FMA Releases Sector Risk Assessment on Managed Investment Schemes
The Financial Markets Authority (FMA) -Te Mana Tātai Hokohoko, has published its Managed Investment Schemes (MIS) Sector Risk Assessment (SRA). The SRA assesses different risk factors in the MIS sector and notes the importance of risk management frameworks.
The SRA considered surveys conducted in 2021 by the FMA on the four MIS supervisors. The surveys mainly enquired about the risk level and effectiveness of risk mitigation strategies adopted by the 53 licensed fund managers they supervise. Superannuation schemes, workplace savings schemes, and 'MIS-Other' (Forestry and Property Funds) schemes were out of scope. The SRA also considered factors such as fund type and size.
What are the important findings?
The SRA breaks down MIS sector risks into three different categories:
- Governance risk — risks that affect the business management of the fund. Governance risks occur at the board and senior management level.
- Examples include poor culture of compliance, deficiencies in capacity and/or capability.
- Operational risk — risks embedded in the fund manager's business operations, processes, and systems.
- Examples include risks connected to product marketing, effective oversight of outsourced investment providers.
- Investment risk — risks caused by inappropriate investment decisions, mostly in active high-volume investing, that could lead to investment losses to investors.
- Examples include inability to predict and respond to macro-economic impacts (i.e., inflation or interest rates), risks associated with novel product offerings and concentrated fund portfolios.
The SRA found the overall risk of the MIS sector, after the application of mitigants and controls (including those required by law such as licensing and supervision) to be "Medium-Low". As such, the FMA considers the risk of harm to be 'unlikely' and the consequences of that harm to be 'minor'. This is good news for the sector. However, the FMA did identify that there are some pockets of relatively higher risk, which are the main focus of the SRA.
Key risk factors and risk mitigants
The FMA has identified the following key risk factors as the top contributors to risk in the MIS sector overall.
- Macro impacts on investments – Macro-economic factors are notably impactful as they can have systematic impacts to investment performance. Interest rates, foreign exchange rates and geo-political movements can affect the valuation of financial products. Some fund managers have adopted successful risk mitigation strategies against macro-economic factors such as diversifying investments, complying with investment strategy and governance policies, and upskilling in-house investment management professionals.
- Product offering risk – Product offering risk includes the risks associated with documentation, disclosure, and distribution, reporting and advertising. It can be the most significant risk factor among fund managers. As fund managers seek to expand their investment products catalogue with more novel products, they risk making unsubstantiated assumptions and errors in drafting product disclosure statements. To avoid this, fund managers should adopt a robust due diligence process for disclosure, document review and sign-off, and ensure that any marketing activity complies with the Financial Markets Conduct Act 2013.
- Investment operations and outsourcing oversight risk ¬– Although many fund managers outsource their investment operations, fund managers are still responsible for those functions. Managers should ensure they effectively oversee, conduct diligence on and communicate with outsourced providers.
- Manager decision-making risk – this refers to the competency of managers, the quality of decision making, governance, and includes key person risk. The SRA noted high staff turnover and inadequate training as key factors. Having appropriate delegation and training processes and outsourcing where there is a lack of capacity or capability can reduce manager decision-making risk.
- Manager financial strength risk – Financial strength (relating to the long-term viability of the manager based on factors such as projected funds under management, revenue and costs, IT and systems needs) is one of the highest-risk factors for some small fund managers. The SRA suggested that fund managers should have healthy solvency ratios and positive net tangible assets and that board and senior management should focus on financial strength and a business model that supports growth in funds under management to ensure long-term financial resilience.
- Board oversight risk – Board oversight risks can be mitigated by a strong presence of independent directors, having a board with a good and diversified mix of industry experts in different specialist areas, ensuring that there is effective board training and encouraging an open and questioning board culture.
- New financial instruments (and trend chasing) risk – With the rise of emerging asset classes such as cryptocurrencies and non-fungible tokens (NFTs), a fund manager might fall short of understanding the risk and return profile of such investments, which could lead to unclear disclosure documentation and unsound due diligence processes. The SRA notes sound due diligence processes as a mitigating factor, highlighting sufficient and clear disclosure and appropriate internal and external advice on new products as important.
The SRA found some risks correlated to industry sub-sectors. The FMA found certain medium-sized fund managers (i.e., those having between NZD250 million and NZD10 billion in funds under management) had the highest risks, possibly due to capability not keeping pace with growth. Mortgage funds have the highest overall risk due to illiquidity, macro-economic impacts and having concentrated portfolios.
What happens next?
The FMA and supervisors of MIS also assessed several key emerging risks in the SRA. These include:
- Cyber security on which the FMA has published several information sheets for financial advice providers (see here and here).
- Business continuity planning through which fund managers should ensure they have effective and robust business continuity plans to respond to risks that could disrupt critical business functions, including natural disasters, major cyber-attacks, or other disruptions.
- Climate-related disclosure and integrated financial products (IFP) disclosure will require MIS managers with more than NZD1 billion in total assets under management to disclose under the Financial Sector (Climate-related Disclosures and Other Matters) Amendment Act 2021. You can read more about mandatory climate- related disclosures in our previous update.
We recommend that licensed managers and supervisors of MIS carefully consider the SRA as it provides insight into the FMA's expectation of risk identification and mitigation, and how key risk factors should be managed. Fund managers should review current risk mitigation policies in light of the guidance and expectations set out in the SRA.
As this SRA is the first assessment on the MIS sector released this year, we are likely to see further and more detailed guidance on risk management from the FMA, building on the insights and data obtained from this SRA.
In particular, MIS managers who are looking to establish IFPs (such as ESG compliant or 'green' funds) should pay close attention to their risk disclosure practices, as the FMA has noted inadequate disclosure to be a key investor risk for IFPs. MIS Managers who are looking to engage with 'novel' financial products (such as cryptocurrency, NFTs, etc.) should note the expectation for obtaining qualified advice on risks and issues specific to the 'novel' nature of the product. This is especially important for smaller fund managers that may lack the resources to implement a robust risk management and compliance process tailored to novel financial products.
Furthermore, fund managers of mortgage funds should be vigilant in ensuring that their risk management strategies are sound in these times of macro-economic volatility where we are likely to see an increase in liquidity and credit risk.
Please contact us to discuss any queries relating to risk management and compliance – particularly in light of the above findings.