pa analysis nobody spotted Invesco failings

Why did nobody else spot this? Why did none of the professional investors, carrying out incredibly detailed – so they tell me – investment and operational due diligence on the funds, their managers and the company not spot this?

 

One failing of Invesco Perpetual according to the FCA is that, rather than failing to disclose the use of derivatives in various funds’ prospectuses, it did not adequately explain the downsides. Specifically, it incorrectly describing the impact of using derivatives in key investor information documents produced in 2012.

 

There are at least three different points of view here:

It is the FCA’s job to spot problems like this and make sure the end investor is not out of pocket as a result. It has not been confirmed whether or not what Invesco Perpetual was fined for was spotted by the FSA – as the regulator for the majority of the time – or reported by the fund group. It was probably a combination of the two.

If it was the former, credit to the regulator.

According to the FCA, Invesco Perpetual breached regulations on 33 separate occasions, breaking rules across 15 funds that represent more than two-thirds of the firm’s £47bn in assets under management. 

Even if it was the fund group who spotted the error and reported it to the FCA, it is still a major compliance oversight or a serious breakdown in the firm’s operational due diligence. 

So why did the legion of wealth managers, fund analysts, portfolio managers and researchers not spot this? Surely one of them should have spotted this either within their own investment committee discussions or during their one-on-one meetings with the group and the manager?

 

But, as Lee Robertson, chief executive at Investment Quorum said: “If they are not telling people, would you ask a fund manager if they have derivatives if that fund is not supposed to use derivatives? Due diligence has to be proportionate and appropriate.” 

 

If a fund is not supposed to use derivatives, you have to trust that they are not using them.

Also, talking with the FCA, in this case the funds were allowed to use derivatives – it was their lack of balance in the literature between their pros and cons that was their undoing. 

What would undoubtedly help is if fund researchers, wealth managers and their ilk are able to get full disclosure of the funds. 

The norm is for fund fact sheets to include the top-10 holdings of a fund; at best some groups provide all their holdings but only to the biggest research/fund buying groups; at worst, the fund fact sheets have no holdings data at all – take a bow Neptune Investment Management.

 

Talking to Rob Gleeson, head of research at FE, he pointed out that in the US funds have to give full disclosure whereas in the UK they do not. Therefore, the vast majority of those reviewing the fund would not have seen the various derivative positions unless they asked for them.

“The regulations should change, not just for derivative positions but all equity positions,” he argues. “Fact sheet rules, for example, say what should not be included but not what must be."

 

The regulator, as part of its ‘Treating Customers Fairly’ programme, needs to ensure that investors know exactly what they are buying into so they should additionally pressure the fund groups into disclosing more information, more openly, clearly and transparently.

 

Derivatives are not traded instruments and are agreements made with banks in the background so there would have to be a sea-change in attitudes for fund buyers to automatically be able to see this information.

 

And there will be exceptions. Hedge funds, for example, will not want to give away a competitive advantage by divulging short positions.

In Invesco Perpetual’s case, it is obvious what it needs to do. Its internal processes need to be corrected if they have not been already and communication through its literature has to be fair and balanced, pointing out the pros of how it uses derivatives as equally as the cons. 

 

Companies like FE – whose qualitative fund research capability was set up at the end of 2012 – has a strong relationship with most of the fund groups so gets a greater level if disclosure than others. The same goes for a lot of the bigger firms who do ask the questions and who do get the information.

 

“Like any good research firm, we want to get as much disclosure as possible. If we don’t then it might be a reason not to invest in a particular fund,” says Beverley Sharp, global head of retail research at Mercer.

 

Mercer already gets full disclosure for equity positions and attribution analysis for fixed income holdings. In the specific example of the use of derivatives, she adds that they can be good for efficient portfolio management such as hedging risk or for the fund manager to stay in the market, but she would not necessarily sanction them if being used to generate alpha. 

 

“It highlights the importance of knowing what you are investing in,” she adds. “What the Invesco Perpetual fine shows is a failure of systems and controls so shows how important operational due diligence is.”

Mercer, for example, splits the due diligence function between investment and operations with the latter run by part of its business called Sentinel that looks at “very specific areas of non-investment and service provider risk” including a firm’s custody facilities, investment operations and execution, and risk management.

 

Admittedly, the FCA investigation may well have been looking for something very specific. It also has significantly deeper pockets than many wealth management firms that invest in Invesco Perpetual. And admittedly this may have been an internal accounting/reporting/systems and processes error by that was then reported by Invesco Perpetual – nobody will confirm either way.

 

But if I was an investor in any one of the 15 funds the FCA has pointed out has breached regulations on 33 separate occasions, I would want to know why the person investing on my behalf did not know.