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Extreme Events – Specimen Answer A.9.1 – Answer/Hints

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Q. Set out the main types of risk to which a conventional asset manager managing funds on behalf of others might be exposed. Which of these risks is likely to be perceived to be most worth rewarding by its clients?

 

The types of risk that a conventional asset manager might face in this context are many and varied, and readers are advised to consult an expert for more details or to refer to appropriate books/material covering this topic (e.g. by searching third party content referred to in Nematrian’s Reference Library).

 

They include:

 

(a)    It could suffer from adverse market movements. Most asset managers are remunerated on an ‘ad valorem’ basis, i.e. as a percentage of funds under management. Its future revenue stream is therefore dependent on their (market) value.

 

(b)   It could be carrying on business unprofitably. Asset managers compete with each other. This competition includes competition on price. Most (good) asset managers are profitable, although severe declines in asset values can drag them into loss, and if it is a new business there may also be start-up costs.

 

(c)    It could suffer operational failures that result in it needing to compensate clients or otherwise incurring reputational damage. This is perhaps the most obvious risk that an asset manager faces on its own account (and the one that ‘risk managers’ in such a firm might often concentrate on), but is not necessarily as large a risk in financial terms as (a) (or (b)).

 

Operational failures could include pricing errors, incorrect booking of trades, misunderstanding of tax position of clients, staff fraud, etc.

 

Risks can also interact. For example, the investment manager might fail to invest assets in line with client restrictions or other relevant documentation (a type of operational risk). However, risk of breach of client mandates might increase in volatile market conditions. Moreover, in times of market distress clients and their lawyers may be more creative and more focused on linking losses they have suffered to supposed failures in business processes, moving the loss from being an investment one borne by the client to an operational one borne by the fund manager.

 

(d)   Its outsourcing arrangements could prove flawed. For example, the entities to which it has outsourced could fail to provide it with an adequate service leaving the asset manager itself to compensate its clients or to incur the expense necessary to rectify the issue.

 

(e)   Its investment performance could deteriorate, leading to client defections and/or failure to win new business.

 

(f)     There may be weaknesses in non-investment related aspects of its business activities, e.g. client servicing, or deficiencies in contractual arrangements. Asset managers may offer ancillary services to clients, e.g. member record keeping, which create risks not directly related to investment management. There are also servicing requirements for their core business activities, and these could be weak and in extremis result in loss of clients and/or compensation payments.

 

(g)    It could grow too rapidly, particularly if the lines of business are capital intensive. Rapid growth may place strains on investment and business processes. Some types of activities that conventional asset managers carry out may also be more capital intensive (in terms of systems and staffing requirements and/or in terms of regulatory capital).

 

(h)   It might become overly complicated. More complicated business models may be more difficult to manage and more prone to operational risk than simpler business models. Of course, they may also be more remunerative.

 

(i)      It might have inappropriate sales or staff incentives (including remuneration structures) leading to mis-selling or inappropriate communication of product characteristics, or other behaviours that benefit the staff involved but create risk for the firm.

 

(j)     It might have inappropriate credit and/or liquidity exposures, either for itself (e.g. unpaid fees payable by clients) or for its clients for which it is then found liable to compensate them for. Certain types of fund structures can have specific credit risk exposures which may need managing appropriately.

 

(k)    Its product structures may be rendered redundant due to changes in external factors such as tax and regulatory frameworks.

 

(l)      Its funds could suffer a liquidity squeeze, and it might need to buy in the assets in question onto its own balance sheet.

 

(m) It might find itself contributing to industry wide compensation schemes even though it has not itself run into difficulties. More generally, its business will be influenced by sentiment elsewhere in the industry – if clients are generally disinvesting from an asset class then asset managers in general will struggle to buck this trend.

 

(n)   It will be subject to a large number of other types of risk more generally applicable to businesses operating in the financial sector, including:

-          It may have inadequate management information systems and the like to manage its business effectively.

-          It may be exposed to terrorist risk, IT systems failure, breach of competition rules, health and safety rules etc.

 


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