In the current climate of macro-economic volatility and ever-increasing regulatory prominence, asset managers are compelled to enhance their investment management risk identification, measurement, mitigation and monitoring processes and frameworks. Indeed, global economic uncertainty and higher levels of volatility have become the new normal in today’s financial markets, placing renewed focus on sound risk management.
The role of risk management in the investment management process cannot be underestimated. The industry designs products and makes client commitments based on the promises of future returns. Returns that can evaporate when risk management fails. A sound investment management risk framework enables a proactive approach to the prevention of undue or extreme losses in client investment portfolios and thus contributes towards long-term performance and client retention.
Deloitte’s recent Investment Management Risk Survey themed “Shedding light on South African risk management trends”, examined the level of sophistication of South African asset managers in the execution of investment risk management and operational activities.
Given the lack of formal South African regulations in this regard, the survey was based on the ERM process from the “Risk Principles guidance”.
This guidance was published in February 2009 by the Committee of European Securities regulators (now ESMA – the European Securities and Markets Authority) and outlines the general risk management principles that underpin the Undertakings for Collective Investment in Transferable Securities (UCITS) regulations. Using this document as a reference, we determined:
- The level of sophistication of South African asset managers’ investment risk management practices.
- The state of readiness of South African firms with regards to the adoption of a regulatory regime similar to the UCITS framework.
Generally, the results from the survey indicated that risk management practice levels are well developed and that South African asset managers appear to have taken some steps in the path towards UCITS preparedness. There are however key gaps that need to be addressed. Please refer to the full survey results here:
The output from the survey was grouped into investment activities which are a crucial part of an asset manager’s operations and distinguishes it from competitors as well as operational activities which support and facilitate the execution of investment activities. Operational activities can be classified into two components namely, client registry and asset registry.
Some of the key results are summarized below.
In terms of organisational governance of the risk policy, 43 percent of firms indicated that the board, senior management and audit risk committee are aware of but do not actively attend to investment risk and mandate compliance risk. Due to the increasing complexity of financial markets and expected regulatory developments, there will be an increasing demand for senior management to become more involved in investment risk management. According to the ESMA ERM guidance principles, an asset manager’s risk management function should also implement the risk management policy and procedures and report to the board of directors and senior management.
Asset managers have a strong reliance on third parties for their operational activities. This is to be expected given the specific nature and scale of the operational risks faced by asset managers such as continuous trading, daily reporting on returns and regulatory compliance. Our main concern in terms of operational activities is asset managers’ reliance on third parties, where they do not necessarily have close oversight of such parties’ control frameworks. Given this, we recommend more frequent monitoring of third parties and the formal inclusion of third-party risk in asset managers’ risk appetite framework.
According to the ESMA ERM guidance principles, outsourcing of risk management activities does not exempt asset managers from retaining full responsibility for their effectiveness and appropriateness of the risk management process. Asset managers should take the necessary steps to ensure that the third party is able to carry out the outsourced activities reliably and effectively and in compliance with applicable laws and regulatory requirements.
Sufficient human and technical skills must be maintained by an asset manager to ensure proper and effective supervision on the carrying out of the outsourced activities. Asset managers should also establish procedures for the periodic assessment of the third part’s governance, technical and business environment to the extent that it is material to the quality and the appropriateness of the risk management process.
For investment management firms, regulatory readiness is increasingly difficult to achieve. And even in uncertain times, firms will still need to adopt leading practices to respond effectively to a constantly shifting regulatory environment. Survey findings revealed that 40 percent of respondents’ policies do not ensure that there is adequate accountability for risk management decisions taken. This number is concerningly high. A lack of accountability
breeds complacency, which is the breeding ground for oversights and unwelcome surprises. South Africa firms would benefit from aligning their policies with the ESMA guidelines on risk management decisions.
A sound investment management risk framework enables a proactive approach to the prevention of undue or extreme losses in client investment portfolios and thus contributes towards long term performance and client retention. It also creates a platform for consistency in the identification, measurement, management, monitoring and reporting of risks across all portfolios. This, in addition, enables asset managers to translate the house view on market movements and the investment philosophy into a risk appetite statement
which clearly articulates the way asset managers sees risk, to investors. Some of the benefits to this approach include:
- Reduced earnings volatility leading to higher accuracy in earnings forecasts and as a result improved investor confidence.
- Enhanced client satisfaction as risk-return expectations are better managed.
- An investment management risk framework creates a platform for consistency across all portfolios.
- Operational effectiveness resulting from formalization and clarity of roles, improved risk reporting to all key stakeholders, enhanced decision-making ability due to additional information as well as effective disaster recovery planning for counterparty risk events or third-party failures.
For more information on Management Risk trends in South Africa and Investment management click here: