Originally Published: September 26, 2011, Phocion Investments Inc.
The advancement of the investment industry has accelerated over the last two decades to where, today, we have high frequency trading powered by algorithms cumulating significant profits from numerous singular trades. During this period, the middle office functions of performance, compliance and risk have had a hard time keeping up. Stories of front running, misrepresentation of results to increase sales and overleveraging the firm to maximize bonuses have become much too common. Many firms have established controls to minimize operational risk but surprisingly, there are far too many firms that have only paid lip service to establishing proper controls.
Current Issues
Numerous investment management firms have the functions of performance, compliance and risk assigned as additional tasks to persons with other responsibilities. For instance, in many firms the front office calculates and prepares their own performance to present to clients. What this creates is the significant possibility of misrepresentation of performance. Reading the Wall Street Journal’s article by Jason Zweig (“Here’s One Way To Beat the Market”) is further evidence of the significant risk of misrepresentation if the performance functions of a firm are not independent and designated to qualified individuals. The article discusses the way some firms present the Total Return performance of their portfolios versus the Price Return performance of the benchmark.
Often times the Chief Compliance Officer’s duties are assigned to the role of the CIO, COO or CFO. What this does is minimize/nullify the independence of the position. On top of that, there is a significant possibility that these persons neglect their compliance functions due to the overwhelming amount of work under their responsibility and their lack of compliance experience. Many managers have discarded the policies and procedures of their firms to conduct themselves in an unethical manner. Front running trades for their own personal accounts, accepting gifts from brokers that will influence their trading business to the disadvantage of the most important stakeholder, the client.
Similarly to performance, many managers calculate their risk exposures creating a significant risk to the firm. Not only does the risk analysis lack independence, a portfolio manager may be willing to increase his/her exposure to maximize their remuneration. An independent risk department would ensure that the firm exposure and that of any individual is within the stated policy.
Optimizing Your Corporate Structure
The most important aspects that all these functions should have in common are independence and competence. For performance, compliance, and risk to be effective within a firm, their independence cannot be compromised and experienced people must be in place. An optimal corporate structure would be one where all three functions do not report directly or indirectly to the front office. With the rapid evolution of performance, as witnessed by the accelerated adoption of the Global Investment Performance Standards (GIPS®), performance specialists have risen to the executive level and have gained considerable independence. Furthermore, to maintain independence this function requires a voice and as such would report directly to the board and the fund sponsor(s). Their ability to properly maintain performance activities cannot be influenced by the portfolio managers and the sales staff.
Continuing with compliance, a compliance officer should report to the firm’s legal department with a dotted line to the board and the fund sponsor. In this manner, the compliance department would have more weight in their decisions when regulatory and policy issues are in play and help the firm avoid circumventing the established rules. Their opinions on the state of the firm’s compliance would be heard by those overseeing the best interest of the stakeholders.
With respect to risk, a firm should have a risk officer who could oversee the firms risk measurement and analysis, and contribute to the firm’s policies. What is important here is that the risk functions remain segregated from the front office. No firm would like to experience rogue managers/traders who can compromise the firm’s status as a going concern because they have taken excessive risk.
Experience goes hand in hand with independence. For example, having an independent compliance department will not be effective if the compliance officer (or Chief Compliance Officer) does not have the necessary experience. As stated earlier, many times these positions are handed to others as additional duties, which should lead to question a firm’s leadership when entry level position candidates are evaluated more critically than leadership positions in performance, compliance and risk.
Investment management firms cannot continue to view these functions solely as cost centers. The benefits they bring far outweigh the costs incurred to operate them. Having the proper performance operations would assist the firm in properly evaluating and compensating managers. Keeping on managers who actually add value to the firm and replace those who do not would directly impact the firm’s P&L. Not limiting ourselves to compensation, but a firm that is GIPS® compliant stands a greater chance of attracting more clients than those who do not. This would greatly assist the sales department and no wizardry would be required in performance reporting to bring in more clients.
Compliance and risk would play their roles in avoiding operational risk situations with employees not focused on the client and firm’s best interest. Incidents like the David Sokol and Lubrizol purchase would be avoided. Strategies would be set with a clear view on the risks being taken and more in line with the objectives of the firm. An insurance company should not be taking on more risk than required to meet their obligations. How much would the AIG situation differ if the risk exposure was properly measured and analyzed and effectively communicated to the stakeholders?
Final Words
The fund sponsors, the board and management must work together to establish independent and competent performance, compliance and risk functions. These stakeholders cannot shirk their responsibilities and place sole responsibility on the other. It must be a team effort where the roles of each office is understood and respected by the other. Living in an increasingly cynical world, it would be a breath of fresh of air to see investment firms hold themselves up to the ethical standards that they often times glowingly express in their speeches but quickly hesitate to establish the same rhetoric in their middle office.