Good Risk Governance Pays

Good Risk Governance Pays

Investment Best Practices | Risk Management | Valuation

Investment Benchmarking “Must Do” Tasks

Posted in Disclosure and Transparency, Financial Reporting, Governance, Investment Management, Regulation, Risk Management

Cute young boy with stinky shoe pitching his nose

Whenever the topic of performance measurement comes up in conversation, I think back to a story someone told me about a woman who took the number two spot in a race. Proud of her accomplishment, she telephoned friends and family with the news. Here’s the catch. Only one other runner competed. Technically, her statement was correct but probably a stretch. A typical listener would likely interpret her claims to mean second best out of a large group of athletes.

When it comes to investing, context is likewise critical. A classic fallacy is to describe a security as riskier based on its standard deviation alone and ignore rates of return. If it turns out that the “riskier” security realized large enough gains compared to a second security, the resulting coefficient of variation (“CV”) would flip the ranking. (Ignore for now the notion that relying on a single statistic alone is ill-advised.)

It’s not always easy to construct an appropriate investment benchmark but the exercise is nevertheless vital since performance monitoring drives other decisions. The topic continues to receive focus from practitioners and scholars alike. A deep dive about construction and review is left for another day but the urgency may accelerate sooner than later.

As I listened to a series of compliance Q&A sessions this week about the Fiduciary Rule, I kept pondering how asset allocations are likely to change over the next year. Revised business models, the use of algorithms via robo-advisors and modified sales compensation arrangements will almost surely result in portfolio composition shifts for some investors. Should that occur, it will be incumbent upon a service provider to craft an appropriate benchmark that reflects the new regime and then explain its rationale to each investor. Otherwise, an individual or a plan sponsor may question why the performance of a post-Fiduciary Rule collection of assets is being graded against a stale benchmark.

This issue of dynamic performance evaluation is not new. However, given the regulatory focus on numerous factors that influence asset allocation, one can readily conclude that benchmarks will be part of the Fiduciary Rule implementation agenda in the months to come.

It’s Heeeere – The Fiduciary Rule Has Arrived – Now What?

Posted in Compliance, Disclosure and Transparency, ERISA, Fees, Fiduciary Liability, Governance, Investment Management, Mutual Funds, Regulation

Naughty dog - Lying dog in the middle of mess in the kitchen.

Like most people who work in the financial services arena, I hastily downloaded the long anticipated “Fiduciary Rule” when it was released by the U.S. Department of Labor (“DOL”) on April 6, 2016 and am busy tackling this final version. With more than two hundred pages, it’s going to take longer than a lunch break but is nevertheless vital reading. DOL’s Fact Sheet is a good start. No doubt there will be a flurry of articles and webinars about details and implications. I am attending two events early this week alone.

As with any new regulation, a cadre of professionals will be involved to discuss how best to comply. Ideally, an organization will coalesce its brain trust from Legal, Operations, Sales, Public Relations and Accounting at a minimum. In deference to industry concerns about how long it would take to make necessary changes, implementation will be phased in with a final adherence date of January 1, 2018. Other sought after modifications survived and are expected to make it easier for financial service firms to inform their clients in the aggregate about regulatory mandates.

The elephant in the room is the uncertainty about how post-mandate behavior could veer from the goals of the regulators and who might get hurt as a result. Free market economists refer to the Law of Unintended Consequences when they decry an event that distorts the invisible hand that optimizes demand and supply. Realists will counter that the financial services industry is already regulated and therefore does not operate on the basis of unfettered buy and sell signals. Nevertheless, history has repeated itself many times, demonstrating the acuity of those in search of profitable loopholes.

According to “Beware the Fiduciary Rule’s Unintended Consequences” by Christopher Robbins (Financial Advisor Magazine, April 6, 2016), many industry executives expect smaller firms to wither away “when some of their revenue streams dry up.” A related view is that tiny client accounts will be jettisoned by the remaining service providers and left with few choices other than “computers or robots,” despite the stated purpose of this initiative being to help all retirement investors. Keep in mind that the U.S. Securities and Exchange Commission (“SEC”) seems poised to challenge whether a robo-advisor can serve as a fiduciary. If the answer is “no,” does that preclude these algorithm-based providers from serving retirement customers?

Some attorneys exclaim that this conflicts of interest mandate will open the door wide to added ERISA lawsuits. In “Why Plaintiff Firms Will Love DOL’s New Fiduciary Rules,” Skadden Arps partner Seth Schwartz is quoted as saying that “As night follows the day, there will be more litigation.” In “Fiduciary Rule Less Complex, but Questions Linger,” reporter Sean Forbes (Pension & Benefits Daily, April 7, 2016) interviews a handful of attorneys who express concerns about (a) private rights of action to bring a lawsuit (b) a definition of a fiduciary that “goes way beyond common law” and (c) questions about the enforceability of the Best Interest Contract Exemption (“BICE”).

One big upside of the Fiduciary Rule is that the topic of fiduciary duty is being mainstreamed as never before. Transparency can be a good thing as long as investors pay attention.

Not everyone is convinced that more information will translate into better decisions made at the individual level. During a quick call last week with an in-house benefits attorney, I got his message loud and clear. An employer can only do so much if a participant remains reluctant or unable to engage. Wall Street Journal pundit Jason Zweig echoed this view in his April 8, 2016 column entitled “You Are Responsible For Your Retirement Savings.” His central point is that the DOL Fiduciary Rule is not a panacea that can fully eliminate investment product risk or prevent an individual from working with an ethics-challenged advisor or broker.

Stay tuned for subsequent posts about the DOL Fiduciary Rule.

Puerto Rico: Pensioners Versus Bondholders

Posted in Credit Risk, Municipal Bonds, Pension

financial crisis graphic design , vector illustration

As I wrote in 2006, underfunded public pension plans create headaches for lots of different people. There are participants and retirees who worry about their benefits. Taxpayers could feel the pinch if rates rise. More recently, in the matter of Puerto Rico, bondholders are being asked to step aside, at least temporarily, in favor of plan participants.

According to remarks made by U.S. Senator Bob Menendez on March 14, 2016 about S.2675, the Puerto Rico Recovery Act of 2016: “Once the Governor submits a restructuring proposal, a judge selected by the First Circuit Court of Appeals would have to confirm that it complies with the fiscal plan, protects the rights of pensioners, and, if feasible, does not unduly impair general obligation bonds.” (I added the bold.)

Most people would acknowledge that the situation in this U.S. territory is dire. Pensions & Investments reported a nearly zero percent funding ratio for the Puerto Rico Employees Retirement System as of June 2014 with “just 0.7% of the assets needed to pay all the benefits that had been promised, a level unheard of among U.S. states.”

The problem in taking from Paul to pay Peter (and I will defer to the jurists to decide which legal claim comes first) is that a large number of bondholders of Puerto Rico’s $72 billion debt are themselves retirees or saving for retirement. CNN reporter Heather Long explains that “A lot of regular Americans hold these bonds.” (See “Who owns Puerto Rico’s debt?” August 6, 2015.) On February 22, 2016, she wrote that “30% of the debt is held by middle class Puerto Ricans…Another 15% is held by other ‘average Joe’ Americans who invested in bond funds.” The Main Street Bondholders, “a coalition of small bondholders from across America,” just took out at least one full page newspaper ad to remind readers that they have “worked hard, saved and played by the rules.”

Contagion is another potential problem. In “How Puerto Rico Fatigue Could Spell Real Trouble for Munis” (Bond Buyer, March 16, 2016), consultant Matt Posner writes that “Any government finance officer in the country should be concerned that investors will view their debt offerings as subordinate to pension liabilities if a new federal standard is adopted and only more so for issuers with underfunded pensions.” I agree that uncertainty about repayment could eventually push the cost of capital upward for other government borrowers, if they can find lenders at all. Should this occur, everyone will eventually pay in some fashion.

Regrettably, this tug of war among competing interests is likely to continue. A new study from Citigroup, entitled The Coming Pensions Crisis, estimates that “the total value of unfunded or underfunded government pension liabilities for twenty OECD countries is a staggering $78 trillion, or almost double the $44 trillion published national debt number.”

Take your vitamins. The next few years are likely to require stamina and an ability to live with great uncertainty when it comes to underfunded public pension fund economics and who gets what and when.

Tradeoff Between Lower Hedge Fund Fees and Longer Lock Ups

Posted in Fees, Hedge Fund, Liquidity

Perception and Reality words on a stack of balls to illustrate finding the truth among myths, facts vs fiction and real versus unreal claims

As I’ve written many times, assessing whether a product or strategy makes sense for a particular investor (whether individual or institutional) depends on facts and circumstances. At a minimum, one has to consider what an investor seeks to accomplish, relevant constraints, need for liquidity, overall risk tolerance and the risk-return profile of the product or strategy.

Costs are another factor and need to be compared to competing possibilities on an “apples to apples” basis. When this does not occur, it is hard to know whether fees are “reasonable.” Higher fees may be justified if an investor receives something it needs and is not getting from other vendors. The only way to know for sure is to delve into what fees represent.

Results of a just-published study of newly formed hedge funds illustrate the importance of understanding fee structures. According to The Seward & Kissel 2015 New Hedge Fund Study, asset managers may be willing to lower fees to attract investors but not without getting something back. “About 68% of the funds (as compared to 72% in 2014) offered lower incentive allocation and/or management fee rates to investors who agreed to greater than one year lock-ups…” This quid pro quo is not necessarily bad as long as an investor understands that there is no free lunch and can satisfy its liquidity needs elsewhere. Click to download The Seward & Kissel 2015 New Hedge Fund Study.

Customer Service and the Financial Advisory Industry

Posted in Customer Service, Risk Management, Valuation

The Customer Service Target Market Support Assistance Concept

Once a company has identified the categories of customers it wants to attract and retain, most people would agree that providing effective service is important. After all, it is hard to expand enterprise value without a healthy growth in cash flow. While this is a truism for nearly all industries, financial advisory executives are thinking hard about this topic right now as the operating environment is poised to significantly change.

According to “DOL Fiduciary Rule Set To Shake Up Retirement Marketplace” (LifeHealthPro, February 24, 2016), “Experts say that the rule will be approved soon and many of the changes will be implemented by year’s end…” If true, some organizations could exit certain activities or otherwise alter the way they do business. This means that an existing customer may be forced to go elsewhere. Some suggest that compliance costs incurred by financial service companies will be passed along to the end-user. Whether that happens will depend on a variety of factors, including the bargaining power of the consumer and the “stickiness” of the buyer-seller relationship.

Technology is another consideration. Robo-advisors are predicted to gain a slice of the “estimated $250 billion to $600 billion of IRA assets” up for grabs should full service firms decide to jettison clients with low account balances. See “Who Wins, Who Loses With New DOL Rule? $3 Trillion in Play” (ThinkAdvisor, December 31, 2015.) Even before talk about a possible passage of the Conflict of Interest Rule, larger firms were hungry acquirers of financial technology companies. Michael Kitces describes a flurry of these recent deals in “Top Financial Advisor Issue For 2016 – The Department of Labor Fiduciary Rule and the Best Interests Contract Exemption” (Nerd’s Eye View blog, January 4, 2016).

Greek philosopher Heraclitus supposedly said “There is nothing permanent except change.” Given what is going on now in financial advisory land, this is indeed true – not just for service providers but possibly for their customers as well.

Increased Regulation of Derivatives by Registered Funds

Posted in Derivatives, Disclosure and Transparency, International Investing, Investment Management, Mutual Funds, Regulation, Risk Management, Susan Mangiero, Trading

A large display of daily stock market price and quotations during normal economic period with decorative crystal ball, flags of main country in the world

On December 11, 2015, the U.S. Securities and Exchange Commission (“SEC”) took steps to more actively regulate how derivative instruments are used by registered investment companies such as mutual funds, exchange-traded funds (“ETFs”), closed-end funds and business development companies. According to its Fact Sheet, a portfolio manager would have to either limit leverage via the use of derivatives to 150 percent of the assets under management or be allowed to increase exposure to 300 percent as long as a risk-based test (“based on value-at-risk”) was satisfied. Other conditions include, but are not limited to, the following:

  • Segregation of liquid assets to make a counterparty whole should a fund decide to terminate a derivatives trade “under stressed conditions” or otherwise exit its obligations;
  • Board approval of an appropriate risk management strategy and designation of a “derivatives risk manager”; and
  •  Heightened disclosure about their use.

Click here to download the 421 page proposed rule.

Even if this oversight document languishes on a shelf, investors are wise to ask about the use of derivatives since the economic risk-return profile of a fund can be dramatically impacted. Here are a few questions:

  • Does a fund use derivatives to hedge, speculate or synthesize exposure to a particular asset class, country or currency?
  • Is there a risk manager who stays on top of the type of derivatives being used and how counterparty exposure is assessed?
  • Has the fund ever run into trouble because of the use of derivatives?
  • Who determines trading limits?
  • Does the fund have adequate liquidity to meet relevant margins?
  • For complex derivatives, how are they valued and by whom?
  • How is the economic impact of the use of derivatives reflected on performance statements?
  • How is the risk management strategy established and updated and by whom and on what basis?

For institutional investors that have Investment Policy Statements that preclude the use of derivatives, they could be in violation of their own guidelines if they utilize registered funds that trade futures, swaps, options and hybrid derivatives. Certainly increased volatility can whipsaw performance if derivatives are aggressively employed to catch potential upside that never materializes. An institutional investor that allocates to a supposedly even-keeled fund manager could be in for a nasty surprise. Then there is the issue of embedded derivatives that show up in securities such as mortgage-backed bonds.

Although in need of an update of some chapters, Risk Management for Pensions, Endowments and Foundations by Dr. Susan Mangiero offers multiple checklists that can be used by an institutional investor as part of its fund manager due diligence.

Q&A With Susan Mangiero, Certified Fraud Examiner

Posted in Fraud, Risk Management, Susan Mangiero

Q&A, A white card with text of Q&A and a fountain pen on a wooden desk

While I have worked on multiple forensic matters over the years, I took the time last fall to earn the designation of Certified Fraud Examiner. The instructors were amazing in terms of their breadth of knowledge and I learned some new investigation techniques.

A few weeks ago, the Association of Certified Fraud Examiners asked to interview me about my education, experience and lessons learned. Hot off the press, my interview is available to read by clicking here.

Among the questions asked, the topic of red flags came up. I replied that “One major lesson I have learned is that an overly complicated business or investment structure merits further investigation. A forensic examiner needs to identify assets and their location and know who has a legitimate claim to those assets.”

By way of illustration, a few years ago, I was asked to determine the enterprise value of a hedge fund. Contrary to what the principal owner and his counsel told me, the company’s legal and related economic structure was far from simple. I ended up doing multiple documents reviews and was still unable to get my questions answered about how the offshore and onshore units fit together. I withdrew from the assignment as a result.

Complexity is not necessarily a bad thing but it does require extra work in order to assess whether the parties involved are trying to hide assets. The risk of possible foul play applies to both public and private companies that utilize multiple ownership layers without a particular rationale.

As authors of a recent Bain & Company financial services industry study describe, “Organizational complexity, more than a few rogue employees, lies at the heart of recent compliance and risk management breakdowns.”

Investment Risk Is Here To Stay

Posted in Investment Management, Risk Management

Colorful Candy Conversation Hearts for Valentine's Day

Even if you did not celebrate Valentine’s Day on February 14, it was hard to miss the many bags of conversation candies, in between the chocolates and bouquets of flowers. According to the website for the New England Confectionery Company (“NECCO”), Sweethearts® have been around since 1902. “Each year, NECCO manufactures about two billion hearts in order to keep up with the passionate demand for this American classic.”

There is a lot to be said about things that never go out of style. Take investment risk awareness for example. Whether the global capital markets are zigzagging, plunging or heading up, a prudent investor will still want to consider how much risk he can tolerate in order to meet his goals. Regrettably, risk is sometimes given short shrift, especially when the bulls are running.

As New York Times journalist Ron Lieber points out, volatility is a good eye opener since no one likes to see their performance reports veering into negative territory. According to “As Stocks Gyrate, It’s Time to Measure Your Risk Tolerance,” reconsidering one’s philosophy about uncertainty may be the best way to ensure a good night’s sleep. Interested parties can avail themselves of risk-focused questionnaires provided by companies such as FinaMetrica or Riskalyze.

I concur that “too many people don’t know their tolerance well enough and take on too much risk.” As I’ve long maintained, not every anticipated dollar or basis point return is equal in terms of risk. When an investor assumes “too much” risk, there is a chance that expected higher returns will not materialize and losses may occur. My sense is that he is sorry not to have done more “what if” homework at the outset.

Concerns about anticipated payouts, and the related desire to become more risk savvy, apply to all sorts of securities and funds and not just stocks. I have a friend who is on an emotional roller coaster right now as he awaits news about the restructuring of an insured fixed income security. He purchased it two years ago as a safe haven, never thinking that the wrapper would be in name only.

Risk is a veritable four letter word for a reason. Unless you are lucky, ignoring risk could turn out to be an expensive mistake. Taking risks is a fact of life. The objective is to make informed decisions that incorporate risk. Scoring your ability to withstand adverse outcomes is a good first start but don’t forget that qualitative unknowns need to be investigated as well. As I’ve shared with blog readers of Good Risk Governance Pays and Pension Risk Matters, numbers alone seldom tell the entire story.

Breach of Fiduciary Duty Tops FINRA Disputes Again

Posted in Compliance, Fiduciary Liability, FINRA, Investment Management

According to dispute resolution statistics, published by the Financial Industry Regulatory Authority (“FINRA”), breach of fiduciary duty continues to lead the list of “controversy types in customer arbitrations.” Negligence, failure to supervise, misrepresentation, breach of contract, suitability and omission of facts follow.

FINRA Arbitration Statistics_2011 to 2015

That breach of fiduciary duty allegations feature so prominently in FINRA customer disputes is notable since ERISA litigation patterns reflect a similar focus on how decisions are made by stewards of other people’s money.

Given the heated debate about the “Conflict of Interest” rule (sometimes referred to as the fiduciary rule) put forward by the U.S. Department of Labor (“DOL”), the spotlight on fiduciaries is unlikely to dim. To the contrary, should the Office of Management and Budget accelerate its review and issue the rule before April 2016, it is almost certain that the financial community writ large will add to the chatter about fiduciary responsibilities. A quick Google search makes it clear that the investment industry is gearing up for what they believe will be dramatic changes in the way advice is dispensed.

I will be adding more to this blog about the fiduciary rule from an economic and governance perspective in the ensuing months. In the meantime, click on “February 2 Hearing On New Fiduciary Bill” if you want to download the archived hearing about the Affordable Retirement Advice Protection Act and the U.S. House of Representatives counter to the DOL fiduciary rule.

How to Be More Transparent With Your Investment Clients

Posted in Compliance, Disclosure and Transparency

Investigation text on typewriter

I’m only a few pages in but, so far, Reacher Said Nothing: Lee Child and the Making of Make Me by Andy Martin is an entertaining read. Drawn to this new book in my quest to learn how bestselling writers write, I am impressed by Mr. Child’s uncanny ability to create. After a successful career in British television, Lee Child triumphed with an award-winning first novel entitled Killing Floor, followed with sixteen more popular offerings. Forbes describes Child’s protagonist, Jack Reacher, as a “billion-dollar brand” with 70 million books (and counting) in print. It’s no surprise then that whatever Lee writes, people are likely to read. I’m one such person.

I happened on his New York Times essay entitled “A Simple Way to Create Suspense” (December 8, 2012) and wondered whether the art of thriller writing lends itself to fund manager communication with investors. My conclusion? No. Here is why.

As Mr. Child astutely instructs, you make your family hungry by having “them wait four hours for dinner.” You tease your readers by asking a question or inferring a nugget of information at the outset and then wait to close the loop until later on. His premise is that “Readers are human, and humans seem programmed to wait for answers to questions they witness being asked.” Once the television remote control device appeared on the scene, it was even more necessary to keep viewers from jumping ship.

I believe that the opposite is true when applied to how a fund company, bank or financial adviser should share knowledge with its clients. You don’t want them to be digging around in search of needed information until the “end of the book.” For one thing, regulators continue to push for transparency and straightforward language. Then there is the reality that, absent costs that make it too expensive to terminate, investors who don’t get their questions answered may go elsewhere. Another detriment of building suspense in your investment communiques is that too much ambiguity could discourage your clients from further transactions. If they can’t understand what’s going on with their portfolio, it’s going to be tough for them to decide what to buy or sell. Whether you receive fees or commissions, asset size impacts your revenue. Add to the mix the fact that busy people are impatient for news about their money and want customer service that takes their schedules into account.

Red herrings and drawn out plot points have their place in nail-biting novels but not when it comes to enlightening institutional and individual investors.