The investment fund industry in Cyprus experienced remarkable growth in the last few years with Cyprus Investment Funds reaching €10.7 billion at the end of the second quarter of 2021, recording almost 300% growth since the end of the year 2016.
The increase of assets under management (AUM), the expansion of the client base and the operations in new geographical areas, creates numerous challenges for management companies to continue offering high quality services to their clients and be compliant with the national and EU regulations. Senior managers and Board of Directors need to take the necessary actions promptly that will provide their companies with the necessary tools to adapt in the new environment, overcome “growing pains”, remain competitive and achieve a smooth transition from a small/medium size company to a larger organization, avoiding the dangerous so-called “Bermuda Triangle of Growth”.
As Management companies grow, they should enhance their internal processes for compliance with European regulations governing the operation of investment funds. Supervisory authorities consider the nature, scale, and complexity of the Management companies’ activities and thus, larger organizations are expected to be compliance with stricter regulations. In addition to regulatory compliance, management companies are also advised to develop and apply their own “code of ethics”, which shall set out the organization’s ethical guidelines and best practices to follow for honesty, integrity, and professionalism. Alternatively, Management companies may adopt codes of ethics and professional standards, developed by global associations of investment professionals, such as the CFA Institute “Code of Ethics and Standards of Professional Conduct” or the “Asset Manager Code of Professional Conduct”. Environmental, Social and Corporate Governance (ESG) principles shall also be an integral part of each company’s internal policies.
The purpose of this article is to examine selectively some operating conditions of management companies, which become more important as they grow, and propose best practices for compliance of investment professionals with European legislation and adherence to the highest standards of ethics and professionalism.
Management Companies shall ensure that they employ sufficient number of qualified portfolio managers with the necessary work experience and academic/professional background to be able to manage the investment funds effectively. Each fund shall be managed based on its investment policy as disclosed in the Prospectus and other incorporation documents of the fund. The company shall develop internal processes to ensure that the investment policy and the investment limits included in the Prospectus are embedded in the investment decision making process. The impact of each trade in the investment limits and liquidity risk of the Fund shall be examined at the pre-investment stage as well. For UCITS, the investment limits included in the legislation, which ensure a particular level of diversification, shall also be an important element of the investment decision making process.
According to the “Code of Ethics and Standards of Professional Conduct” of the CFA Institute, the investment managers shall “exercise diligence, independence and thoroughness” before taking investment decisions, for which they shall “have a reasonable and adequate basis, supported by appropriate research and investigation”. Before taking investment decisions, managers utilize a variety of resources, which include companies’ reports with financial information and performance metrics, databases, third-party research, and results from quantitative models. When Managers are using third-party research, they shall perform the necessary due diligence to ensure that the investment research is sound and of high quality. Loyalty to clients is also an important element of the “CFA Asset Manager Code of Professional Conduct” and investment professionals are expected to behave in an ethical manner by placing clients’ interests before their own.
The EU Directive 2011/61/EU emphasizes the importance for management companies of employing an independent and effective risk management function. To ensure its independence, management companies shall functionally and hierarchically separate the said function from other operating units and especially from the portfolio management function. Furthermore, management companies shall take safeguards against conflicts of interest, including a remuneration policy which will promote sound and effective risk management and will not encourage risk-taking not consistent with the investment policy of the funds under management.
Technological advances and Fintech provide to management companies effective tools to develop sophisticated risk management methodologies to identify, measure, manage and monitor appropriately the investment risks in which the funds under management are exposed. The risk management function shall employ stress testing and scenario analysis to examine the impact of various macroeconomic factors, such as a potential increase in inflation, interest rates or oil prices, to the performance and risk profile of the investment portfolios of the funds under management. Liquidity stress testing is also of paramount important, especially for open-ended UCITS and AIFs, and the Management Companies shall use such tools to ensure that they can satisfy redemption requests of investors even in periods characterized by extreme events. ESMA Guidelines on Liquidity Stress Testing (LST) in UCITS and AIFs shall be examined and adopted by management companies while developing their own LST policy.
Delegation, Oversight and Due Diligence
The operation of mutual funds requires the constructive cooperation of the Management Company with other service providers, such as the Depositary, Fund Administrator and External Auditor, which ensures that there are the necessary independent lines of defense for effective risk management and control, which are essential for protecting investors’ interests. Management Companies shall implement adequate due diligence procedures to confirm that the delegate has the necessary resources, organizational structure, and internal procedures to effectively perform the delegated functions. In addition, the management companies are responsible for the oversight of the delegates to verify that the functions are performed diligently, honesty and fairly in the best interests of investors.
In a nutshell, fund management companies shall take decisive actions to successfully manage growth and adopt to the new environment and challenges of the investment industry. The enhancement of their internal procedures is essential for compliance with stricter EU and national regulation governing the management and operation of larger investment funds. In addition, the adherence of the companies’ employees to the highest standards of ethics and professionalism is of paramount importance and will ensure that the companies safeguard investors’ interests while offering their services.
Author: Constantinos Kourouyiannis, CFA, Executive Director of Easternmed Asset Management Services Ltd, Secretary of the CIFA Asset Management and Distribution Committee