Review of host Authorised Fund Management firms

Overview of requirements: due diligence

The Principles [6]require AFMs to conduct their business with due skill, care and diligence and to take reasonable care to organise and control their affairs responsibly and effectively, with adequate risk management systems. AFMs must also meet specific requirements when delegating investment management to a third party. For example, requirements to have the necessary resource and expertise to monitor delegation arrangements, managing associated risks and ensuring that unitholders are not subject to undue costs and charges. See, for example, SYSC 5.1.1R[7], SYSC 8.1.3G[8], COLL 6.6.15AR(2)[9], COLL 6.6A.2R(5)[10], COLL 6.11[11] and COLL 6.12[12], and articles 17, 75 and 76 of the AIFMD level 2 regulation.

We expect AFMs to have considered how they will comply with the requirements before they take on and submit an application to us for a fund to be authorised. We can only authorise a fund if we are satisfied that the purposes of the scheme are reasonably capable of being carried into effect. See s.243 and 261D of FSMA[13], and 15 of the OEIC Regulations[14].

Due diligence

Overall, firms performed poorly in this area. While some firms did follow a set process, others relied on more informal conversations to assess and understand proposals. We are concerned that firms did not gather the level of detailed knowledge required, through their due diligence, to adequately understand the funds for which they would have responsibility. Where firms did identify risks or inconsistencies they were often addressed inadequately.

We saw a lack of effective challenge from AFMs to proposals and information from sponsors and delegate third party managers throughout the due diligence process.   In some firms we saw an over reliance on delegates having written policies and procedures in place, with little practical observation or testing of how effectively these were implemented in practice and whether they produced good outcomes. On several occasions we saw a lack of adequate systems and controls in place to operate the funds before firms submitted applications to us.

There was often no obvious link between the questions asked during the onboarding of a fund or investment manager and the planned subsequent tracking of outcomes. Specifically, we noted:

• little analysis of the model portfolio versus the actual portfolio ex-post
• a lack of analysis on the actual distribution of the fund versus the planned distribution
• little monitoring of the evolution of the OCF and the charges modelled initially
• little in-depth analysis of the delegated third-party investment managers’ expertise, track record or investment process during the take on process
• poor levels of analysis of how the investment manager could achieve stated performance or income targets
• inconsistent escalation of issues from the product governance committees to the management committee and on to the board

Fund authorisation applications

Firms repeatedly submitted fund applications that required material changes before the funds were approved. Questions raised by us as part of the authorisations process often had to be referred to the delegated third-party investment manager, implying a lack of knowledge. As fund operators, we expect firms to fully understand their funds before submitting an application.

Overview of requirements: delegation

In line with accepted global practices, our rules and regulations allow AFMs to delegate investment management to third parties provided they comply with various conditions. This does not change the AFM’s regulatory responsibility for funds or fund investors. See COLL 6.6.15AR(3)[15], regulation 28 of the AIFMD UK Regulation[16], and article 75 of the onshored AIFMD level 2 regulation.

Where an AFM delegates investment management to a third party it must ensure that it can effectively monitor them and must retain the necessary resources and expertise to do so. The delegation arrangement must not prevent the AFM from acting, or the authorised fund from being managed in, the best interests of investors. The AFM must be able to give further instructions to the delegate investment manager and withdraw the delegation mandate if in the interests of investors. See COLL 6.6.15AR(2)(b),(c) and (d)[17], SYSC 8.1.13R[8], FUND 3.10.2R(2)(e) and (f)[18] and article 75 of the onshored AIFMD level 2 regulation. This brings particular challenges in a host model.

We sometimes observed AFMs referring to a third-party investment manager to whom they have delegated functions as their ‘client’. This is an incorrect description of the relationship anticipated by the regulatory framework.

Investment strategies

Staff at AFMs need to be sufficiently experienced in and understand the characteristics of the financial instruments found within the funds it oversees, the investment services provided, the characteristics and objectives of the funds, as well as the analysis and investment risk and performance. Some firms we reviewed were overseeing a wide variety of investment strategies without putting in place appropriate resources, including enough appropriately skilled and experienced people. We expect staff responsible for fund oversight to have direct and relevant experience of the types of instrument and strategies being used.

Oversight

AFMs should take account of PROD 3 as guidance[19] on the Principles and other relevant rules. An AFM should assess resilience in volatile market conditions and scenarios that may affect how an individual product performs. An AFM should also conduct stress tests covering adverse market conditions, asset-specific stresses and any risks from a highly concentrated consumer base. See COLL 6.12[12] and FUND 3.7[20].

The host AFM should ensure that any information delegated third-party investment managers give customers in their wider marketing material presents a fair and clear account of charges, including any portfolio transaction costs. Failing to do this risks breaching Principle 7[6], which requires firms to communicate information in a way which is clear, fair and not misleading.

Feedback on product governance for product providers (manufacturers) can be found in our recently published results of our MiFID II: product governance review[21].

A number of firms displayed poor oversight of delegated third-party investment managers. We also observed a lack of in-depth understanding of investment management activities and investment strategies by key people undertaking delegated investment manager oversight, with little in the way of formal qualification or first-hand direct experience of investing or investment risk oversight.

Some firms did not demonstrate adequate oversight of delegated third-party investment managers, including how they plan to produce returns, and how they performed in different risk environments against fund objectives, benchmarks and peers. For example, one firm exclusively relied on Value at Risk (VaR) as part of their fund risk and performance oversight process for funds targeting benchmark relative performance.

We expect, at a minimum, to see firms undertaking the following on performance and risk oversight:

• Operating with a clear understanding of tolerance levels for each of the indicators being used, referenced to acceptable consumer outcomes. 
• Having clear lines of escalation for issues that fall outside of tolerance, and clear tracking metrics to ensure issues are followed to conclusion. 
• Using a risk metric that is determined to be appropriate for each fund, rather than operating with a ‘one size fits all’ approach. 
• Ensuring the frequency of data and the time periods used are consistent with the fund’s objectives. For example, only looking at the previous month’s performance is inconsistent with medium term return objectives.

Overview of requirements: governance and oversight

Our Principles[23] require an AFM to conduct its business with integrity, due skill, care and diligence and to organise and control its affairs responsibly and effectively with adequate risk management systems. Our rules require an AFM to have robust governance arrangements. The arrangements must include:

• clear organisational structure with clear lines of responsibility 
• effective processes to control the risks the AFM is or might be exposed to 
• internal control mechanisms[21] 
• orderly records of the AFM’s business and internal organisation must be kept. See SYSC 9.1[22] and article 57 of the onshored AIFMD level 2 regulation  

An AFM is required to employ senior personnel[23] that are sufficiently experienced to ensure the sound and prudent management of the firm. These staff assess and periodically review the effectiveness of the AFM’s policies, arrangements and procedures to comply with its obligations under the regulatory system and take appropriate measures to resolve any deficiencies. See SYSC 4.3[24] and article 60 of the onshored AIFMD level 2 regulation.

Board effectiveness

In our review we found a number of the AFMs were unable to provide evidence of robust governance procedures. Minutes of board meetings and discussions did not show effective challenge by independent non-executive directors (INEDs) of, among other things, potential conflicts and their management. In some cases, it appeared that decisions had been taken outside formal meetings with little or no discussion or challenge. In cases where follow-up actions had been identified, there were no or only inconsistent records of what had actually been done. 

Challenge from non-executive directors

We saw a wide difference in the quality of contribution from the independent non-executive directors (INEDS). Directors at a firm for several years, could be informal at board meetings, and lacking in challenge. We observed a number of board discussions which happened outside board meetings, with limited attendance, which questions whether all Board members were given an opportunity to provide challenge and means decisions are not appropriately documented. We saw evidence that risk and conflicts of interest registers were static, standalone documents, and, in some cases, there was little or no board discussion about them. These documents should be regularly updated.

Overview of requirements: conflicts of interest

In broad terms, firms are required to:

• identify conflicts of interest 
• to avoid or prevent any conflicts of interest which risk damaging the interests of investors in the funds operated by the firm

Where AFMs cannot avoid or prevent conflicts, they need to manage and monitor them to ensure that the funds are treated fairly. Where it is not possible to prevent a conflict of interest risking damage to the interests of the authorised funds or investors, AFMs are required to disclose information about the conflict to the fund investors. See the rules in SYSC 10[2], COLL 6.6[15] and the onshored AIFMD level 2 regulation.

General approach to conflicts of interest

Most firms in our sample had a framework for managing conflicts of interest, but not all appeared effective. We expect AFMs to take meaningful steps to avoid or prevent, manage and monitor all conflicts of interest. Several host AFMs in the review were unable to show us sufficient evidence that they had identified relevant conflicts of interest despite some appearing obvious. This included, for example, the potential conflict between a fund’s investors and a sponsor whose fees are paid by the fund.

Assessment of value

These rules require an AFM to conduct an assessment, at least annually, of each fund it manages to identify whether the charges paid out of the scheme property are justified in the context of the overall value delivered to unitholders.

While some firms had worked quite hard to negotiate break points in fees paid to depositaries and fund accountants (whose fees amount to a very small proportion of total fund fees), most firms had not considered negotiating break points in the much larger fees paid for asset management services. This was the case even when funds had grown significantly in size. Host AFMs need to pay particular attention to this conflict.

One firm told us that it was unreasonable for us to expect it to hold such discussions with its asset managers as they thought the delegate asset managers were the firm’s clients. We found that some firms had agreed with fund sponsors to cut their ACD charges as funds under management grew. While this reflected economies of scale from their ACD operations, the benefits of this fee cut did not go to fund investors but solely to the fund sponsor through a greater share of an unchanged Ongoing Charges Figure (OCF). We are concerned that these firms are not acting in a way that prevents undue costs being charged to a fund or its investors, or acting solely and in the best interests of their funds or the fund investors. This increases the risk that investors suffer higher levels of charges than would otherwise be the case. See COBS 2.1.1R and COBS 2.1.4R[4], and COLL 6.6A.2R[10] and article 17 of the onshored AIFMD level 2 regulation.

We found that firms had often applied a broad-brush approach to their value assessments, for example by reviewing performance at fund level rather than share class level. See COLL 6.6.20R(2) and COLL 6.6.21R(7)[25]. Where a firm assessed a fund’s net performance against a cheaper ‘institutional’ share class, any conclusions that fund performance was providing value against more expensive retail share classes would have been incorrect.

We saw firms misapplying some of the 7 review considerations. By way of example, we saw situations where some unitholders are paying higher charges than others for substantially similar rights, for example, because some unitholders are paying charges that include renewal or trail commission on pre-RDR unit classes. In these cases, some firms only described fee differentials between share classes and several firms had not assessed whether the higher charges were appropriate in the context of the 'Classes of units' consideration. The assessment of value must cover each of the minimum considerations specified in COLL 6.6.21R. 

Overview of requirements: financial resources

An AFM authorised under the Financial Services and Markets Act 2000 (FSMA) must meet the Threshold Conditions, including that which requires a firm to have appropriate resources and a suitable business model (see COND 2.4[26] and 2.7[27]). A firm’s resources (both financial and non-financial) must be appropriate to the regulated activities it carries on or seeks to carry on. Principle 4[25] requires an AFM to maintain adequate financial resources.

As explained in our guidance[26], we expect firms to understand the risks in their activities so that they can detect, identify, and rectify problems themselves. They can do this by ensuring that their systems and controls, governance and culture enable them to take effective steps to prevent harm from occurring.

In FG20/1, we explain firms should consider forward-looking financial projections and strategic plans, under both business-as-usual and adverse circumstances. This helps a firm to understand the viability risks to its business model and the sustainability of its strategy over a period of at least 3 years.

Business model

We observed that several firms operate at relatively low operating margins and appear to lack appropriate investment in systems, controls and people to execute their role as host AFM effectively. Several firms also cited fee pressure from their delegated third-party investment managers. Together these suggest that some host AFMs may not be adequately charging to execute their services effectively. 

Risk framework and assessment

While all firms had some level of risk framework in place, we found wide differences in their effectiveness, maturity, coverage, governance and use within the business. A number of firms did not have clear risk appetite statements, meaning management could not articulate how they would identify if the firm was operating outside of its risk tolerance. Several firms were not adequately assessing the risks from their activities and the harm they may pose (to consumers, the wider market or the firm) across all risk types, including operational risk.

A number of firms could not demonstrate how they used capital risk assessments in their ongoing operations and decision-making. In some cases, the documentation and responses they provided suggested that they saw the requirements as ‘tick-box’ rather than processes used in the business. On at least two occasions we were told documents had not materially changed year-on-year, despite the business having changed and grown in that time.

Only a small number of the firms we sampled demonstrated reasonable consideration of a forward-looking approach to risk assessment and how risks may evolve throughout the economic cycle. Failure to adequately identify, assess and mitigate risks affects firms’ ability to calculate their financial adequacy.

Reliance on professional indemnity insurance and/or parent support

Some firms relied heavily on the support of a parent firm to maintain capital adequacy, sometimes without formal arrangements in place, and had not considered the impact should access to funding be delayed or unavailable. We expect all UK regulated firms to properly assess their risks and assess how much capital they need throughout the economic cycle.

Several firms use Professional Indemnity Insurance (PII) to manage the risks from their activities. Though insurance can form part of an appropriate risk mitigation approach, it is not a substitute for adequately assessing risk and maintaining adequate financial resources in all circumstances. This is because many scenarios may not be covered by PII policies, due to exclusions. Additionally, a successful insurance pay-out would not be immediate.

Stress tests and wind-down planning

In several instances, firms’ stress testing was limited to failing to reach forecasted growth, with no evidence of stress conditions. One firm did not have a documented wind-down plan while several others had only recently started to develop one. We found some firms’ plans were inadequate. For example, they did not explain their firm’s rationale for the wind-down timeline; did not assess the resources (financial and non-financial) required; and had not identified scenarios that would prompt an orderly wind-down of the business. The lack of credible plans increases risk of disorderly exit from the market, with a resulting increased risk of harm to both consumers and the market. Firms should refer to our Wind-down Planning Guide[27], originally published in 2016 and subsequently updated, in addition to FG20/1 in improving their existing plans.

Regulatory reporting

We also noted errors in some firms’ regulatory reporting, including use of incorrect units, failure to report cumulatively (on a year-to-date basis) on the FSA002 or FSA030 Income Statement return, and failure to report all relevant fields on capital adequacy returns. These errors hinder the use of the data and can materially distort aggregated data used to analyse a sector or a group of firms. The information in these returns also forms an integral part of firms’ risk management frameworks.