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For an asset manager, conflicts can and do manifest in a multitude of ways. Rather than focusing on entertainment and hospitality policies and practices, there are far more interesting and nuanced ways conflicts can affect investors – both positively and negatively.
Conflicts can and do arise due to corporate structures
Fees and compensation are certainly an important starting point. Ideally, those should all be agreed and negotiated between the parties right from the start. It’s true some investors aren’t in a position to easily negotiate the fees but they should at least be actively aware of what they’re contractually agreeing to. By themselves, these fees and compensation arrangements don’t necessarily give rise to conflicts of interests. However, conflicts can manifest when a client is responsible for the transaction charges of a secondary provider, such as fees generated by stockbrokerage, debt origination transactions, underwriting activities or services provided by associated companies or related companies within the same group.
Such conflicts can be direct and obvious when the primary and secondary providers are inter-related and where the company consolidates the profits earned. It can and should be beneficial to the investor for the asset manager to have corporate connections with secondary providers; but investors should be able to assure themselves the asset manager completes the transactions on a truly arm’s length basis and that there’s ongoing independence of investment judgment.
In some quarters the issue of how stockbroker commission is paid and shared with the asset manager has received a great deal of attention. Brokerage, paid by the investor, is often bundled and includes macro and micro research, as well as trading execution services. Such services are delivered in a number of ways to the asset manager in the ultimate service of the investor.
It’s incumbent on the asset manager to ensure these services – regardless of whether or not they’re received by way of electronic platforms – are clearly research and execution services and don’t unduly influence the manager’s broker selection processes or directly benefit the client investor. It’s within the investor’s rights to interrogate whether any conflicts that may be created by such practices are adequately mitigated.
Independence may be a state of mind. However, it’s not solely that and, unfortunately, a state of mind is seldom easy to prove or demonstrate. Disclosure of the conflict isn’t enough in this instance and the arm’s length nature of any such transactions does need to be demonstrated. Consequently, investors should be able to test they receive fair value for those services and that the secondary fees are competitively comparable. It’s suggested – perhaps controversially – that asset managers should be in a position to provide these benchmark comparisons in any situation where a conflict does occur, as investors would seldom be in a position to do that.
Exploring incentives as conflict creators
The sub-text of any discussion on incentives and fees is unfortunately that of remuneration. The remuneration structures within asset managers can be a double-edged sword: it’s both a source of conflict and can be a remedy.After all, if our judgments were not influenced by financial interest performance, incentive schemes would have no real influence. In the corporate world, companies can align management interests with shareholder interests by means of share ownership or share option schemes.
Similarly, an asset manager may introduce investment performance fees as a means of aligning portfolio manager and client interests. Ignoring uncontrollable market and sector trends, the aim is to drive the portfolio manager to more accurate and successful investment decisions. In the corporate example, that remedy is dependent on independent decision- making about performance targets and the valuation and accounting processes they use to measure those.1
In the asset manager world, the performance fee remedy is equally dependent on independent measures of investment performance and whether the structure of the performance fees is sufficiently long term in nature to align with the investor’s long-term interests. The added dimension for asset managers is the tension created by regulatory and mandate restrictions that may apply to over- or under-performing instruments.
Views on share dealing: personal or corporate?
Depending on your perspective, having your investment manager co-invested in the same instruments as you can either align your interests or represent an unmanageable conflict. Typically, the issue is resolved with disclosure, restrictions on timing of transactions and the price or value of any transactions. That last aspect is particularly important where the buyer and seller set the price rather than an active and liquid market doing so. It may be that the co-investment is simply prohibited in its entirety. In this case, investors may wish to assure themselves that prohibition hasn’t simply pushed the practice underground.
Again, depending on the investment objective, it may work in an investor’s favour for the asset manager to have the capacity to underwrite, initiate or mature potential investments prior to transferring them to a client portfolio either directly or via inter-group structures. It’s unlikely an asset manager would be able to directly trade as principal with the client funds under his control. South African legislation doesn’t generally permit that, but some fairly simple product structuring and wrapping can make it both possible and lawful. Investors should therefore be exceedingly cautious and understand how the instruments are valued, the timing of any transactions, any transaction fees that may fall due and, importantly, how the asset manager proposes to manage being both an agent and principal in the deal.
Similarly, it may be advantageous – and, in some instances, a regulated requirement – for asset managers to prove or “seed” any new portfolios or investment strategies with proprietary capital prior to introducing it to clients. Investors may welcome or challenge this position but – at the least – they should assure themselves the proprietary funds or capital doesn’t become an actively traded position that competes for intellectual capital, market liquidity or price.
So is disclosure enough?
Disclosure of a conflict can never remove the conflict: it merely mitigates2 as activities undertaken in the public eye are possibly less likely to be dishonest. Disclosure requirements can positively drive the behaviour and practices of the disclosing party. However, from the investor’s perspective the disclosure may not have a significant value. “As is often the case, investors have no real alternatives. They can only compare the relative detrimental effects of conflict situations.”
Put bluntly, it’s difficult for investors to patrol their own rights and to test the integrity and honesty of their selected asset managers, as the asset manager itself holds the information necessary to be able to perform that testing. That asymmetry of information makes the trust relationship between client and asset manager that much more important and maintaining that trust requires, in part, transparency. It aids with monitoring the conflicts and permits clients to contract with sufficient prior knowledge.3 Perhaps the most persuasive control is that those in positions of financial trust build their businesses on reputation. And reputation, once damaged, takes a lot more than policies and practices to rebuild
References
1. Watter, R and Maizar, K; “Structure of Executive Compensation and Conflicts of Interest”, Kluwer Law Internation, pp 39-41
2. Wymmersch, E; “Conflicts of Interest, Especially in Asset Management” Kluwer Law Internation, 2006, p266
3. Bahar, R and Thevenoz L, p19
KERRY HORSLEY
Prudential
HORSLEY was appointed head of risk and compliance in February this year. She joined Prudential from the Old Mutual Investment Group, where she was head of compliance. She was responsible for regulatory compliance and reputational risk management for the full suite of investment companies within the cluster. Prior to that, Horsley worked at Old Mutual as a legal adviser to the institutional business and as an account executive, where she consulted on benefit structuring and administration to a number of retirement funds. She holds a BA, LLB (UK/ZN), Certificate in Compliance Management, LLM in Commercial Law (UCT, distinction).
Conflicts can and do arise due to corporate structures
Fees and compensation are certainly an important starting point. Ideally, those should all be agreed and negotiated between the parties right from the start. It’s true some investors aren’t in a position to easily negotiate the fees but they should at least be actively aware of what they’re contractually agreeing to. By themselves, these fees and compensation arrangements don’t necessarily give rise to conflicts of interests. However, conflicts can manifest when a client is responsible for the transaction charges of a secondary provider, such as fees generated by stockbrokerage, debt origination transactions, underwriting activities or services provided by associated companies or related companies within the same group.
Such conflicts can be direct and obvious when the primary and secondary providers are inter-related and where the company consolidates the profits earned. It can and should be beneficial to the investor for the asset manager to have corporate connections with secondary providers; but investors should be able to assure themselves the asset manager completes the transactions on a truly arm’s length basis and that there’s ongoing independence of investment judgment.
In some quarters the issue of how stockbroker commission is paid and shared with the asset manager has received a great deal of attention. Brokerage, paid by the investor, is often bundled and includes macro and micro research, as well as trading execution services. Such services are delivered in a number of ways to the asset manager in the ultimate service of the investor.
It’s incumbent on the asset manager to ensure these services – regardless of whether or not they’re received by way of electronic platforms – are clearly research and execution services and don’t unduly influence the manager’s broker selection processes or directly benefit the client investor. It’s within the investor’s rights to interrogate whether any conflicts that may be created by such practices are adequately mitigated.
Independence may be a state of mind. However, it’s not solely that and, unfortunately, a state of mind is seldom easy to prove or demonstrate. Disclosure of the conflict isn’t enough in this instance and the arm’s length nature of any such transactions does need to be demonstrated. Consequently, investors should be able to test they receive fair value for those services and that the secondary fees are competitively comparable. It’s suggested – perhaps controversially – that asset managers should be in a position to provide these benchmark comparisons in any situation where a conflict does occur, as investors would seldom be in a position to do that.
Exploring incentives as conflict creators
The sub-text of any discussion on incentives and fees is unfortunately that of remuneration. The remuneration structures within asset managers can be a double-edged sword: it’s both a source of conflict and can be a remedy.After all, if our judgments were not influenced by financial interest performance, incentive schemes would have no real influence. In the corporate world, companies can align management interests with shareholder interests by means of share ownership or share option schemes.
Similarly, an asset manager may introduce investment performance fees as a means of aligning portfolio manager and client interests. Ignoring uncontrollable market and sector trends, the aim is to drive the portfolio manager to more accurate and successful investment decisions. In the corporate example, that remedy is dependent on independent decision- making about performance targets and the valuation and accounting processes they use to measure those.1
In the asset manager world, the performance fee remedy is equally dependent on independent measures of investment performance and whether the structure of the performance fees is sufficiently long term in nature to align with the investor’s long-term interests. The added dimension for asset managers is the tension created by regulatory and mandate restrictions that may apply to over- or under-performing instruments.
Views on share dealing: personal or corporate?
Depending on your perspective, having your investment manager co-invested in the same instruments as you can either align your interests or represent an unmanageable conflict. Typically, the issue is resolved with disclosure, restrictions on timing of transactions and the price or value of any transactions. That last aspect is particularly important where the buyer and seller set the price rather than an active and liquid market doing so. It may be that the co-investment is simply prohibited in its entirety. In this case, investors may wish to assure themselves that prohibition hasn’t simply pushed the practice underground.
Again, depending on the investment objective, it may work in an investor’s favour for the asset manager to have the capacity to underwrite, initiate or mature potential investments prior to transferring them to a client portfolio either directly or via inter-group structures. It’s unlikely an asset manager would be able to directly trade as principal with the client funds under his control. South African legislation doesn’t generally permit that, but some fairly simple product structuring and wrapping can make it both possible and lawful. Investors should therefore be exceedingly cautious and understand how the instruments are valued, the timing of any transactions, any transaction fees that may fall due and, importantly, how the asset manager proposes to manage being both an agent and principal in the deal.
Similarly, it may be advantageous – and, in some instances, a regulated requirement – for asset managers to prove or “seed” any new portfolios or investment strategies with proprietary capital prior to introducing it to clients. Investors may welcome or challenge this position but – at the least – they should assure themselves the proprietary funds or capital doesn’t become an actively traded position that competes for intellectual capital, market liquidity or price.
So is disclosure enough?
Disclosure of a conflict can never remove the conflict: it merely mitigates2 as activities undertaken in the public eye are possibly less likely to be dishonest. Disclosure requirements can positively drive the behaviour and practices of the disclosing party. However, from the investor’s perspective the disclosure may not have a significant value. “As is often the case, investors have no real alternatives. They can only compare the relative detrimental effects of conflict situations.”
Put bluntly, it’s difficult for investors to patrol their own rights and to test the integrity and honesty of their selected asset managers, as the asset manager itself holds the information necessary to be able to perform that testing. That asymmetry of information makes the trust relationship between client and asset manager that much more important and maintaining that trust requires, in part, transparency. It aids with monitoring the conflicts and permits clients to contract with sufficient prior knowledge.3 Perhaps the most persuasive control is that those in positions of financial trust build their businesses on reputation. And reputation, once damaged, takes a lot more than policies and practices to rebuild
References
1. Watter, R and Maizar, K; “Structure of Executive Compensation and Conflicts of Interest”, Kluwer Law Internation, pp 39-41
2. Wymmersch, E; “Conflicts of Interest, Especially in Asset Management” Kluwer Law Internation, 2006, p266
3. Bahar, R and Thevenoz L, p19
KERRY HORSLEY
Prudential
HORSLEY was appointed head of risk and compliance in February this year. She joined Prudential from the Old Mutual Investment Group, where she was head of compliance. She was responsible for regulatory compliance and reputational risk management for the full suite of investment companies within the cluster. Prior to that, Horsley worked at Old Mutual as a legal adviser to the institutional business and as an account executive, where she consulted on benefit structuring and administration to a number of retirement funds. She holds a BA, LLB (UK/ZN), Certificate in Compliance Management, LLM in Commercial Law (UCT, distinction).
