Revisiting the Statement of Investment Policy and Objectives

Disclosure documents issued for managed investment schemes (MIS) are not normally headline material.  For the general public, they can be pretty obscure and unexciting.  The most likely of them that the ordinary investor will come across is the Product Disclosure Statement (PDS), usually when given one, for example, upon joining a KiwiSaver Scheme.  Far less probable to catch the public’s eye are the engagingly titled Statement of Investment Policy and Objectives (SIPO), and Other Material Information (OMI) adjuncts that accompany the PDS as the typical set of disclosure documents for MIS.

SIPOs are legislatively embedded within the Financial Markets Conduct Act 2013 (FMCA), with the acronym formally specified in Section 5 Interpretation of the Financial Markets Conduct Regulations 2014 (FMCR).  FMCR Schedule 5, Part 1, regulation 16 (1) (a) requires that the PDS must make reference to the SIPO and how it can be changed as a “key feature” of a registered scheme.  There can be little doubt that frequent and detailed references to SIPOS in both the FMCA and the FMCR reveal how seriously legislators have viewed such disclosure documents as centrally important to investor information.

FMCA section 164 sets out the requirements for SIPOs as follows:

A manager of a registered scheme must ensure that there is a statement of investment policy and objectives that provides adequately for the investment policy and objectives of the scheme and for the following matters:

(a) the nature or type of investments that may be made, and any limits on those; and

(b) any limits on the proportion of each type of asset invested in; and

(c) the methodology used for developing and amending the investment strategy and for measuring performance against the investment objectives of the scheme.

FMCA section 165 specifies the role of the licensed Supervisor with respect to changes to SIPOs, while section 166 sets out requirements for lodgement of SIPOs with the Registrar and states a monetary penalty for non-compliance.  Of particular consequence under the FMCA is section 167, which covers “limit breaks” as they may arise in regard to SIPO-specified limits imposed on the nature and type of investments that can be made for, or the proportion of asset types allowed to be held within, a managed fund.  Limit breaks represent a point at which a managed fund may no longer be “true to label” as defined in its scheme’s SIPO and are the key area wherein a material breach of SIPO may occur.  

When they do happen, limit breaks trigger a range of consequences as set out in the FMCR, which has a separate section heading for three regulations applying.  FMCR regulation 94 requires that a fund manager must provide a report to the Supervisor (or alternatively in the case of a restricted scheme to the FMA) as soon as practicable of an uncorrected* limit break.  In regulation 95, requirements are stated for fund managers to provide regular quarterly reports concerning any limit breaks that have occurred to the Supervisor (or FMA, in the case of a restricted scheme).  Regulation 96 sets out in detail the exact reporting format for fund managers to use when notifying of limit breaks. 

(*Meaning not corrected within 5 working days after the date that the fund manager becomes aware of the limit break)

Far from being mere technicalities in legislation, SIPOs and limit breaks have direct bearing on the interests of the investing public.  The SIPO functions like a published rulebook for the fund manager to adhere to scrupulously in managing funds on behalf of investors.  For their part, investors should be able to rely in good faith on the SIPO as an accurate description of how their money will be invested and managed.  Limit breaks represent a deviation from the rule book and if left uncorrected mean that the “true to label” characteristics desirable of a managed fund may no longer apply.  At the extreme, the fund may morph into something quite different from what investors expected it to be when they put their money in and they may find themselves invested instead in manners incompatible with their personal financial needs, goals, and objectives.  Because the risk is far from trivial that investors could end up invested in ways they did not initially envisage or agree to, licensed Supervisors pay keen attention to SIPOs and limit breaks when carrying out their duties and obligations on behalf of investor interests.

A disclosure document emerges from obscurity

In August 2020 a media stir was generated by the Financial Markets Authority’s (FMA’s) release of a commissioned report on value for money in KiwiSaver scheme fees.  This independent report, MyFiduciary Analysis of Active versus Passive Management in KiwiSaver, examined the relationship between active and passive management styles in KiwiSaver funds on the one hand, and the fund management fees charged to scheme members on the other hand.  Value for money is topical where KiwiSaver scheme fees are concerned and the FMA has been energetically promoting the subject publicly in part as financial literacy education and in part to keep up pressure on KiwiSaver providers to eliminate excessive fund management fees.  A beneficial secondary effect of the media coverage on the report was that it dragged SIPOs out on a rare excursion into the light of day.  For many people, it might have been a first time acquaintance with one of the most important investment documents they have never read.

The MyFiduciary report based its analysis of active versus passive management of KiwiSaver funds primarily on information contained in SIPOs.  In seeking actual “true to label” status concerning funds management principles and styles, the analysis proceeded from the premise that, “All KiwiSaver Providers state their investment philosophy and management style in their Statement of Investment Policies [sic] and Objectives (SIPO)” (p. 4).  However, the report went further to state that, “We also suspect results [of the report’s classification of fund management styles] may reflect caution in the writing of SIPOs – Providers possibly being equivocal about their style in order to ensure they are always compliant” (p.5).  There is evident tension between the expectation that KiwiSaver fund managers will write their SIPOs “true to label” and the suspicion that these managers are actually equivocating so that their SIPOs can sustain differing interpretations that can be selectively cherrypicked to the managers’ advantage.  If the latter is in fact happening, then that should cause concern.  Ideally, SIPOs should be written unambiguously in plain, concise English that is principally addressed to investor interests.

Key SIPO rules reiterated

COVID-19 caused the FMA to issue some FAQs on SIPOs and limit breaks in April 2020.  At the time the pandemic had triggered chaos in financial markets because of the economic uncertainty it generated.   Limit breaks were likely to be caused by extreme market volatility and the FMA was concerned to reiterate that FMCR regulations 94, 95 and 96 still applied, notwithstanding crisis conditions.  In response to an FAQ concerning the potential for fund managers to change their SIPOs in order to reduce the risk of limit breaks, the regulator had the following to say:

SIPO limits should not be changed for the primary purposes of avoiding limit break reporting, but there may be appropriate reasons to consider SIPO limit changes. The guiding principle is that SIPO limits should be appropriate and aligned with the manager’s investment strategy. Managers are required to adhere to the investment strategy and to act in the best interests of scheme participants.

Recent market volatility may have revealed some disconnects between the SIPO limits and the fund’s investment strategy.  In that case, it may be appropriate to make changes to SIPO limits to ensure the manager has sufficient flexibility to manage the fund according to the investment strategy in the SIPO. But it is generally not appropriate to change SIPO limits solely to reduce the likelihood of limit breaks occurring under volatile market conditions.

It is plain that the FMA is opposed to the manipulation of SIPOs in order to serve the interests of fund managers wishing to avoid limit breaks by shifting the goal posts.  The clear intent of the regulator is that any SIPO changes undertaken must be justifiable as being in the best interests of investors.

Making good use of the FMA’s SIPO resources

The FMA has issued some earlier information for fund managers and their Supervisors concerning SIPOs and limit breaks.  The most comprehensive is its November 2014 guidance note Statements of Investment Policy and Objectives under the FMC Act.  This document would be the starting point for those wishing to understand SIPOs and the role they play in the regulated retail investment markets of New Zealand.  Tellingly, in relation to the FMA-commissioned 2020 MyFiduciary report, the guidance states:

“Investment philosophy

Describing your investment philosophy provides a useful background to the investment strategy, and to the resulting risk/reward profile of the MIS. The explanation can also provide the linkage between the investment beliefs and investment strategies of the MIS and/or an explanation of how this links in with the risk profile of the MIS.

The SIPO should set out a high level statement of the investment philosophy to outline the manager’s chosen investment management style, structure, and strategy. For example:

Do you believe that markets are efficient and prefer to adopt a passive investment approach, or do you believe there are opportunities in financial markets for active managers to exploit? [our emphasis.]” (pp. 8-9)

The guidance also sets out the FMA’s expectations around regular reviews of SIPOs to be carried out by the fund manager (p. 12), which is something of importance for Supervisors to note.

Concerning limit breaks, the FMA has published its 2015 information sheet Reporting SIPO limit breaks.  This document is of particular interest because it discusses the regulator's views on materiality as it applies to limit breaks.  The FMA provides a disclaimer where it states:

“There is no definitive test of materiality, and we do not consider it necessary at this stage to issue frameworks or methodologies about materiality.  However we may review this depending on how limit break determination and reporting develops.” (p. 2) 

The information sheet nonetheless goes on to list seven “factors” for potential materiality that together or separately could justify characterizing a limit break as material:

-     the size of the breach, in relation to the scheme
-     any losses caused to scheme participants
-     whether the breach involves related-party transactions
-     whether the breach is an isolated incident, or part of a recurring pattern of breaches
-     if the breach causes the PDS, registry entry, or an advertisement to which the offer relates, to be false or misleading
-     how quickly the breach is rectified after the manager became aware of the breach
-     how long the breach went on for.  (ibid.)

The clear message from the regulator in the information sheet is that the responsibility sits with the fund manager to determine whether limit breaks are material:

“The above list of factors is not intended to be exhaustive.  The obligation to determine materiality and report a material limit break remains with the manager.  No single factor is more important; nor does it necessarily require more than one factor for a limit break to occur.  Rather, a manager must assess the circumstances, in the context of the MIS, taking into account the factors outlined, to determine whether a breach is material.”  (ibid.)

A Supervisor, when notified by a fund manager with a limit break report under FMCR regulation 96, would need to form its own independent view of the materiality of the breach, taking into account the adequacy of any evidence and reasoning provided by the fund manager, in order to draw conclusions as to materiality, including on whether to report to the FMA under section 203 of the FMCA, for potential further action.

Supervisors will have their own expectations of fund managers concerning SIPOs.  These expectations should at minimum include that fund managers they supervise:

1. Ensure that the Supervisor is given sufficient opportunity to participate in developing and improving their SIPOs;
2. Establish clear linkages between SIPOs and related investment governance frameworks;
3. Institute appropriate SIPO oversight functions for their Compliance teams;
4. Undertake scheduled reviews of internal controls to track that investments are being implemented according to SIPOs and any exceptions such as limit breaks are being monitored and reported on;
5. Periodically check their systems to ensure SIPO limits are captured and updated when changes are made;
6. Proactively identify limit breaks in order to comply promptly with the requirements of FMC Regulations 94, 95, and 96, and formally notify the Supervisor as soon as such limit breaks are discovered;
7. Implement formal procedures for regular reviews of SIPOs and related investment strategies;
8. Standardly incorporate SIPO limits monitoring and limit break reporting within Compliance Assurance Programme (CAP) testing;
9. Make certain that they meet the FMA’s requirement that their SIPOs “must deliver on the overarching statutory duty to act in the best interests of scheme participants” (November 2014 guidance note, p. 7). 

Conclusion

“SIPOs are unsung heroes of financial product disclosure in New Zealand,” said Matthew Band, General Manager of Corporate Trustee Services at Trustees Executors.

“It showed wise foresight for the framers of the FMCA legislative regime to place much importance on SIPOs as a means to help ensure fair play in New Zealand’s financial markets.”

“Even if many investors are unaware of SIPOs and the role they serve, fund managers, Supervisors, financial advisers, and the FMA still have to pay attention to SIPOs and ensure that the investment rules they set out are adhered to and any limit breaks are duly reported and followed up on.”

“Key take outs from the FMA’s published materials on SIPOs are that the legislative requirements concerning them must be respected including with regard to limit breaks, changes to SIPOs must be supported by evident connection with the best interests of investors, and SIPOs must be regularly subjected to formal review by fund managers in order to ensure that they remain fit for purpose.”

For comment or more information, please contact:

Matthew Band
General Manager, Corporate Trustee Services
Email: [email protected]