The growth in the number of socially responsible investment (SRI) funds, and the number of competitive briefs from local authorities, municipal funds and religious organizations looking for ethically driven investments is but one example of the increased operational challenge that asset management houses face in executing their fiduciary duty-ensuring that the terms of their clients' mandates are enforced as required at each stage of the investment process. Regardless of the conditions in the market-whether good, bad or downright ugly-that responsibility remains sacrosanct and must be executed with due skill, care and diligence. Failure to comply with a client's mandate can result in the loss of business and, where retail funds are concerned, additional regulatory sanction.
As clients impose more technically demanding restrictions on their investments, firms must raise their game. Tighter constraints are not simply a result of the current crisis, although it will certainly have considerable consequences for buy-side firms. Clients have been subjecting their portfolios to ever greater levels of scrutiny and tighter mandates for many years.
Such technical challenges have encouraged asset managers to re-evaluate compliance systems and the associated reference data in order to provide their clients with more highly focused coverage on these stricter mandates.
The use of synthetic instruments-which has proved more challenging to manage in recent times-has also led to more complex mandates where managers strive to improve the performance of funds while managing portfolio risk. Even before the events of the last 12 months led to renewed attention on scrutiny, due diligence, and risk management disciplines, industry consultants were very well informed about the requirement for good operational processes and guideline management systems. What's more, clients themselves are more conscious of the fact that although custodians may protect their physical cash very well, it is the investment managers' decisions that determine whether the net asset value (NAV) of their £500 million ($737 million) portfolio increases, decreases or disappears completely.
In addition to these structural changes in the industry, asset managers have been inundated with increased regulation. The European Union's Undertakings for Collective Investment in Transferable Securities (UCITS III) regime, which is now fully operational, requires supervisory responsibility over instruments like derivatives. Further, the Markets in Financial Instruments Directive (MiFID) demands greater clarity in the documenting of investment management agreements (IMAs). As a result, investments can only be made for those instruments specifically listed in a private client's IMA. Previously, such an IMA would be more general in nature, taking the view that investments in instruments were allowed as long as the client did not expressly prohibit their use.
In the UK, the Financial Services Authority (FSA) has also emphasized the Treating Customers Fairly (TCF) principle. This brought about a cultural shift toward a more risk-oriented approach to the handling of client assets. Even as recently as two years ago, TCF did not have the high profile it has today in asset management houses. A fund manager who has to place a program trade in the market for a number of different clients needs to uphold TCF principles while ensuring compliance. This is virtually impossible where there is sole reliance on manual processes. A firm would have to demonstrate to the regulator that appropriate operational risk controls were in place to facilitate timely and accurate trade execution.
The increase in industry and fund-specific regulation has happened within a general commercial environment that is more mindful of corporate governance than ever before. Directors and trustees can now be held personally liable for any corporate disasters-a sobering thought. These individuals know that they must undertake appropriate due diligence when appointing third-party providers such as asset management firms, to ensure that those providers have the appropriate operational controls to reduce and mitigate operational risk.
The management of retail products imposes even greater regulatory scrutiny and responsibility on asset managers. A firm could suffer reputation damage if it did not manage its funds in line with the applicable regulations and other guidelines listed in a fund's prospectus. The assessment of these potential operational risks are better documented and managed by the industry now than 10 years ago.
In addition, clients are more aware of the impact that operational errors can have on their portfolios. Some operational errors can cause clients to lose valuable market exposure. Guaranteeing compensation through restitution is all very well, but clients, regulators and asset managers themselves prefer to avoid operational errors completely. Furthermore, when senior management has to take time out to assess and resolve operational errors, this impacts the efficient and timely delivery of the firm's professional services.
Attempting to meet all these demands without automated controls is a near-hopeless task-which is why guideline and risk management are once again enjoying the spotlight as the current economic crisis unfolds. The pressure to automate is certainly more pressing now than ever before.
Although the economic environment is increasingly challenging for asset managers, they still need to focus on allocating the necessary resources to implementing systems that will facilitate dynamic and proactive controls. Investment philosophy, strategy and performance are no longer the only things that are under review-operational risk controls, process definitions, and systems are undergoing greater levels of scrutiny to determine a firm's ability to manage clients' money in a compliant and efficient manner.
If we needed any further evidence of the central role played by compliance systems, we only need look at the growth and development of vendors like Fidessa LatentZero over the last eight years. Guideline management systems like LatentZero's Sentinel-which Baring Asset Management uses-provide asset managers with the ability to assess a large number of trades without causing any detriment to the timely implementation of investment decisions. The popularity of such systems has grown enormously because the guideline management process has to be automated to operate effectively.
Asset management houses will need to continue to automate decision-making, trade implementation and guideline management processes in order to respond in a timely and efficient manner to changes within the financial services industry. The various versions of Sentinel that Baring Asset Management has used since the initial implementation in 2000 facilitate ever greater coverage on institutional and retail products. Systems cannot remain static; they must respond to the requirements of regulators, clients and an ever-changing financial services industry. The wish list for the immediate future, from an asset management perspective, is topped by system connectivity and performance-meaning faster and more seamless processing. Structured products and over-the-counter (OTC) traded instruments will create the biggest challenges going forward-a fact made more urgent by the current economic situation.
In addition to compliance systems, the buy side as a whole will need to make a bigger investment in reference data and the associated data management infrastructure. Systems are only as good as the reference data that is loaded into them. And firms must be committed to investing in technically qualified operations staff. Employing skilled people who understand the technology and the reports generated by these systems will be the key to successfully increasing automation.
Banks and brokers may be urgently reviewing their internal processes and controls after a year of write-downs, collapses, takeovers and insolvencies. The need to manage structured products is only the latest in a series of compliance issues facing the investment industry. Even firms without their own proprietary trading desks require highly advanced, multi-functional systems to automate controls and enhance risk management.
The buy side has long been seen as the sell-side's poor relation when it comes to technology. But that is no longer the case. Evidence shows that buy side firms are making greater investments in compliance technology-not just to protect their reputations, but also in order to remain competitive.
Rob Knight is head of operational compliance director at Baring Asset Management. She is based in London. -->