Focus: Lessons from the credit crunch

The credit crunch has turned expectations about risk management on their head. This has been most apparent in the banking and structured-product industries, where ‘safe’ assets began to look extremely risky. The investment funds industry may have escaped the more lurid headlines, but it has certainly seen its structures and regulation tested as never before. What conclusions can be drawn about the strength of the industry from the credit crunch?

The IMA has aimed to answer this question with its report . It covers seven basic areas – governance, security of assets, management of market and counterparty risk, valuation and pricing, liquidity management, suspension of funds and communication with clients.

The report concludes that, overall, the regime is robust. Only seven funds were suspended during the period, and these targeted sophisticated investors with high minimum subscription levels. The review suggests that, while this could be considered a ‘good’ outcome given the circumstances, the IMA wants to ensure adequate protection is in place to keep suspensions low in future.

It identifies a number of significant advantages in the structure of the collective funds industry that contributed to its resilience. First, the assets of the fund are kept separate from the balance sheet of the fund management company and are under the safe-keeping of a depository. This has been important in corporate failures such as New Star's. Although the group’s funds suffered performance problems as a result of redemptions, there was no danger investors would lose all their money if the parent company became insolvent, as happened with structured products on the failure of Lehmans.

The industry has also benefited from independent, fully audited valuation and pricing. All funds have a fund manager regulated by the FSA and, therefore, subject to its principles and rules, including Treating Customers Fairly and conduct of business rules. The managers are also required to act in the best interests of all investors. This is often supported through manager salaries and bonuses, which see managers rewarded for long-term outperformance. The report also highlights the importance of the independent depository, unique to the UK regulatory regime.

All UK funds are required to diversify their investment and counterparty exposure. In particular, this has ensured that, where multi-manager funds had exposure to Bernard Madoff, it did not dent performance significantly. They must also operate a derivative risk-management process. Although UK-authorised funds can now use derivatives to generate investment performance - rather than simply for risk management purposes as was previously the case - there are still limits on derivatives exposure, which had provided good protection for investors.

But according to the report, the industry did face a number of issues, in particular liquidity and pricing. Liquidity problems were first seen with property funds, then in niche areas such as the New Star Heart of Africa and Arch Cru funds. Although there were only seven suspensions, plenty more unitholders suffered the effect of illiquidity on the performance of their investments.