Conflicts of Interest in Asset Management

Case Studies
 

While regulatory fines are not the only indicators of materiality of conflict of interest risks in the industry, the following anonymised case studies exemplify how some asset and wealth management firms failed to manage their conflicts of interest.It should however be noted that fines and public censure, such as exemplified in these case studies, are only the tip of the iceberg of regulatory activity.

In most cases, the regulator would not take the costly, lengthy and resource heavy approach of public enforcement or legal action but instead require the firms identified during non-public supervisory action to undertake lengthy and expensive internal remediation actions to address identified gaps or weaknesses in the management of conflicts of interest. These remediation actions are often combined with the requirement of a final detailed internal or third-party audit report on the outcome and effectiveness of the remediation and, where necessary, with requirements of compensation payments to investors.Also noteworthy is that in some enforcement cases, the conflict of interest did not crystalise and no benefits were obtained by the firm or its members of staff. However, the firms:

• Could not evidence that material incentives indicating conflicts of interest were managed at all; or
• Could not evidence that existing controls were applied or effective; or
• Oversight of the conflict type was negligent or reckless; or 
• Disclosure to investors was insufficient or misleading. 

We are setting out below summarised and anonymised examples that are representative of material issues that arose from mismanagement of conflicts of interest:

Side by Side Risk – Cherry Picking

A regulator fined a firm for systems and controls failings to manage conflicts of interest fairly. These failings led to compensation being paid by the firm to ensure that none of the investors in the funds managed were adversely impacted.

The firm employed a side-by-side management strategy on certain desks whereby funds that paid differing levels of performance fees were managed by the same desk . This incentive structure created conflicts of interest as these portfolio managers had an incentive to favour one fund over another. This risk was particularly acute on funds that had very similar investment objectives but different investors.

The firm identified this and recorded it in its conflict register. However, while the firm’s policy required trades to be allocated in a timely manner, portfolio managers could delay recording the allocation of executed trades for several hours. By delaying the allocation of trades, the portfolio managers could assess a trade’s performance throughout the day and, when it was recorded, allocate trades that benefitted from favourable intraday price movements to one fund and trades that did not to other funds. This was an abusive practice commonly known as cherry picking.

Side by Side Risk –Incentives

A firm has been fined for inadequate disclosures to investors regarding its management of funds with similar investment objectives. The firm managed both external and internal funds but failed to adequately manage conflicts of interest and client disclosure, as it moved portfolio managers (PMs) between those funds.

Both funds could invest in a wide range of financial instruments and most of the internal fund’s capital and its stated purpose was to attract and retain senior partners and other key members of staff.

From the launch of the internal fund a conflict of interest was present. By the end of the relevant period, its assets under management had risen, with a larger number of PMs exposed to it, including PMs who traded for the funds.

This should have been disclosed to investors and regulators. Decisions concerning the internal fund’s allocation of PMs were made exclusively by the senior staff members invested in it, which placed them in a situation where they benefited from these decisions personally, in conflict with the duties they owed to investors in the external fund.

Moreover, disclosures about the number of PMs allocated to the external fund were insufficient and misleading. Limited information, which the firm intended to disclose reactively, did not provide 

Multiple Roles

A firm inherited the management of a fund which was partly invested in one part of the equity tranche of a CDO. The firm was also the collateral manager of the CDO. As such, it was committed to hold the equity tranche in custody until the CDO’s maturity. The position held by the firm in this CDO was risky and so indirectly impacted the liquidity and value of the fund. This holding was thus not in the interests of the investors in the fund.

According to the regulator, the firm had not complied with its information duties, not acted in the exclusive interests of its investors and preferred instead to act in its own interests, to the prejudice of the investors, by not informing them of this conflicted position and by continuing to hold in custody the equity tranche of the CDO, even though it had identified the conflict of interests which resulted from its multiple roles in managing the CDO.

The regulator also challenged the way the firm continuously underestimated the CDO and therefore affected the interests of the fund investors. By maintaining a low valuation of the CDO, despite an offer by the structure manager to purchase the equity tranche at a much higher value and the favourable trend of the markets in which the underlying assets of the CDO were invested, the firm prioritised its own profits to the prejudice of the investors of the fund.

Proprietary Fund Fees

Investment Advisers of a firm paid fines to settle charges regarding their failure to tell clients about certain aspects of how they selected investments in their retail investment advisory program, which included the selection of more expensive investments from which the firm’s advisers profited.

When selecting investments for clients, the advisors preferred funds managed by the firm and invested approximately 50% of client assets in proprietary funds. This practice resulted in payment of additional management fees to the firm, however, neither of the advisers disclosed this practice or the associated conflict of interest to clients. Moreover, when considering funds, the firm evaluated the lower-cost institutional share class for both proprietary and non-proprietary funds, but the higher-cost, non-institutional share class for proprietary funds always was selected for the funds in question.

In addition, an advisor failed to disclose its conflicts of interest arising from investing the client assets in higher-cost share classes of certain funds, including funds managed by the firm, when lower-cost share classes were available. By selecting the higher-cost share classes, the adviser received revenue sharing payments and avoided paying certain transaction costs, while clients received lower returns on these investments.

Material Holdings
 

A firm breached its fiduciary duties to clients by failing to disclose that one of its portfolio managers, who oversaw the portfolio management of some sector funds, was also running a family-owned company in that sector that partnered with a publicly traded company that later became the largest holding of the sector fund he ran for the firm.

Retrocessions

A firm was fined since it failed to disclose its preference for investing its client funds in certain commodity pools or exempt pools, namely hedge funds and mutual funds managed and operated by an affiliate and subsidiary.

The firm also failed to disclose its preference for investing its clients’ funds in third-party-managed hedge funds that shared management or performance fees with a firm affiliate.

The firm sought retrocessions from third-party hedge fund managers that were under consideration for investments. During introductory meetings, third-party hedge fund managers were typically asked about their willingness to pay retrocessions. If a manager declined to pay retrocessions, the firm typically sought an alternative manager with a similar investment strategy who was willing to pay the firm retrocessions. The firm did not disclose its preference for retrocession-paying third-party hedge fund managers.

Cross Trade

A regulator fined a firm for failing to manage a conflict of interest between two of its clients that arose when the firm caused one client to enter into an ill-advised transaction which rescued another client from serious liquidity concerns.

Both clients focused on making investments in the same market. The firm caused one client to invest in an unlisted bond issued by an offshore firm, purchasing it from the fund of the other client in the form of a cross trade. It failed to ensure that the bond's valuation or the rationale behind the investment were properly scrutinised at the time of the transaction, and it proved to be a poor investment for that fund, which halved in value over the next two years.

The transaction gave rise to a clear conflict of interest between the two funds. The firm was slow to identify and failed to manage the conflict fairly. The firm did not disclose the conflict and failed to ensure that the one client understood that the transaction proceeds would be used to repay an investment made by one of the firm’s other clients. 

Closet Tracking

A regulator fined a firm for not acting in the interests of all its clients by closet tracking. The firm’s fund claimed to actively purchase investments and charged a commensurate fee for this product. When the firm decided to significantly reduce the level of active management of the fund (aiming to track rather than outperform the relevant benchmark)  it offered to institutional investors to manage the fund at a reduced fee but continued to charge retail investors the same level of fees as it had before the decision was made. Therefore, the fees charged to retail investors were inappropriate given the diminished level of active management, a clear conflict of interest of which the retail investors were unaware.

Assessment of Value and Multi-Asset Funds
 

A firm was challenged by the regulator for not managing the conflict of interest between a funds’ profitability for the firm and the fund’s value for investors. During the Assessment of Value, the firm had to identify suitable peer groups for the assessment of Performance and Comparable Market Rates. This presented challenges for a Multi-Asset Fund, since the comparison data used by the firm (e.g., relevant sector or peer group risk classifications) provided extremely wide ranges for comparison of performance or fees. The firm had an interest to keep the comparison group of funds broad and disparate to justify  the fund performance and fees. However, the Assessment of Value process aims to address conflicting interests and therefore the firm had to further customise the peer group through screening to reflect appropriate weightings in equities and fixed income but also to consider the funds specific investment approach which was the use of passive index trackers to reflect the intended strategic asset allocation. Actively managed peers that were definitely not comparable had to be excluded to narrow the comparison spectrum and ensure that quartile rankings of the fund against its peers produced a more meaningful result, indicating that the fund performed in line with its peers but that fees needed to be reduced.