FCA Review of Host AFMs
On 30th June, the Financial Conduct Authority (FCA) published a review of Host Authorised Fund Management Firms. The review, which was carried out between Q4 2019 to Q4 2020, involved the FCA examining:
- How well host AFMs understand their responsibilities for the funds they operate
- Whether these firms had adequate governance, controls and resources to carry out their role
- How effectively the host AFM firms considered their regulatory responsibilities, primarily under the Collective Investment Scheme Sourcebook (COLL)
- How their oversight of delegated third-party investment managers considered the interests of fund investors
- Whether they had appropriate resources for the nature and scale of the business they carried out
Overall, the feedback from the review could have been better, highlighting areas of improvement around governance, controls and monitoring. In particular, the review emphasises key findings under the following four main areas:
Due diligence over delegated third-party investment managers and funds
The review found that the some AFMs performed inadequately in this area with too many relying on “informal conversations to assess and understand proposals.” The FCA were 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.
The FCA also stated that there was a “lack of effective challenge from AFMs to proposals and information from sponsors and delegate third party managers throughout the due diligence process”.
The FCA also 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
Oversight of delegated third-party investment managers and funds
In terms of delegation, the FCA reaffirmed that when an AFM delegates investment management to a third party, it must ensure that it can effectively monitor them and retain the necessary resources and expertise to do so.
Contrary to these requirements, the FCA found that certain AFMs lacked the appropriate resources to deal with overseeing a wide variety of investment strategies. This lack of resources included not enough appropriately skilled and experienced people.
The FCA also noted that AFMs often referred incorrectly to a third-party investment manager to whom they have delegated functions as their ‘client’.
Additionally, the review provided that a number of 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.
The FCA also outlined that as a minimum, they expect firms to be conducting the following 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.
Governance and oversight
In the review the FCA flagged that the rules require an AFM to have robust governance arrangements in place, including:
- 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
- Orderly records of the AFM’s business and internal organisation must be kept. See SYSC 9.1 and article 57 of the onshored AIFMD level 2 regulation
However, once again contrary to the requirements, the FCA review found that some AFMs were consistently unable to provide evidence of robust governance procedures.
When evaluating the contributions from non-executive directors, the FCA saw a wide difference in the quality of contribution from the independent non-executive directors (INEDS). They also saw evidence that risk and conflicts of interest registers were static, standalone documents with very little to no board discussions about them.
Although the FCA expects 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 sufficient evidence that they had identified relevant conflicts of interest despite some appearing obvious.
Issues surrounding the FCA Assessment of Value were also flagged during the review, which included:
- Firms not considering negotiating break points in the much larger fees paid for asset management services.
- Firms applying a broad-brush approach to their value assessments; and
- Firms misapplying some of the 7 review considerations.
The fourth area the FCA flagged within the review concerned financial resources. During the review, the FCA 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.
The FCA also found wide differences in their effectiveness, maturity, coverage, governance and use within the business.
The review also uncovered several instances where firms’ stress testing was limited to failing to reach forecasted growth, with no evidence of stress conditions.
Finally, the FCA 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.
Firms are expected to review the finding and assess whether there are weaknesses in their own systems. Should any weaknesses be identified, the FCA expect these to be addresses and remedied.
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