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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 The Credit Crunch: A Stress Test for UK-Authorised Funds. 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.

Rob Burdett, joint head of multi-manager at Thames River Capital, says: “Across the board, funds tend to underperform when there is corporate distress. It has an important knock-on effect. A wall of redemptions is extremely difficult to manage against. We have always examined this area of a company, looking at the structure of a business.”

But what is the alternative? Mark Dampier, head of research at Hargreaves Lansdown, says: “Open-ended funds aren’t great for illiquid assets, but it wouldn’t stop me going for commercial property in the future. It could have happened in a small-cap fund or, indeed, almost any fund where everyone heads for the exit at the same time. You can’t prevent it other than by investing in large, liquid stocks or by having some kind of lock-in.”

The answer for many has been to launch funds that invest in illiquid assets such as closed-end funds to avoid these problems. Mr Dampier, for one, would shy away from a regulatory solution. He says: “I am very suspicious of regulatory intervention – it has generally proved to be useless.”

The report suggests the industry should review the tools available to managers for liquidity management with a view to updating industry guidelines.

Pricing became an issue for many fixed income funds when a number of the credit markets simply shut down. Fund managers could not buy or sell and were forced to employ ‘fair-value pricing’ for the assets in their portfolio. This was fine in principle, but different fund managers employed different methods, leaving some funds at a disadvantage in the performance tables.

Andrew Fleming, chief investment officer at Aegon Asset Management, says: “Fixed income is a market-maker's market and, therefore, not as transparent as the equity market. We took a more realistic line in pricing than some other managers, which gave us some apparent performance issues in 2008. There are different pricing sources and standards in different firms. It is one of the issues the industry needs to work on. Hopefully, we will never get the same set of circumstances as we had in 2008, but we need to work on standardisation.”

Mr Dampier says pricing is inevitably subjective. He adds: “Ultimately, it is a bit like a house – the value is what someone else will pay for it. There is a price at which you can sell something today in distressed circumstances, and there is a price at which you can sell later. Some managers wanted to keep liquidity in their funds and were forced to sell at ridiculous prices to do so. But the funds that were weakened by ‘fairer’ pricing last year have bounced back strongly this year.”

The report suggests fund managers need to follow guidelines and the industry needs to review its operation of single pricing to improve that industry guidance.

The majority of fund selectors agree with the IMA’s conclusion that the system has generally held up well in the face of difficult circumstances.

Gavin Haynes, investment director at Whitechurch Securities, says: “Regulation of UK-domiciled open-ended funds has generally proved to be robust in the fallout of financial markets over the past year. At the same time, the use of illiquid assets within open-ended funds has been highlighted as an area of concern, and suspension of high-profile funds such as New Star International Property, Heart of Africa and the Arch Cru funds highlighted that liquidity risk needs to be closely regulated.”

Mr Dampier believes the only funds example of real regulatory failure was the Arch Cru fund. He says: “This was heavily invested in private equity investments and not suitably named. A number of groups complained to the regulator, and the FSA did nothing.” He says the other fund suspensions were simply down to the difficulty of managing illiquid assets in open-ended funds.

The liquidity regime is imperfect, but it is difficult to think of a viable alternative. While the corporate bond markets are unlikely to close in the way they did last year, fair-value pricing needs some standardisation to avoid putting prudent firms at a disadvantage. Mr Fleming concludes that, while the fund management industry should not be complacent, it can take some pride in the way it has emerged from the credit crunch.

Cherry Reynard is a freelance journalist

IMA credit-crunch report: key findings

- Only seven funds - all targeted at highly sophisticated investors - were suspended during the crisis. The IMA perceives this a 'good' outcome, but wants to ensure fund suspensions remain low in future

- However, illiquidity in some funds - particularly property and frontier funds - caused investor detriment

- Collective funds remain resilient because their invested assets are kept separate from the balance sheet of the fund management company and because the industry operates under independent, fully audited valuations and pricing

- The importance of the independent depository, unique to the UK regulatory regime, is highlighted

- The industry should review the tools available to managers for liquidity management with a view to updating industry guidelines

- The issue of market-maker pricing for fixed income assets should be reviewed and industry guidance improved. However, some argue pricing is inevitably subjective