British reg' finds poor due diligence over delegation of portfolio management
The Financial Conduct Authority (FCA) has called upon ‘host’ Authorised Fund Managers (AFMs) to improve their standards, after finding weaknesses in governance structures, conflict of interest management and operational controls. Firms that operate a host model must be well-capitalised, having assessed risks and resources needed to function effectively and good governance from the senior management.
In its latest review, the FCA found that, overall, firms performed poorly when it came to due diligence over delegation of portfolio management. The regulator highlighted its concerns that firms did not gather the level of detailed knowledge required to assess proposals to understand the funds that would be under their responsibility. The FCA also noticed “on several occasions”, a lack of adequate systems and controls in place to operate the funds before these firms submitted the applications to the regulator.
There was often no obvious link between questions asked during the onboarding of a fund or investment manager and the planned tracking of outcomes, said the regulator. The review found that firms had done little analysis of the model portfolio versus the actual portfolio ex-post, as well as the actual distribution of the fund when compared to the planned distribution. Additionally, there was little in-depth analysis of the delegated third-party investment managers’ expertise, track record or investment process and poor analysis on how the manager could achieve the stated performances.
The regulator also stated its concerns over the relationship between the AFM and the third-party investment manager. Ideally, the former must effectively monitor the latter and the delegation arrangement must not prevent the AFM from acting in the best interests of the investors. “We sometimes observed AFMs referring to a third-party investment manager to whom they have delegated functions as their ‘client’. This is an incorrect description of the relationship anticipated by the regulatory framework,” added the FCA review.
Poor oversight, governance lapses
Several firms displayed poor oversight of delegated third-party investment managers and the FCA had also noted a lack of in-depth understanding of investment management activities and strategies. “Some firms did not demonstrate adequate oversight of delegated third-party investment managers, including how they plan to produce returns, and how they performed in different risk environments against fund objectives, benchmarks and peers,” said the FCA. The regulator warned that firms must operate with a clear understanding of tolerance for each indicator and have a clear line of escalation for issues that fall outside these thresholds.
AFMs also fell short when it came to governance and oversight. In the review, AFMs failed to provide evidence of robust governance procedures and a lack of challenge by independent non-executive directors (INEDs) when it came to potential conflicts. Firms reviewed had a framework for managing conflict of interest but were inefficient. While all firms had some level of risk framework, the FCA found wide differences in their effectiveness, maturity, coverage, governance and use within the business.
The FCA has provided written feedback to all firms in the review and will review the progress of these firms in the next 12 to 18 months. The regulator is also pondering upon demanding firms to hold additional capital to guard against the risks inherent in their business. Sheldon Mills, executive director for consumers and competition at the FCA added that the regulator will consider if there is a need to make changes to existing rules to supplement the review’s findings.