Survey results analysed and published

January saw the FMA publish its long-awaited Managed Investment Schemes Sector Risk Assessment (SRA). This document is based upon surveys of four licensed Supervisors, including Trustees Executors, conducted by the FMA in late 2021, concerning 53 licensed managed investment scheme (MIS) managers under supervision. Left out were superannuation and workplace savings scheme managers, and the MIS-Other category which includes the likes of forestry and property scheme managers. Mortgage fund managers were included in the survey.

As the title of the SRA implies, the focus of the document is on risk as it manifests itself within the MIS industry. The SRA states in this respect:

The performance of managed funds is dependent on how well the fund manager identifies and manages business and fund risks within a MIS. Risk in this context refers to the likelihood and impact of harm to the best interests of investors, and to fund managers. A goal for fund managers is not to eliminate risk, but to manage risk in an effective way that serves and protects the best interests of investors.

(SRA, p. 3)

The Supervisors were asked to rate risk levels across 22 different risk factors for the MIS managers they supervised and assess and comment upon the mitigants that these MIS managers used to manage risk. In this context, “mitigants” is a technical term defined by the FMA as referring to “the efforts and controls that the MIS entities take to reduce risk” (ibid., p. 4). As some examples of mitigants, the SRA cites those specified by existing regulatory frameworks such as requirements for MIS managers to be licenced and supervised. In its analysis of the survey data collected, the FMA distinguishes between pre-mitigation and post-mitigation risk levels, hence the importance of mitigants.

An enormous amount of data was produced by the Supervisor surveys, which the FMA then aggregated into categories for SRA analysis:

1.  MIS manager
2.  Risk category:
      a.  Operational risk
      b.  Governance risk
      c.  Investment risk
3.  Sub-sector
4.  Sector level

The stated purpose of this vast enterprise reveals why the SRA is essential reading for MIS managers and their Supervisors, as its sets out the kinds of risk areas, particularly those wherein the risks are higher than the rest, that the FMA wants MIS managers and their Supervisors to pay close attention to:

The data that informs this SRA establishes a broad perspective on the risks in the MIS sector. This view of sector risks will guide more targeted work on specific issues and managers.  It will further highlight higher risk areas to help enhance supervisor monitoring and raise awareness with fund managers. We intend to collaborate with supervisors to ensure risks identified in this SRA are (or continue to be) managed effectively.

 (ibid., p. 3)

Nor is it intended that the new SRA is to be the FMA’s final word on the matter. It is just the beginning of a series of MIS sector SRAs to come. In relation the role of these SRAs, the FMA states that, “This is the first SRA on the MIS sector, and we expect that the insights drawn from it will inform future iterations. Our intention is to continue to build more data and intelligence on the MIS sector to promote our purpose of facilitating the development of fair, efficient, and transparent financial markets” (ibid., p. 3). This kind of wording from the regulator makes clear that MIS sector SRAs are intended to have profound and far-reaching effects on the ways in which MIS managers identify and mitigate their risks and how Supervisors undertake effective, risk-based monitoring activities. In this respect, SRAs represent blueprints for action that are binding on both MIS managers and Supervisors.

Analytical results at overall MIS sector level

The SRA offers some comforting findings when its results are considered at MIS sector level. In the absence of risk mitigants, the MIS sector’s overall risk level ranks as Medium-High. However, post-mitigation, the sector drops to Medium-Low risk level. According to the SRA, this mitigated risk ranking cashes out into the likelihood of harm occurring being “unlikely” and the consequence of the harm being “minor”.

The SRA lists the top contributing risks to which the sector taken as a whole is exposed:

1. Responsiveness to changes in macro-economic factors (e.g. inflation, interest rates, exchange rates)
2. Product management (e.g. product disclosure documentation, marketing, and advertising)
3. New financial instrument management and trend chasing risk (e.g., innovations like cryptocurrencies or assets otherwise new to MIS manager experience)
4. Investment operations
5. Manager oversight of outsourced investment services

(ibid., p. 5)

Three key risk categories defined

At MIS sector level, the risks are considered both pre-mitigation and post-mitigation, which dual analyses produce risk rankings that vary within the framework of three risk categories (operational risk, governance risk, investment risk) examined.

Table 1: SRA descriptions of the three risk categories

(ibid., pp. 6-8)

Pre-mitigation at MIS sector level, in descending order, governance risk ranks higher than operational risk, which in turn ranks higher than investment risk. Post-mitigation, this order changes, with operational risk ranking higher than investment risk, which outranks governance risk. This changed outcome at MIS sector level is attributed to product offering, investment operation, and outsourcing oversight risks attaching to operational risk. In terms of emphasis for monitoring activities undertaken by Supervisors at the MIS sector level, post-mitigation operational risk would assume more importance than business governance or investment risk, but the latter two categories could not be neglected either.

Table 2: Risk category rankings (descending order) at MIS sector level

(ibid. p. 5)

Pockets of resistance

The SRA analysis does more drilling down into the survey data in order to identify “some pockets of relatively higher risk within the sector” (ibid. p. 5) as its major subject matter. One way in which this differential analysis is achieved is by sorting MIS managers according to their funds under management (FUM) scale:

Table 3: Scale differentiation for MIS Managers*

*As of 29 October 2021. **The eight large MIS managers represent >60% of market share within the SRA’s scope. ***Fifteen small managers were surveyed.

(ibid. pp. 8-9)

It turns out that the MIS sector level risk rankings change yet again once filtered through FUM scale, most relevantly for post-mitigation, as shown below.    

Table 4: Comparative post-mitigation risk rankings (descending order) of MIS managers by FUM scale

(ibid. p. 9)

It should perhaps not surprise that the ordering by riskiness shown in Table 4 turned out like it has. The SRA essentially attributes this ordering to the quantity and quality of resources available to MIS managers depending on their scale, with large managers best endowed in that regard. MIS managers generally tend to become less risky as the scale of their FUM increases. However, the three risk categories do not replicate the same weightings under each FUM scale class. Small managers rank highest for business governance risk, whereas large fund managers rank highest for operational risk. The SRA goes into some analytical detail as to why these differences arise, which gives Supervisors pointers as to what to look for, again with signals for emphasis on particular risk category monitoring activities.

Large managers need to be monitored by their Supervisors with more emphasis on operational risk, the SRA suggests, due to their higher exposure to investment operation and product offering risks. By contrast, small managers should receive greater Supervisor scrutiny of their business governance risk arising from manager financial strength, board efficiency and competency risks. Medium managers fall in between with no standout risk category, but potentially present “growing pains” issues in the need for their risk mitigation capabilities to keep pace with increasing FUM scale. The risk attaching to a medium manager will be aggravated to the degree that its acquisition and development of sufficient risk mitigation resources lag behind FUM growth.

The SRA provides some asset class-specific risk analysis of MIS managers. Mortgage MIS managers are singled out as representing the most risky MIS sub-sector overall, albeit that only three were included in the original survey. The primary issue with mortgage MISs is the illiquidity of their underlying assets, although the SRA notes that there are further problems with interest rate sensitivity, fund concentration, and potentially related-party transactions. Mortgage MISs represent an interesting case of mitigation resistance, in that their post-mitigation investment risk comes out as Medium, whereas average post-mitigation investment risk for the MIS sector overall is Medium-Low. The consequence arising is that mortgage MIS managers and their Supervisors need to maintain focus on managing investment risk.

The risk of novelty

The SRA also makes comments about the heightened investment risk for MIS managers arising from investing into “novel” financial products, which it classifies into two cases under “new financial instruments (and trend chasing) risk”:

1. Novel because investing in novel or high-risk financial products, including funds with unique structures, cryptocurrency, private equity, commodities, and venture capital;
2. Novel because MIS managers are investing in new ways outside of their previous experience and without the knowledge base and capability needed, such as:

• Investing in private equity and venture capital by a traditional MIS manager
• Developing innovative financial products
• Developing or promoting new or innovative distribution channels or platforms

As acknowledged in the SRA, it is not unusual for MIS managers to go down the path of novelty and innovation for commercial reasons:

With the continuing growth in the managed funds sector, managers have been developing new product offerings in an effort to increase their market position, to take advantage of investment opportunities, and to differentiate their product offerings. Some fund managers have introduced novel financial product that present new risks.

(ibid. p. 8)

Generally, the FMA has represented product innovation as a good thing for New Zealand’s financial markets and investor choice. However, the SRA strikes a note of caution for MIS managers and their Supervisors alike in that novelty in financial products, whether due to the types of assets included or the previous experience of MIS managers, is going to require careful and focused risk management and mitigation if the interests of investors in such products are to be addressed satisfactorily.

Further reading

The FMA’s first MIS sector SRA has been non-exhaustively examined in this article from the perspective of sampling some of its themes. There is no substitute, however, for MIS managers and their Supervisors studying this new FMA document fully in depth. It should also be borne in mind that while the SRA identifies and describes various MIS sector risks individually (listed in Appendix 1 below), these risks can interplay dynamically with each other to create risk complexes. To counteract such risk clustering, the mitigants will need to be nimble, adequate, targeted and mutually compatible. An example could be a fast-growing medium manager that skimps on compliance infrastructure because of a continuing small manager mentality, posing heightened business governance risk due to a compounding combination of financial weakness, board inefficiency and lack of competency.

The SRA also raises a cautionary flag over emerging risk factors. These risks include cybersecurity, business continuity planning (BCP), climate-related disclosure (CRD), and integrated financial product (IFP) disclosure. The first two of these risks could affect any MIS manager at any time, as they could any other business, whereas the second two are specific to MIS managers captured either by the CRD regime or Financial Markets Conduct Act (FMCA) fair dealing rules applicable to disclosure and advertising of “green” financial products such as bonds and managed funds. Failure to address these risks properly could land an errant MIS manager in serious strife with the regulator. 

Conclusion

“Publication of the FMA’s first MIS sector SRA is an important event for MIS managers and their Supervisors,” said Matthew Band, General Manager of Corporate Trustee Services at Trustees Executors.

“With input from Supervisors, the FMA has provided a valuable service to the MIS sector in bringing together a risk-focused analysis which better assists sector participants to identify and evaluate risks, and analyse whether the existing mitigants they have in place are fit for purpose or there are mitigant gaps that need to be remediated.”

“The SRA also brings out how MIS manager risks can vary due a number of factors including FUM scale and the types of assets or elements of novelty involved.”

“Mitigants will need to be flexible, adaptive, proactive and responsive to such variability, with due emphasis on foresightful prediction of actual or potential risks rather than just hindsightful reaction to them.”

“As a Supervisor, Trustees Executors will be examining the ways in which the SRA interrelates with how we monitor our MIS manager clients, with an eye for any improvements that can be implemented.”

“We would expect that our MIS manager clients will similarly be making close reference to the SRA for any lessons to be learned.”

“The FMA has served notice that there will be further data gathering on the MIS sector and future iterations of the SRA published.”

“Supervisors and MIS managers will need to keep abreast of new developments with MIS sector SRAs and alive to the nuances of change in the regulator’s views on risks as they impact on the MIS industry.”

For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt Band at [email protected].

Appendix 1: List of risks specified in the FMA’s first MIS sector SRA

Risk categories

• Operational risk
• Governance risk
• Investment risk

Key risk factors

• Macro impacts on investments
• Product offering risk
• Investment operations and outsourcing oversight risk
• Manager decision-making risk
• Manager financial strength risk
• Board oversight risk
• New financial instruments (and trend chasing) risk

Key emerging risk factors

• Cybersecurity
• Business continuity planning (BCP)
• Climate-related disclosure (CRD)
• Integrated financial product (IFP) disclosure