Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

Unlike Confucius who extolled the virtues of travel when he said that "A thousand miles begins with a single step," change may not be a good thing for asset managers and their investors. In recent presentations by attorneys, I have heard more said about litigation related to investment style drift than ever before. The notion is that portfolio managers need to disclose any change in the way they trade so that presumably investors can make an informed decision about whether to stay or go.

According to hedge fund attorney Judy Gross, we are likely to see more litigation around disclosures (or lack thereof) about what a fund manager promises to do with other people's money. In "Is Your Hedge Fund Style 'Drifting'? Quick, Catch It" (Forbes, June 25, 2012), she cites the matter of the United States Securities and Exchange Commission v. Patrick G. Rooney and Solaris Management, LLC as a prime example. Among other things, the hedge fund is accused of having overly concentrated positions instead of diversifying. With Form PF and other mandatory filings a reality, investors and the plaintiffs' bar will arguably be better able to compare what a fund says it will do and what it does.

In "When investing, what you see may not be what you get," TIAA-CREF economist Brett Hammond asserts that style purity is akin to "truth in advertising." He adds that when style drift occurs, it makes it difficult for the investor to properly benchmark. This in turn means that one might end up over- or under-weighting a particular asset class or issuer or both. I would add that for some types of investors such as ERISA pension plans, the danger is that an Investment Policy Statement could be violated. As a result, allegations of fiduciary breach might ensue, with benefit plan committee members being accused of not doing sufficient due diligence on the errant money manager.

Some investment managers have long been granted tremendous latitude in how they invest. I remember calling an equity fund manager during our last bull market and asking why his performance was lagging. It turns out that he had parked a large amount of the portfolio in cash because he was uncertain about directional moves. Unfortunately, given his freedom to take this action, much of the rest of the market ran ahead of expectations while this fund's performance suffered, with investors paying the price. More recently, my work as a financial expert entailed offering an opinion about whether a fund manager had wronged investors because he and his partners had prettied up performance with capital injections on behalf of some and not others. What caught my attention in that matter was a description in the Private Placement Memorandum that granted the managers full freedom to invest as they pleased. The language about style was overly broad, perhaps intentionally so.

What will likely remain a challenge in some situations is to accurately define the investment strategy in order to discern whether drift has occurred. Moreover, it will be important to identify when a fund manager is allowed to switch strategies in order to preserve capital versus "flagrantly" ignoring the desires of its institutional and individual clients.

My comments on April 3 about investment fraud and risk governance struck a chord. As a co-presenter for "Going Beyond the Essential Background Checks: Accessing Crucial Information About the Management Team, Board of Directors, the Economics for the Team and the Succession of the Investment Staff," 4th Annual Due Diligence & On-Going Monitoring of Alternative Investments Summit, Financial Research Associates, LLC, I talked about the numerous reasons why a typical background check is necessary but insufficient.

Send an email to Dr. Susan Mangiero if you would like more information about investment fraud thought leadership under way.

In the meantime, some hot button items that should be considered by institutional investors and asset managers that want to be green lighted by pensions, endowments, foundations, family offices and sovereign wealth funds include, but are not limited to, the following:

• Legal Ownership Structure - Ask for information about who owns what, who has voting rights and whether or when assets can be transferred across legal and tax jurisdictions. If an asset manager cannot or will not provide an organization chart and legal documentation that explains an often complex ownership structure, think twice about taking next steps. I resigned from an assigment to value a U.S. hedge fund limited liability partnership ("LLP") when the CEO and the company's attorney begrudgingly provided by-laws and an organization chart that illustrated firsthand a hard-to-understand web of cross-ownership (offshore and onshore). Should trouble occur, it is imperative to understand how economic rights are distributed and on what basis.
• Job Descriptions - A titular executive is not the same thing as having an experienced and knowledgeable person fill a critical function. As an expert witness, I wrote a report that pointed out, among other things, that the Chief Risk Officer was in name only. The actual person who bore that title was anything but a risk management professional.
• Internal Controls - Entire books have been written about the importance of vetting operational risks and internal controls. Suffice it to say, make sure that important tasks such as trading and approving wire transfers are each carried out by different individuals. Transactions should be verified on a regular basis by independent parties. Checks and balances should be in place to avoid breach for items such as surpassing trade size, making a material change to investment reports and/or modifying the approval process for moving money.
• Complexity and Model Risk - As I discussed in "Model Risk and A $242 Million Overlay" (February 3, 2011), models can be nested so that mistakes made at one level can be catastrophic if not caught early and corrected. That is exactly what happened in a matter relating to AXA Rosenberg, costing the firm nearly $250 million. Someone has to kick the tires on a regular basis. Model audits should be conducted by individuals who are not going to be compensated on the basis of a model's outcome(s).  When trading strategies are complex, it is sometimes tough to identify problem areas. I remember the words of one of my doctoral professors vividly because they still ring true today. "If you can't explain a trading strategy or make-up of a model, you don't know enough to make important decisions."
• Key Person Risk - Marquee name traders may be a draw for institutional and high net worth investors but proceed with caution. First of all, banking on a name trader does not guarantee that good processes are in place. Second, it is critical to know if key person insurance is in place to address the early exit of a trader or executive and the exact nature of the coverage. Also inquire about what happens if a key person gets a divorce and an ownership stake in the asset management firm becomes part of the settlement. Investigate whether the firm has a succession plan, a non-compete contract for departing executives and/or buy-sell agreement to guide how partners leave or join the firm.
• Intellectual Property - Ask about ownership of a patent, trademark, proprietary technology and/or marketing/sales collateral. In one situation, there was a real concern that the head of sales would have carte blanche to use the client list on behalf of a competitor. Depending on the costs to acquire each client, use of a list elsewhere could deal a crushing blow to a firm and by extension, destroy value for limited partners and/or investors in a particular fund or fund family.
• Governance and Committee Structure - A board of advisors can serve as a line of defense for investors in a fund as long as its members do their job well. I recall being interviewed to serve as an expert for a large hedge fund litigation. After having read the initial documents, I told the attorneys that the existence of a pricing committee and a risk management committee was impressive and asked to see the meeting minutes. The response was that neither committee had ever met. Of course a committee could meet on a regular basis but never address critical issues and thereby be ineffective, offering no safeguard for an investor(s).
• Vendor Contracts - Unless someone is doing a comprehensive review of service provider contracts, an investor is likely to encounter a coverage gap. In the matter of hard-to-value investing for example, many times an independent verification of prices is left undone when fund of funds managers, prime brokers, custodian banks and/or consultants accept numbers from hedge fund and private equity funds "as is" as part of their respective contracts.
  
• Investment Reports - Financial statements, audited or otherwise, do not always provide the same information on investment reports. The topic of performance reporting is left for another post as it is both broad and complicated. Suffice it to say however, all investors should be treated equally in terms of information access. With side letters and side pocket arrangements, disclosure may be limited and provided on a selective basis. As an expert on a regulatory enforcement case, I explained what industry standards exist for reporting true economic risks and returns versus statements that may be misleading at best. The hedge fund being investigated had topped off losses for some investors but not others and used some creative ways to report results.
• Borrowing Capacity - In 2008 and 2009, numerous investors were taken by surprise when asset managers were unable to honor redemptions (if allowed in the first place). One indicator (and there were many) of a liquidity crisis was the inability for some asset managers to borrow enough cash to keep going. Even worse, some prime brokers pulled back existing credit lines and/or charged considerably more which in turn depressed potential upside for investors. Ask about the current costs of borrowing and the capacity and sources for an asset manager to borrow more if needed. Depending on the leverage inherent in an asset manager's trading strategy, it may be necessary to ask for a copy of borrowing agreements and to understand what could trigger a margin call(s).

The list of problem areas is long and worthy of close scrutiny, ideally by an independent third party who can work with the internal auditor, external auditor and/or board of directors (assuming that all of these parties are focused on best practices and not contributing to a fund's downfall). Institutional and high-net worth investors alike should monitor these and other risk factors before writing a check.

Background checks are invaluable tools for investors who want to conduct proper due diligence. Importantly however, a background check is simply not going to provide the kind of information described above that can make a difference between investment success and failure.

Insider trading, anti-money laundering, investment fraud techniques and much more are left for future blog posts...

In addition to sovereign debt restructuring, European financial market executives have a new mandate - high frequency trading governance. On February 24, 2012, the European Securities and Markets Association ("ESMA") published the final version of "Guidelines on systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities" in all official languages of the European Union ("EU"). As a result, regulatory supervisors must "declare whether they intend to comply with the guidelines or otherwise explain the reasons for non-compliance."

What caught this blogger's attention is the document's emphasis on governance as being "central to compliance with regulatory obligations" and having to address technical, business and operational risks, among other things. The document continues that policies and procedures must be in place to monitor a firm's trading systems and algorithms for adherence with the firm's internal control requirements. Additionally, it is critical for a firm to be able to detect when failures occur.

Whether these directives have an impact on high frequency trading remains to be seen. Bruce Love does a nice job of explaining the likely impact of ESMA's guidance. See "ESMA's HFT rules widen net, cash shadow over dark pools" (The Trade, January 24, 2012).

In "Fannie, Freddie Proble Focuses on Disclosure" (March 14, 2011) Wall Street Journal reporters Nick Timiraos and Jean Eaglesham write that the former CEO of Fannie Mae has received a Wells notice from the U.S. Securities and Exchange Commission that alleges knowledge of improper risk disclosures. An earlier response by Mr. Mudd, now CEO of Fortress Investment Group LLC, was published by Bloomberg on March 11, 2011 and describes said disclosures and procedures as "accurate and complete" and "previewed by federal regulators." Click to read "Statement by Fortress CEO Daniel Mudd on SEC Wells Notice" by Lawrence Roberts, Bloomberg, March 11, 2011.

As I wrote on August 28, 2008 in "Fannie Mae Gets a New Chief Risk Officer," changes appeared to be underway at that time, begging for details. For one thing, how was Fannie Mae's new focus on risk management different from past practices? Second, several of the Fannie Mae board members added since early 2004 were no longer listed as active in 2008 but certainly held themselves out as risk management experts. What was their contribution to improving policies, procedures and oversight? According to a November 2007 letter to shareholders by then chairman of the Fannie Mae board Stephen B. Ashley, "These past three years, Fannie Mae has undertaken a series of fundamental changes to remediate our accounting and controls and to put the company on a solid foundation going forward. These changes have done more than fix what needed fixing about the company."

On September 30, 2010, U.S. District Judge Paul A. Crotty granted defendants' motion to dismiss allegations regarding Fannie Mae's "subprime and Alt-A mortgage exposure and financial reporting as to all the Individual Defendants" but denied defendants' "motion to dismiss as to Plaintiffs' allegations regarding Fannie's internal controls and risk management" as to then CEO and Chief Risk Officer, respectively. Click to read "In re Fannie Mae 2008 Securities Litigation," United States District Court, Southern District of New York, filed September 30, 2010.

As I've long predicted, examinations about existing best practices (or lack thereof) are going to continue. If there is a silver lining to the financial fallout and risk management oversight failures that make for headlines aplenty, it is that "good players" will hopefully be rewarded for their discipline and those who have been remiss will start to pay more attention to the nuts and bolts of risk management.

Regarding Fannie Mae and its putative importance as part of the national housing finance market, shareholders and taxpayers welcome insights about who knew what and when and why.

Russell research strategist, Mr. Bob Collie, writes about the growing liabilities and assets of large public U.S. corporations. Large indeed!

According to 2010 data, 16 publicly traded U.S. corporations boast membership in what he refers to as the "$20 billion club." Their combined balance sheet liabilities of $740 billion or roughly 40% of corporate America's pension IOUs gives them investment muscle in terms of market price movement and influences what and how financial service providers deliver retirement plan solutions.

While improving economic conditions boosted assets by $21 billion to $619 billion, declining interest rates pushed liabilities upward wih a "total shortfall of assets below liabilities of $121 billion" or about the same as 2009 levels.

I concur with conclusions made by Mr. Collie that companies are going to be forced to reckon with their defined benefit plans. Figuring out where the cash will come from in order to write checks to participants is one challenge. Another task will be conducting a capital budgeting analysis of the money going to meet pension IOUS instead of investing in positive net present value projects. Notably however, studies do suggest that companies often need to provide good benefits in order to attract talent. This means that the costs of employee benefit plans (retirement, health, profit-sharing) must be netted against the expected advantages of having a productive workforce in place as a result of providing incentives.

A reasonable response by corporations would be to include retirement plans as part of enterprise risk management ("ERM") activities. However, in a study I conducted with the Society of Actuaries in 2008, the results were sobering. Specifically, "Pension Risk Management: Derivatives, Fiduciary Duty and Process" by Dr. Susan Mangiero summarizes survey results about ERM for 169 organizations with pension plans as follows:

• Only 30% of companies that used derivatives in their pension plans had corporate Chief Risk Officers in place.
• Of those roughly fifty organizations, only 25% of them or about 12 companies included pension plans as part of their corporate risk endeavors.
• Only 25% of organizations that used derivatives in their pension plans had ever discussed a link between Sarbanes-Oxley obligations and ERISA fiduciary duties. For those organizations that did not use derivatives in their pension plan, only 19% had discussed corporate governance versus pension governance.

Note to Readers:

• Click to read "Sharp increase in both assets and liabilities for the pension world's $20 billion club" by Bob Collie, Russell Investments, March 2011.
• Click to read "Pension Risk Management: Derivatives, Fiduciary Duty and Process" by Susan Mangiero, October 2008. The new email address for Dr. Mangiero is susanm@fiduciaryleadership.com.
• Click to visit www.pensionriskmatters.com for information about pension funding, financial and fiduciary risk management, governance and ERISA litigation.

If The Bond Buyer journalist Dan Seymour is correct, litigators may soon be even busier. According to "Headline Risk Drains Muni Bond Funds" (Money Management Executive, January 31, 2011), the week ending on January 19, 2011 saw investors withdraw an unprecedented $4 billion from mutual funds that invest in bonds issued by municipalities. In context, this is roughly 1% of the $470+ billion market and about $1 billion more than the former exit record of $3.1 billion for the week ending on November 17, 2010. Seymour adds that "Muni bond funds have now reported $29.3 billion of redemptions in the past 10 weeks" or "65% more than the previous record for outflows in a 10-week period of $11.5 billion established in 2000."His conclusion is that investors are scared. With credit spreads not moving out as would be expected during a flight to quality path, investors just want to leave the asset class altogether.

Another journalist with The Bond Buyer cites several muni bond portfolio managers as saying "not so fast." Headlines about bankruptcy risk grab attentions but may lure investors away from "solid, safe investments because of distorted opinions in the media." See "Don't Let Headlines Overshadow Buys: DWS" by Christine Albano, Money Management Executive, January 31, 2011.

A hat tip to the "Securities Arbitration and Litigation" blogging team. Their February 8, 2011 post entitled "Enough Transparency in the Municipal Bond Market?" cites a recent study from DPC Data about the paucity of financial disclosures by municipal bond issuers. According to "DPC Data Issues New Study on Transparency in the Municipal Bond Market" (February 3, 2011):

• Issuers of 60 to 70 percent of 17,000 municipal bonds file information "too late to be of practical use in credit risk analysis."
• For the bonds issued from 1996 through 2003 that were still outstanding between 2005 and 2009, "56 percent of issuers/obligors did not file annual disclosures for one or more years; 19 percent did not file for any of those years."
• "At least a third of the expected disclosures were never filed in the designated official repositories."

As DPC Data CEO Peter J. Schmitt suggests "there is no way around the fundamental need for timely financial statements to obtain critical information that can warn investors of impending problems."

Pension plan IOUs are another drain on municipal coffers. With unfunded retirement plan liabilities estimated at $3 trillion, state, city and county issuers with employee benefit funding gaps (excluding healthcare obligations), the last thing a municipal bond investor wants is a nasty surprise heretofore not disclosed in a timely and complete manner.

Late last week, U.S. Congressman Devin Nunes and U.S. Senator Richard Burr introduced the House version of the Public Employee Pension Transparency Act, H.R. 567. The goal to "amend the Internal Revenue Code of 1986" and "provide for reporting and disclosure by State and local public employee retirement pension plans." Failing to comply with this proposed rule, if approved and passed into law, could push the cost of borrowing up for numerous public entitities since they would be denied federal tax exemption status. This means that investors in turn would not be able to exempt realized bond income and would likely rethink the risk-return profile of muni bonds.

Having done a lot of work in the area of performance metrics and risk measurement, I will be the first to tell you that numbers can be misleading. Investors must look beyond reported data to have a solid understanding of the economic exposures they face when deploying assets. The problem is that one cannot even begin a proper analysis without access to information.

As the U.S. Securities and Exchange Commision begins its exploration of the disclosures made (or not as the case may be) by state and local bond issuers, expect a lot of questions from unhappy investors about the due diligence conducted by their advisors and consultants if no one has sufficiently granular information to do a good job of default risk assessment.

Reader's Note: Click to read "$3 Trillion Challenge" (Governing Magazine, October 2007) and a sidebar interview with Q&A Interview With Dr. Susan Mangiero about public pension finances.

In "'Swaps' Add a New Risk" (February 7, 2011), Wall Street Journal reporter Ari I. Weinberg writes that little is known about the use of over-the-counter derivative instruments by mutual funds and that the risk of non-performance by a swap counterparty must be considered.

Having worked on several derivative trading desks, I have direct experience dealing with swap contracts, pricing, hedging and counterparty risk. As the saying goes, there is no free lunch. The use of an interest rate, credit and/or currency swap can help an asset manager hedge price variability or enhance returns. The ex-ante economics must consider the riskiness of the party on the opposing side of the contract and much more.

Since Enron and other mammoth bankruptcies of companies that used swaps in large amounts, U.S. bankruptcy law has changed to allow for netting of bi-directional cash flow obligations. Additionally, collateral is often posted (with the amounts being determined by a host of factors such as creditworthiness of the posting entity, type of collateral, existing borrowing facilities, deal structure and so on). New regulations mandate the use of a central clearing house for swaps, heretofore traded privately among mainly large global banks. Even with all of the so-called reforms, work remains.

Attorney Rose DiMartino with Wilkie Farr & Gallagher LLP is quoted in the Wall Street Journal article about her observation that the quality and quantity of disclosure about the use of swaps by investment funds can vary considerably. Attorney Mark Perlow with K&L Gates LLP urges guidance from the regulators about the use of swaps as a leverage creation mechanism. I concur with both sentiments but add that measuring leverage is part of the challenge. Moreover, with respect to disclosure, it's critical to understand what derivative instrument has been used and how, along with understanding more about collateral posted and the nature of the counterparty involved. Consider the following example:

• An equity swap is used by Investment Fund A to hedge its long positions.
• The same structure swap is used by Investment Fund B to take an activist stake in Company X, in anticipation of a management reshuffle and an increase in share price sometime soon.
• Yet another asset pool managed as Investment Fund C may employ the identical type of swap as part of a multiple leg transaction that allows it to gain exposure to a sector not otherwise available by investing directly.

The  risk-return profile is going to differ across funds. Even if all three mutual funds reported the identical swap on its filings, one would still need to play financial detective (assuming he or she had access to further details) to understand how the use of swaps is likely to change things.

In addition, there is the issue of valuation. Some swaps are straightforward to price and some are not. You could have the same over-the-counter swap valued by two or more independent pricing services and get different numbers that are far apart if the derivative has a complex structure that veers from the standard fixed to LIBOR arrangement.

Investors do need more information about the use of derivatives by mutual funds. The question is whether they will get sufficient clarity to properly assess risk.

Interested readers can link to "SEC Proposes Joint Rules with CFTC to Define Swap Related Terms" (December 3, 2010) and/or "SEC proposal would give customers clarity on pricing" by Sarah Nl. Lynch, Reuters, February 2, 2011.

Also check out "The Role of the Financial Expert in Valuation of Derivative Instruments" by Susan Mangiero, Expert Evidence Report, BNA, 2004. Note that BVA, LLC is now known as Fiduciary Leadership, LLC.