Extreme Events – Specimen Answer A.9.1 –
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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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