Conflicts of Interest: What You Need to Know
Conflicts of interest are now getting more attention from clients and regulators. Ethical standards are being raised, and regulators are taking a harder line. Some practices need to change. It is no longer enough just to “do the right thing” for clients — instead, a rigorous framework for managing and reporting conflicts is needed. Asset managers are under pressure to raise standards. There will be demands for clearer policies on conflicts and fair allocation as well as demands for explanations of how errors are corrected. Clients need to know which questions to ask and what information they deserve.
The old-fashioned approach to conflicts involved simply trusting managers to do the right thing. And most managers tried hard to do what they thought was in a client’s interest. But clients are now less tolerant of this paternalism; they do not want someone else to decide what is best for them. As a result, many firms now offer full transparency on conflicts, seeking informed consent from clients about the decisions being made.
But informed consent is no longer best practice; that standard is being superseded. Asset managers are now expected to actively avoid conflicts whenever possible. Best practice now involves bringing some independence into a review of conflict identification, maintaining a register of conflicts, and presenting clients with a plan for managing any conflicts that cannot be completely avoided. Firms should have controls in place that measure the effectiveness of conflict management. Clients will feel more comfortable knowing there has been some independence in an assessment of conflicts and controls; it is difficult to judge motives and bias externally.
Even the definition of conflicts is changing. No longer is it simply a question of differences of incentives between managers and their clients. Conflicts can arise between clients themselves, leaving asset managers with a problem. Now, firms must recognize the potential for different client mandates or fund objectives to create new problems in applying a fair policy. Allocating research ideas or dealing across clients is complicated by differences in objectives. And with liquidity in some stocks being low at times, it can be hard to fairly allocate incomplete trades.
The topic once seemed simple but has now become complex. Many areas still lack regulatory guidance, so ethical standards in asset management firms are key. More firms may want to promote the professional expertise and ethics of their staff.
Potential conflicts between clients themselves can be hard to assess. Will it be seen as a conflict if a firm runs conventional long-only funds alongside hedge accounts? Will an endowment with a very long-term investment horizon be at odds with a trading fund if the same investment team is generating ideas or setting asset allocation policy? Although few firms permit managers to day trade on personal accounts, the issue of alignment between personal account dealing and client interests is particularly complex. There is a new presumption that managers’ personal investments should be very much focused on the same stocks and time frames in which clients invest.
Ensuring equal access to all suitable investment opportunities across clients usually involves judgment by managers. Subtle differences in mandates and in cash flows can justify a wide range of fair allocation outcomes. But not all firms publish their order allocation policy. Practices will come under close scrutiny. For example, most clients do not want to own a long list of small positions. Yet it would be wrong for one individual fund to be allocated all the partial trades. Asset managers may need to reexamine their policies on fair allocation of incomplete orders.
One of the hardest areas to set best practice in is cross trading — stock switches between clients. This may arise through cash flow differences in accounts. Funds with cash inflows may still wish to buy a position when another is seeing redemptions. Even using a third-party broker might not resolve all the conflict issues.
Asset managers must demonstrate that such a transaction is in the best interests of both the clients involved: the seller and buyer. If a market price does not reflect the size of the deal, then there is a risk that one of the clients could have negotiated a price further away from mid-price. Clearly, it is wrong for one client to provide liquidity support to another, but at times, large parts of the equity market lose liquidity. Demonstrating that the price for a trade is the right one for the size of transaction could be difficult. Funds with less liquid investments may find it harder to allow redemptions in the future without gating (restricting) exits. Those with exposure to smaller companies or markets, or even to such areas as corporate bonds, might need to reappraise their pricing and redemption policies.
The potential conflicts in dealings and commission arrangements mean that the relationship between asset managers and brokers will change, with tighter controls in many areas that are currently blurred. The U.K. regulator recently noted that many firms need to demonstrate better control of spending on research and execution. A new issue is the practice of brokers arranging for access to company management; it could be seen as an unjustified benefit from trading commissions.
Other issues in brokering relationships are also under scrutiny. Gifts and entertainment, for example, might have reduced, but firms should not simply use ticket price in valuing these. Even small benefits can raise concern if there is a pattern of frequent small gifts, which might otherwise have fallen under the radar. Funds following the CFA Institute Asset Manager Code of Professional Conduct are already well placed for this. The Code bans accepting gifts of anything more than a minimal value. Even for such small gifts, managers are required to document any gifts or entertainment accepted.
What is viewed in the industry as normal practice may not be as easily understood by clients or the public. Few managers currently publish their conflicts policy in any detail. There will be pressure for asset managers to publish new policies on websites alongside existing ones, such as voting policies and commission disclosure. For example, the policies that clients might like to see include fair allocation and error resolution, along with an annual conflicts report. And clients and their advisers may pay more attention to whether a firm has signed up to follow the Asset Manager Code and what proportion of the investment staff has a professional membership with ethical standards. More sophisticated clients and trustees will soon start asking for these.
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