CFA Institute Asset Manager Code Gives Firms Head Start on Operational Due Diligence

The 21st Annual GIPS Standards Conference will be held 14–15 September 2017 in San Diego, California.

Investment performance is certainly an important consideration for any investor, but operational failures can be a stumbling block to investors’ investment decisions. Hence, apart from generating competitive investment returns, investment managers also need to demonstrate their commitment to protecting investors’ best interests by adhering to fundamental ethical principles, professional conduct, applicable rules and regulations, and industry best practices if they want to build a sustainable business. This is where operational due diligence (ODD) comes in.

At the 20th Annual GIPS Standards Conference in September, Daniel Page, head of Asset Management Advisory at KPMG Ireland, and George Wood, director of Lavern Partners, shared their thoughts during a livestreamed session about what ODD is and why it is an important part of the manager selection process. They also discussed what ODD covers during the review process and offered other insight about ODD.

ODD is a review process that covers different aspects of an asset management company’s operations. Thorough, independent ODD helps protect investors by providing a review of an asset management firm’s operational standards and the ethical conduct of its investment managers, which ultimately helps investors make wise and informed investment decisions. Each speaker explained his firm’s particular approach to conducting independent ODD aimed at protecting investors from potential losses as a result of managers’ lack of policies, procedures, and controls in their operations — or even as a result of simple fraud. They also emphasized the importance of having an independent risk management function, benchmarking operational practices to industry best practices, and receiving consistent responses to ODD questions from different employees.

Areas of Focus in ODD

The following are areas that should be looked at when conducting an ODD review.

Corporate Governance

• Independent board of directors
• Independent risk management
• Sound business practices
• Well-established policies, procedures, controls, and oversight of operations at all levels (e.g., firm, investments, and risk)

Documentation

• Offering documents (e.g., Private Placement Memorandum)
• Other important documents (e.g., risk committee minutes, management company committee minutes, investment management committee minutes, operations manual, and risk management policy)

Ethical Standards

• Alignment of interests
• Fair dealing
• Transparency
• Trustworthiness

Information Verification

• Access to firm’s employees and third-party service providers to verify information that was provided
• Verified investment returns

Operations

• Back-office reconciliation
• Counterparty risk monitoring
• Information technology
• Red flags (e.g., a lack of business continuity plan to address disaster recovery)
• Regulatory compliance

Alignment with Asset Manager Code

The objectives of ODD and its broad coverage of an asset management firm’s operations are well aligned with those of the CFA Institute Asset Manager Code of Professional Conduct (Code). Both ODD and the Code share many common elements designed to protect client interests and to ensure asset managers are committed to acting ethically, having a high standard of professionalism, putting investors first, complying with industry best practices, and upholding applicable rules and regulations.

The ethical principles of the Code, such as fair dealing, full and fair disclosure, confidentiality, putting clients’ interests first, and avoiding conflicts of interest, match the important ethical conduct that ODD specialists expect asset managers to demonstrate. Reviewing the six categories of responsibilities covered in the Code — Loyalty to Clients; Investment Process and Actions; Trading; Risk Management, Compliance, and Support; Performance and Valuation; and Disclosure — can help asset managers prepare for the ODD review process. Compliance with the Code will help managers establish or improve policies and procedures that will raise their operational standards, meet industry best practices, and build a culture of integrity within firms.

How the Code Gives Firms Head Start

The Asset Manager Code gives asset managers actionable items to use to prepare for the ODD process. The following are examples of provisions in the Code that match important elements of ODD.

Credible Performance Information

Managers must:

• E.1. Present performance information that is fair, accurate, relevant, timely, and complete. Managers must not misrepresent the performance of individual portfolios or of their firm.
• E.2. Use fair-market prices to value client holdings and apply, in good faith, methods to determine the fair value of any securities for which no independent, third-party market quotation is readily available.

Ethical Conduct

Managers must:

• A.2. Preserve the confidentiality of information communicated by clients within the scope of the Manager-client relationship.
• B.3. Deal fairly and objectively with all clients when providing investment information, making investment recommendations, or taking investment action.
• C.2. Give priority to investments made on behalf of the client over those that benefit the Manager’s own interests.

Risk Management

Managers must:

• D.3. Ensure that portfolio information provided to clients by the Manager is accurate and complete and arrange for independent third-party conformation or review of such information.
• D.6. Establish a business continuity plan to address disaster recovery or periodic disruptions of the financial markets.
• D.7. Establish a firmwide risk management process that identifies, measures, and manages the risk position of the Manager and its investments, including the sources, nature, and degree of risk exposure.

Regulatory Compliance

Managers must:

• B.2. Not engage in practices designed to distort prices or artificially inflate trading volume with the intent to mislead market participants.
• C.1. Not act or cause others to act on material nonpublic information that could affect the value of a publicly traded investments.
• D.4. Maintain records for an appropriate period of time in an easily accessible format.

Sound Business Practices

Managers must:

• D.2. Appoint a compliance officer responsible for administering the policies and procedures and for investigating complaints regarding the conduct of the Manager or its personnel.
• D.5. Employ qualified staff and sufficient human and technological resources to thoroughly investigate, analyze, implement, and monitor investment decisions and actions.
• F.2. Ensure that disclosures are truthful, accurate, complete, and understandable and are presented in a format that communicates the information effectively.

Transparency

Managers must:

• F.4.a. Disclose conflicts of interests generated by any relationships with brokers or other entities, other client accounts, fee structures, or other matters.
• F.4.b. Disclose regulatory or disciplinary action taken against the Manager or its personnel related to professional conduct.
• F.4.g. Disclose valuation methods used to make investment decisions and value client holdings.
• F.4.h. Disclose shareholder voting policies.
• F.4.i. Disclose trade allocation policies.
• F.4.j. Disclose results of the review or audit of the fund or account.
• F.4.k. Disclose significant personnel or organizational changes that have occurred at the Manager.
• F.4.l. Disclose risk management processes.

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