The implementation of sound risk management practices can assist Investment Managers to distinguish themselves in the eyes of investors. Managers should be mindful that investors essentially want two things from them: (1) confidence that manager investment strategies are repeatable, and (2) safety of their capital. With respect to the latter point, this article touches on the following: (1) Business Conduct – Code of Ethics, Regulatory Requirements and Conflict of Interest (2) Marketing Risk – Fund Disclosure Documents and Marketing Materials. The practical solutions that follow are designed to be helpful.
Establishing a Written Code of Ethics
Investment management firms are required to establish a written Code of Ethics document that sets out the commitment to conduct business with integrity and in the best interest of their clients. The Code of Ethics can be included in the firm’s compliance manual as an appendix or as a stand-alone document. In order to enforce the Code of Ethics operating controls are required to assist in the monitoring process, namely through policies, procedures and supervision. The Senior Management of these firms need to enforce the Code of Ethics both in words and in action otherwise the document loses its meaning. For instance, management needs to throw their complete support around their Chief Compliance Officer and their compliance department. Also, when a material breach occurs management needs to ensure that it is taken seriously and that it sees a timely resolution. In fact, controls for breaches that need to be set in place to monitor day-to-day operations include: Investigation, Escalation, Resolution and Action. Further a log of breaches should be maintained, and reported to Senior Management and the Board of Directors. The log can also be used as a tool in order to perform trend analysis in order to assess where the firm’s risks reside.
At minimum, all employees of the investment management firm should be required to sign-off on the Code of Ethics at the time of hire and on an annual basis through an annual attestation process. As well, consultants that perform work on managers’ behalf should sign-off on the Code of Ethics during the period that they are engaged to perform work. For documentation purposes, a log should be maintained of all personnel and consultants that have signed-off. The firm should foster and promote a culture that encourages both informal and formal training. For instance, quarterly Code of Ethics training sessions should be provided to all employees in order to ensure that they fully understand their obligations. Larger investment management firms may consider using web based tools to perform this training, with an educational quiz that demonstrates understanding.
Addressing Increasing Regulatory Requirements
A Senior Management top concern is anticipating and managing the implementation of increasingly complex Regulatory Requirements. Regulatory risk further increases as firms venture into different jurisdictions because of the need to be aware of all of the requirements that they are subjected to. To be safe, in new jurisdictions firms should consult with external counsel for guidance. Once a firm has come to the point of establishing the Regulatory Requirements that it needs to conform to, they are in a position to perform a gap analysis which is a tool to assess firm risk. This involves the identification and review of the requirements to ensure that the firm has the proper processes in place. Documentation is a key component to achieving a successful gap analysis process. Implementing proper controls ensure that all gaps and risks are addressed. As well, on an annual basis a review should be performed to ensure that no gap exists and thus controls are complete. Furthermore, ongoing monitoring is necessary in order to address any regulatory changes as seen via visiting regulator websites, other education and training. As an internal control, compliance should utilize a calendar application as a reminder tool to identify when to distribute corporate filings and to which individual.
Conflicts of Interest Can Be Difficult to Identify
Conflict of Interest is an important subject because, if not addressed properly, it can lead to reputation damage, loss of business, legal and regulatory action. Conflicts affecting a firm can be wide-ranging and difficult to identify. Therefore, a proactive approach should be taken, namely the sound practice of maintaining a Conflict of Interest policy. The Conflict of Interest policy should be applied at the time that each employee is hired and involves the gathering of sufficient information to ensure employee or third party conflicts are fully disclosed. To be relevant the sound practice of a Conflict of Interest Inventory Checklist (or Risk Assessment) should be created and it needs to be customised to the level of complexity depending on the risk that the firm is willing to take on. The following table provides an example of how one may consider structuring a Conflict of Interest checklist:
In addition to the checklist, effective controls should be implemented to identify, prevent, manage and monitor any actual or perceived situation where the investment manager, employee or a third party-service provider can gain an unfair advantage or put their own interest over a client. Such sound practice control measures includes (but are not limited to) annual attestation, prior trade approval for personal trades etc. Furthermore, continual monitoring, managing and documenting are required.
Fund Disclosure Documents Must Contain Proper Representations
Fund documents take on several well-known forms such as offering memorandums, prospectuses, subscription agreements, supplements required by regulators etc. Indeed, these documents have a significant amount legal and regulatory content around adhering to industry standards. Essentially it comes down to this: managers must ensure that all fund documents contain proper representations. Within this spirit, sound practices that can assist in distinguishing a firm touch on: (1) the receipt of documents by investors, (2) the updating of fund documents and (3) the use of third party placement agents.
With respect to the first sound practice, managers must ensure that investors receive the fund documents prior to them placing any transactions through subscription agreements.
The second sound practice is designed to assist investors to make well-informed investment decisions. In the event of a material change (e.g. administrator, an additional prime broker, new investment strategy, added restrictions, new class of shares etc.) the manager should provide the proper disclosures either through ad hoc supplements or actual updates.
The final sound practice advocates that should managers hire third party placement agents that they ensure that these entities abide by all of the applicable fund laws and regulations, such as those specifically related to investor suitability.
Marketing Material is an Opportunity to Show off Integrity
Marketing material is any written communication (e.g. websites, social media, emails etc.) directed at more than one person, concerning information about the purchase and sale of a security, or other information about the company. Managers must avoid using this material to make false or misleading statements. Rather, they should act with utmost integrity (e.g. cite sources, disclose conflicts of interest, utilize proper disclaimers etc.). The following sound practices touch on: (1) proper oversight, (2) monitoring and (3) performance advertising.
With respect to proper oversight, all Marketing Materials must be approved by a designated person (e.g. Compliance Officer) who initials and dates, and ensures the storage (either electronically or via hard copy) for a minimum of seven years. This person also ensures that the proper controls are in place for ongoing monitoring.
The sound practice of performance advertising ensures that only factual information is presented and nothing misleading. Prior to disseminating performance returns, controls need to be in place along with an audit trail (such as documentation and backup) pertaining to how the performance returns were calculated. Prior to advertising, performance returns must be pre-approved by a designated person (e.g. Performance Officer). To think that administrators or custodians take care of this is erroneous as the ultimate responsibility for performance return accuracy resides with the Manager. Essentially, investors will never tolerate finger pointing towards the admin or custodian. Should the integrity of performance returns become questionable, Managers face the loss of assets and (more significantly) a huge hit to their reputation.
As an added bonus, the “hot topic” of hypothetical (or back-tested) returns is interesting to explore. The sound practice around this area includes ensuring that these returns are not front-and-centre in the marketing material but rather that they are distributed as supplemental info. They should also be accompanied by a disclaimer that states that “actual results may differ from the model”. A statement outlining any limitations and assumptions used in the model should also be included.
Warren Buffett is quoted as saying “Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you. You think about it; it’s true. If you hire somebody without [integrity], you really want them to be dumb and lazy.” In today’s world, investors are demanding regulators to raise the bar. They want to engage with managers that have strong business conduct and marketing practices, yet some have their heads stuck in the sand and fall short in these two areas.
In summary, managers must continue to communicate to investors how their investment strategies can be repeatable. However, it is through an all-out effort at articulating how their capital will remain safe that managers will demonstrate integrity. It is through this new reality that managers will become successful at raising capital.
“AIMA’s Guide to Sound Practices for Operational Risk Management” by Daniel Johnson, Kurt Hagerman et al. AIMA Working Group Members, 2016, page 24.
“What Warren Buffett Wants to Know Before He Hires You” by Recruiterbox; http://www.recruiterbox.com/blog/what-warren-buffett-wants-to-know-before-he-hires-you/.
 “AIMA’s Guide to Sound Practices for Operational Risk Management” by Daniel Johnson, Kurt Hagerman et al. AIMA Working Group Members, 2016, page 24.
 “AIMA’s Guide to Sound Practices for Operational Risk Management” by Daniel Johnson, Kurt Hagerman et al. AIMA Working Group Members, 2016, page 7.
 “AIMA’s Guide to Sound Practices for Operational Risk Management” by Daniel Johnson, Kurt Hagerman et al. AIMA Working Group Members, 2016, page 26.
 “AIMA’s Guide to Sound Practices for Operational Risk Management” by Daniel Johnson, Kurt Hagerman et al. AIMA Working Group Members, 2016, page 42.
 “AIMA’s Guide to Sound Practices for Operational Risk Management” by Daniel Johnson, Kurt Hagerman et al. AIMA Working Group Members, 2016, page 42-44.
 “What Warren Buffett Wants to Know Before He Hires You” by Recruiterbox; http://www.recruiterbox.com/blog/what-warren-buffett-wants-to-know-before-he-hires-you/.PDF version