices at which investors transact, and the calculation of asset and fund managers fees. We are concerned that some valuations may be unreliable. valuations are also a concern.

Financial Risk Outlook 2010 Asset Management Sector Digest

Priority risks for the asset management sector

We have identified four key risks that the asset management sector poses to the FSAs statutory objectives.

Controls over client money and assets

The protection of We consider the protection of client money and assets to be fundamental in sustaining consumer confidence, and have set out detailed rules in the Client Assets Sourcebook (CASS). This means ensuring client assets is that clients money and assets are safe, and remain safe even if a firm, such as an asset manager, becomes vital insolvent. We are concerned that some firms controls over client money and assets do not always achieve the appropriate level of protection. Failure to comply with the basic requirements of CASS may result in clients losing money through fraud or because their assets become co-mingled with firms assets. and some firms do not meet CASS requirements. Systems integration projects following mergers and general system upgrades can create a higher risk of firms breaching CASS. For investment firms, we are concerned that some firms do not have accurate records of client cash holdings. Controls over segregated accounts appear to be insufficient in some firms, and inappropriate claims over client money may be made. This is a particular problem in firms that engage in contingent liability transactions (for example, contracts for difference and spread-betting).

Key messages
The protection of client assets is vital to sustaining confidence in investment firms. We are concerned that some firms controls over client money and assets do not always achieve the appropriate level of protection. Firms must be able to demonstrate that they understand and are in compliance with their obligations regarding the protection of client money and assets.

Valuation of assets in funds

Continued concerns over valuations Under the Collective Investment Schemes Sourcebook (COLL), asset managers are responsible for producing fair and accurate valuations for authorised funds, a responsibility they sometimes delegate to fund administrators. For unauthorised funds, responsibility for valuations is a matter of agreement between investors and the asset manager, with responsibility often allocated to the fund administrator. The approach to valuing assets in a fund impacts the investment performance calculation, the setting of prices at which investors buy and sell units in funds, and the fees of the asset management firms. We view robust and reliable valuation of assets as an essential part of the management of clients portfolios and collective investment schemes. Failure to value assets correctly could result in litigation or reputational damage to firms and reduce consumer confidence in asset management products. We continue to emphasise the need for robust controls over the valuation process, especially relating to illiquid and complex instruments. Instances of illiquidity in the underlying market and an absence of reliable prices have made valuing fixed income instruments and property investments more difficult. Valuation has also been difficult where there has been disparity in the valuation methodologies for distressed assets.

Financial Risk Outlook 2010 Asset Management Sector Digest

Box 1: Range of pricing in corporate bonds in early 2009

In 2009, Investit performed a valuation experiment on corporate bonds. They found that around half the prices for the same bonds given by various valuation services differed by more than 7%. A small minority differed by over 100%. Investit concluded that had this been a fund, the difference between the maximum and minimum unit price could have been around 10%.

Chart 3: Distribution of percentage difference between maximum and minimum bid prices for a sample of bonds
9 8 7
frequency

6 5 4 3 2 1 0 0 7 14 21 28 35 42 49 56 63 70 77 84 91 98 105

Source: Investit

% difference

raises the importance of governance and systems and controls for fund valuations.

Those responsible for valuing assets should have adequate expertise to take a view on the fairness and accuracy of all valuations, including conducting sense checks and challenging any valuations that do not seem reasonable. Robust governance should exist over the systems and controls used to produce valuations, and there should be procedures to compensate investors if inaccurate valuations occur.

Key messages
We continue to emphasise the need for robust controls over the valuation process, especially relating to less liquid and complex instruments. Firms (and their third-party administrators) should have adequate expertise to take a view on the valuations, including being able to sense check and ultimately query or challenge any valuations they receive that do not seem reasonable. They should also ensure systems are in place to protect and compensate investors if any inaccurate valuation occurs.

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Financial Risk Outlook 2010 Asset Management Sector Digest

Alternative Investment Fund Managers Directive (AIFMD)

The AIFMD will have a considerable impact The EU regulatory landscape for the alternative investment fund management sector will be the subject of considerable change over the next few years. The proposed AIFMD is one of a package of measures put forward by the European Commission in response to the crisis. As originally proposed by the European Commission, the AIFMD would significantly restrict the ability of EU-based fund managers to invest outside the EU by way of delegating portfolio management to non-EU fund managers. The provisions in respect of leverage limits and the liability and equivalence requirements on depositaries and the sub-custodians outside the EU, and particularly in emerging markets, could have a material impact on asset managers investment strategies, or encourage them to consider other fund vehicles such as UCITS. Furthermore, in more recent EU Council drafts of the Directive, restrictions on activities which can be performed by fund managers in addition to managing alternative investment funds could drive changes to business and operating models and could create significant barriers to entry, particularly for smaller firms. The FSA already regulates the vast majority of fund managers captured by the AIFMD and sees benefits from harmonising the regulatory framework across the EEA. We have, for instance, long thought that a pan-European regime for private placement was desirable to replace the current regulation across the EU which is complex and inefficient, and acts as barrier to entry in many countries. The Turner Review also acknowledged that supervisors would benefit from a harmonised framework for the collection and sharing of systemically important information. Since the beginning of May 2009, the AIFMD has been subject to negotiation in the EU Council and the EU Parliament under the Co-decision Procedure. Throughout, the FSA has argued for a number of improvements to the original draft Directive. These have included introducing greater differentiation in the provisions to reflect the different types of fund management caught by the proposals and better address regulatory concerns. potentially limiting investor returns and choice. The independent impact assessment conducted by Charles River Associates4 on behalf of the FSA concluded that the draft Directive would result in higher costs to investors and more limited choice. Should the industry view the regulatory framework imposed by the Directive as disproportionate, any resulting migration of AIFMs outside the EU would weaken the ability of supervisors to collect and share systemically important information. The flight of large parts of the industry outside the EU would leave markets exposed to the risks targeted by the AIFMD but without any ability to control them. It is therefore important that, through the Co-decision Procedure, changes are made to the initial proposal to deliver the Commissions original investor protection and financial stability objectives in a proportionate manner. Practitioners and investors continue to have an important role to play in engaging with policy makers to ensure that the Directive delivers the right outcomes for investors and for the wider financial system.

4 Impact of the proposed AIFM directive across Europe, Charles River Associates, October 2009.

Financial Risk Outlook 2010 Asset Management Sector Digest

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Box 2: Research on the impact of the proposed AIFMD across Europe

The FSA commissioned a piece of independent research by Charles River Associates to assess the possible impact of the draft AIFMD. The results of this research were published in October 2009.4 The alternative investment funds (AIF) sector (which as defined by the Directive covers most nonUCITS funds) is heterogeneous. It invests in a broad range of financial instruments and assets, and employs different investment strategies to provide investors with tailored risk and return characteristics. The different business models adopted by the sector present different regulatory challenges and, although the Directive attempts to address particular concerns arising from some types of AIF, the adoption of a one size fits all approach by the Directive is disproportionate.

Table 1: Summary of estimated costs of the AIFMD across Europe

Hedge funds Private equity Venture capital Real estate Investment Trusts

One-off costs Disclosure to investors Delegation restructuring Relocating/re-domiciling Legal structures Total one-off costs (bp) Total one-off costs (mn) Ongoing costs Disclosure to investors Disclosure re portfolio companies Delegation Valuator Capital Depositary Total one-off costs (bp) Total one-off costs (mn)
Source: Charles River Associates

0.3 8.25 39.9 14.1 62.5 1404

0.0 8.25 19.7 14.1 42.1 756

0.0 8.25 19.7 14.1 33.8 45 0.9 14.1 23.2 451 63.5 63.5 543

0.1 0.0 0.2 0.9

0.0 2.9 0.2 4.3

0.0 3.7 0.0 0.2 9.2 1.5 5 1.9 10 0.2 3 0.0

1 27

14 248

25 33

The research concluded that the AIFMD will have significant impacts in terms of reduced investor choice and substantial compliance costs for the AIFM industry. Some of these costs, resulting from both direct costs and opportunity costs, will be passed onto investors resulting in lower net returns. If adopted in its original form, the Directive will cause a fundamental re-organisation of the business model of EEA based AIFMs, with significant one-off costs arising from changes of domicile and legal structure.

Key messages
The AIFMD is likely to have a significant impact on the global alternative asset management industry and affiliated service providers. Continued engagement between practitioners, investors and policy makers will be important to ensure that regulatory changes are appropriate, proportionate and most importantly deliver the right outcomes for investors and for the wider financial system.

4 Impact of the proposed AIFM directive across Europe, Charles River Associates, October 2009.

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Financial Risk Outlook 2010 Asset Management Sector Digest

Platforms
Platforms are used more frequently Intermediaries remain the main channel for retail distribution of investment funds, delivering 85% of all gross retail sales in 2008 according to the IMA.6 Intermediaries increasingly rely on platforms which offer access to a wide range of funds, tax wrappers and various administrative services. The use of platforms with different business models may create uncertainty over the relationship between advisers, platforms and product providers. Problem areas include uncertainty over the nature of the responsibilities owed by platforms to consumers, the inability of a number of platforms to support re-registration of investments and the failure of many platforms to disclose all relevant charges adequately to advisers and retail consumers. and should be adequately capitalised Some platforms are not profitable on a standalone basis. There is a risk of consumer detriment in the event of failures or poorly executed consolidation in the industry. Capital funding considerations are important for these firms since they are system intensive and expensive to set up and maintain. The wind down of a platform operation may be costly and time consuming, and Pillar 1 capital requirements (or equivalent) may not be sufficient to cover these costs. The increasing volume and concentration of customer assets and transactions on platforms makes the integrity and effectiveness of their systems particularly important. The reconciliation of assets held under custody is a key control to ensure that the client assets are properly accounted for, particularly within bulk nominee or similar structures. Challenges in performing timely and accurate reconciliations would make it impossible for firms that perform custody functions for their clients to run their business adequately.

while also ensuring client assets are protected.

Key messages
Platforms offering broad market access to a wider range of funds, tax wrappers and various administrative services are becoming more frequently used, and firms offering platforms operate a range of different business models with varying degrees of maturity. Firms offering platform services should ensure that these business units are adequately capitalised for the risks that they pose, including the costs of winding down operations. They must ensure that client money and assets are protected at all stages while transactions are processed through the platform.

6 Asset Management in the UK, IMA Annual Survey, 2008.

Financial Risk Outlook 2010 Asset Management Sector Digest

13

Key messages
Controls over client money and assets: The protection of client assets is vital to sustaining confidence in investment firms. We are concerned that some firms controls over client money and assets do not always achieve the appropriate level of protection. Firms must be able to demonstrate that they understand and are in compliance with their obligations regarding the protection of client money and assets. Valuation of assets in funds: We continue to emphasise the need for robust controls over the valuation process, especially relating to less liquid and complex instruments. Firms (and their third-party administrators) should have adequate expertise to take a view on the valuations, including being able to sense check and ultimately query or challenge any valuations they receive that do not seem reasonable. They should also ensure systems are in place to protect and compensate investors if any inaccurate valuation occurs. Alternative Investment Fund Managers Directive: the AIFMD is likely to have a significant impact on the global alternative asset management industry and affiliated service providers. Continued engagement between practitioners, investors and policy makers will be important to ensure that regulatory changes are appropriate, proportionate and most importantly deliver the right outcomes for investors and for the wider financial system. Platforms: offering broad market access to a wider range of funds, tax wrappers and various administrative services are becoming more frequently used, and firms offering platforms operate a range of different business models with varying degrees of maturity. Firms offering platform services should ensure that these business units are adequately capitalised for the risks that they pose, including the costs of winding down operations. They must ensure that client money and assets are protected at all stages while transactions are processed through the platform. Investment product design and characterisation: Innovation can develop new products to meet consumers changing needs. But innovation presents significant problems if the inherent risks are not adequately understood by the product provider or are not properly communicated to investors and their advisers. Firms should ensure that products are designed and characterised appropriately, and take reasonable steps to ensure investors are not offered inappropriate products. Firms must ensure they treat customers fairly and that product communications are clear, fair and not misleading (especially where intermediaries make extensive use of these communications). Consumers: should be aware that if an investment fund provides higher returns/yields than similar funds, they should examine the reasons why (or ask their adviser) as higher returns/yields may indicate greater levels of risk than they are willing to accept. Fund liquidity: We expect firms to manage redemptions in a manner consistent with the expectations created when they marketed the funds to investors. Investors in less liquid instruments need to understand any lock-in periods or limits on redemption rights, as well as the associated valuation and pricing issues that may arise in respect of such investments. In managing cash inflows and outflows, firms must treat all customers fairly. Asset managers capacity to manage complex investment strategies: Asset managers who widen their range of investment techniques and instruments need to have adequate expertise, operating processes, and risk controls. Growth in UCITS funds: We are concerned that in some cases, asset managers are relying on the classification of a fund as a UCITS fund to justify its promotion to retail investors rather than ensuring the investment strategy is appropriate for the target consumer, and remind firms of their obligations under UCITS III.

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The Financial Services Authority 25 The North Colonnade Canary Wharf London E14 5HS Telephone: +44 (0)20 7066 1000 Fax: +44 (0)20 7066 1099 Website: www.fsa.gov.uk
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