MATTHEW WILLIAMS, INVESTMENT DIRECTOR AT PRUDENTIAL’S PORTFOLIO MANAGEMENT GROUP, SAYS THE REGULATOR IS ONLY DOING HIS JOB. AND A GOOD THING TOO
As fund managers, we have an instinctive desire to be given an absolute free reign to do exactly what we want, and exactly what we think is right, in the pursuit of performance. As such, from time to time we inevitably butt up against the regulations – stopping briefly to furrow our brows and curse the hostile regulator before we knuckle down and get on with the job in hand.
And yet, deep down, we know that the interests of the regulator and our own interests ought to be aligned. The point being that, whilst operating in a regulated environment can at times be frustrating, it’s really not true that the interests of the regulator are diametrically opposed to ours – or those of the investors with whose money we’ve been entrusted. Quite rightly, the regulator is trying (amongst other things) to protect investor interests.
Four Main Regulatory Areas
For us fund managers, the regulations bite in various different ways. We can broadly group them under the headings of “clarity and marketing”, “investment and borrowing powers”, “financial strength”, and “systems and controls”.
Of these, the first category doesn’t really impact much on the day-to-day investment of funds. But the second, “investment and borrowing powers” (in various guises), does impact on us by setting down some often prescriptive rules on what assets can and can’t be bought, and in what proportions.
“Financial strength” regulations tend to make their presence felt more profoundly for insurance funds, where assets are not explicitly segregated and where the company’s ability to meet its obligations is clearly important. And although the requirements around “systems and controls” don’t necessarily impact on the investment decision-making or implementation, they do impact on the proportion of time that the fund manager spends on managing money against the increasing amount of time doing record-keeping or attending oversight committees and so forth.
Thinking for Yourself
“As fund managers, we have an instinctive desire to be given an absolute free reign to do exactly what we want, and exactly what we think is right, in the pursuit of performance.”
None of these is necessarily a bad thing, and indeed they should already be at the heart of sound investment portfolio management. The decisions that Prudential made on its with-profits fund in the late 1990s serves as a useful example.
At that time we were in the middle of the telecoms, media and technology (TMT) bubble. (Well actually, it was near the end, but nobody was to know that at the time.) Equity markets had been rocketing ever skywards for the previous few years, and for many people the idea of the new technology paradigm was taking hold.
Bonuses declared on
with-profits policies were generous at that time, and much store was being placed in the high proportions of risky assets that these funds were able to hold. In regulatory terms, at that time funds looked solvent and weren’t investing in “outlawed” assets: they just had a big bias towards equities.
And yet, during all that optimism, Prudential made some changes – not because of any regulatory pressure from above, but rather because our assessment of the balance of risk and return told us that we shouldn’t be relying too heavily on equities in our fund investment strategy, and that we should be declaring bonuses commensurate with a reasonable expectation of return – not an exaggerated one.
We made our decision because we wanted to ensure the continued strong solvency of the fund – not necessarily because of any specific regulatory measure, but upon our own assessment of the risks to the “true” financial strengths of our fund. And at the time, our move was unfashionable among our investors and their financial advisers. But with hindsight it was exactly the right thing to do. In the market fallout which soon followed, Prudential’s With Profits Life fund remained stronger than many of its rivals. It was a good example of where the sound management of the fund and the regulations around solvency did not trip up over each other.
Accepting the Limitations
Unfortunately, of course, this isn’t always the case. Sometimes the regulations themselves can encourage or force behaviours which make the sound management of funds harder. That’s an inevitable fact of life in a world of changing regulations. We just have to live with it.
“Sometimes regulations can make the management of funds harder. That’s an inevitable fact of life in a world of changing regulations. We just have to live with it.”
We’ve seen the move from rules-based to principles-based to outcomes-based; the harmonisation of rules across different jurisdictions; and the “arms race” of regulators trying to keep up with more and more sophisticated instruments and strategies – a battle which is often played out in the banking rather than the investment management arena. So, whilst we believe that the ultimate intent of the regulations is sound and proper, and that it’s aligned with our funds’ interests, there are often less than perfect elements in the regulatory detail which we don’t agree with or like. It’s just a fact of life.
In describing the impact of these, it is worth thinking separately about insurance funds and collective schemes. In some senses, insurance funds tend to be the innovators – finding benefit, for example, in derivatives use for matching particular liability streams, or being able to hold privately negotiated assets without the need for day-to-day pricing or liquidity.
Collective instruments have generally tended to be rather simpler, with the more complicated funds arising only recently under the “wider powers” available under the FSA’s COLL rulebook based on the UCITS directives. But for standard collectives investing in equities, bonds and even property, the investment and borrowing powers rules are hardly a significant hindrance. Generally they limit investors to buying assets only on recognised or approved exchanges – something which fund managers would surely have been doing anyway? – and they ensure a spread of investments by limiting the maximum exposure to any one asset or instrument.
Think about a collective Fund of Funds, where the manager is buying a UCITS compliant scheme. This is perfectly acceptable as long as the underlying fund doesn’t significantly buy other schemes (triple layering) and as long as no more than 35% is invested in any one such scheme. Of course, there might be times where a manager would have preferred to invest, say, 40% – but, ultimately, the rules are broadly sound and sensible, and easy to work with.
It Isn’t Always Perfect
Collectives do, though, have to tread more carefully around the use of derivatives, and this is one instance where sometimes the regulatory impacts are not perfect. The reason being that more complex derivatives strategies contain non-linear pay-offs, and potentially other features such as gearing. And each over the counter (OTC) derivative is potentially unique, as distinct from the simplicity of buying equity shares or the standardised structure of exchange traded derivatives.
Nonetheless, whilst managers may find their wings clipped by these rules at the margins, they generally find that they have sufficient scope and opportunity to run their funds to meet their scheme objectives and deliver sound returns. As ever, the systems and controls overhead in these more complex areas is high. But apart from this, I believe the managers run collective schemes broadly as they would want to. Where the regulations do bite, it is more often at the edges than at the centre of the investment decision.
Changing Solvency Requirements
Insurance funds, though, might be a different story. We have already seen speculation that new regulations will bring about wholesale changes to insurance fund investment strategies. The reason is that the cornerstone of the new regulations concerns fund solvency – which, simply put, is the extent to which a fund’s assets exceed its liabilities.
Recognising that assets are volatile and behave differently to one-another, the new regulations contain a “capital charge” for each type of asset, which is the amount you have to set aside and not count as part of your solvency surplus. There are some subtleties about using the “standard model” (off the shelf built by the regulator), or an internal “model” (built by insurance companies bespoke to their own needs but requiring approval by the FSA). But early indications are that some assets types will be very “expensive” in capital charge terms with others being less so.
Therefore, as things currently stand, there may be wholesale shifts from, say, long dated corporate bonds to short dated corporate bonds. As ever, much useful discussion has been going on between the industry and the FSA in an attempt to avoid throwing out any babies with the bathwater. And remember, not all aspects of the changes are fully nailed down yet. But we hope that wholesale shifts in investment strategy won’t be required; after all, as of now under the current system most insurance companies have a clean bill of health and it would be a bit odd if, without changing anything their apparent solvency became challenged.
Till now, though, we’ve managed both insurance and collective funds to achieve the best results for our clients. Certainly, the distractions of demonstrating systems and controls have increased. But for investment decision-making, we’ve generally focused on the best way to run the funds absent the regulations, with marginal modifications then required to ensure regulatory compliance.
“The ultimate goal of the regulator should be the same as ours – to offer good performance to customers without taking undue risk.”
And the Future?
Going forward, we know that the ultimate goal of the regulator should be the same as ours – to offer good performance to customers without taking undue risk, without obfuscation, and in a controlled environment. And to ensure that we (and more importantly the funds) will still here be here in the future to meet our obligations to clients.
So, if the regulator sets the rules sensibly, we should be able to focus on our main objective of managing funds in our clients’ interests: we should both be pulling in the same direction. But of course, as fund managers, we will continue to be vocal about where we believe the regulator doesn’t set the rules correctly. And even when they do, I think we’re entitled to at least let slip a “harrumph” on those occasions when we find our wings clipped.