Luxembourg is a stronger domicile for the challenges it faced over the last 18 months. But perhaps more needs to be done at an industry level to convey Lux's successes as a fund haven throughout the financial crisis. Senior figures from the industry consider this point and talk about their experiences of working in the second largest fund domicile in the world. (part 1)
Bob Kneip (CEO, Kneip)
Noel Fessey (head of European fund services, Schroders)
Martyn Cuff (Managing director, Allianz GI)
Michael Ferguson (head of asset management practice, Ernst & Young)
Charles Müller (deputy director general, Alfi)
Funds Europe: Luxembourg has successfully positioned itself as a flexible but robust fund centre. Its regulatory regime has been instrumental in this. But last year, in the fall-out from the Madoff scandal, Luxembourg was accused of failing to faithfully implement the Ucits rules. Has this affected Luxembourg’s standing?
Noel Fessey, Schroders: The fund industry – irrespective of domicile – faced significant challenges across every function in 2008, including the depository space. What happened in 2008 also affected the entire financial services industry, not only funds.
The fact that Madoff affected some Luxembourg-domiciled funds is very regrettable but it was not a result of how Luxembourg implemented the Ucits rules, and criticisms to that end are unfair.
The funds industry, and the Luxembourg funds industry in particular, has emerged from the financial crisis with its good standing intact. Mutual funds are safe investment vehicles. They certainly provide better investment diversification and better product protection to investors than bank deposits do. They exist because – in Ucits I, III or IV – a regulatory framework has been created within Europe over the past 20 years that has served retail investors’ interests well and Luxembourg has transposed those regulations into national law very well.
Luxembourg’s success is down to the fact that Luxembourg is a fiscally, politically, jurisprudentially and socially stable place. It’s a good place to do business; it’s a place in which we find skills that are appropriate to our industry, which have been developed over a number of years.
We find not only fund promoters here but also a range of industry participants who provide supporting services. We find an environment in which we can readily exchange information with people in other similar companies, which doesn’t happen in quite the same way in larger financial centres like London. We also – even when the labour market is tight, as it was in 2007 – find that we have access to a broad range of skills and languages, which in a cross-border industry is particularly important.
While 2008 was a hard year for everyone, Luxembourg is recovering from it and I am sure that it will continue to be successful in the future.
Charles Müller, Alfi: To start with, Madoff was a US fraud. Nevertheless Luxembourg took it very seriously even though we were not hit out of proportion by the fraud - not when you consider that Luxembourg has over 25% of all the fund assets in Europe.
Why did we take it so seriously, then? The reason is that the Madoff fraud was the first and most serious incident within the Ucits landscape since Ucits came to life in the middle of the 1980s, so naturally we wanted to deal with it immediately and appropriately.
The CSSF, Luxembourg’s financial regulator, looked into the behaviour of Luxembourg-based service providers in detail and made its position very clear. Alfi, the Luxembourg funds industry’s trade association, also created a Madoff taskforce that looked at what could be done in order to avoid this situation occurring again in the future.
Importantly, though, work by the European Commission and Cesr [the Committee of European Securities Regulators] has clarified that Luxembourg did implement Ucits diligently.
The problem that has to be solved at a European level is the question about the role and responsibilities of the fund depository. It is now clear in the eyes of the EC and of the French authorities that problems do not lie within the realm of how Ucits laws are implemented by a member state, but more specifically within the realm of how Ucits fund depositary rules are harmonised across European member states. The same applies now to the Alternative Investment Fund Managers Directive (AIFM) that is coming up.
Looking at net sales and funds under management, you will see that Madoff has not harmed Luxembourg.
Michael Ferguson, Ernst & Young: The Luxembourg regulator has in my view established a fair balance between regulation and pragmatism. If you look at some of the key regulatory developments within both the Ucits and the alternative investment worlds over the past few years, Luxembourg has led the way. We sometimes need to remind ourselves and our audience of this.
Luxembourg has led the way in, for example, the development of sophisticated Ucits funds. I spend a lot of time in our competing jurisdictions and can see that these jurisdictions are learning from what Luxembourg has done and achieved.
If you look at the alternative investment fund world, we now see that as a result of G2O and other discussions, most believe in a greater level of regulation. But Luxembourg again was there several years ago with, for example, the introduction of their Specialised Investment Fund legislation in 2007. This has facilitated a regulated platform for the complete range of alternatives and has been a huge success, which will, in my view, be further enhanced with the introduction of the directive on Alternative Investment Fund Managers.
Martyn Cuff, Allianz Global Investors: It is worthwhile reinforcing a few well-known points about Luxembourg in the wake of the financial crisis because it is too easy to get caught up in the emotions of a situation like that. If you consider that Luxembourg creates hundreds of thousands of fund prices and processes thousands of investor deals every day, it is notable that there have not been any other such industry scandals over the past years. This is partly due to the deep experience and controls that have been developed over many years.
Let me offer a comparison: When a high-quality car manufacturer has a product recall, does that mean people don’t trust that manufacturer any more to build great cars in the future?
No, it does not necessarily mean so, especially after the initial shock recedes.
Now and again, in a very complex business world, there will be the occasional crisis. But, as usual in times of crisis, those who keep their heads while those around them don’t, and those who look sensibly at the facts and face up to realities, will be best placed to lead the way through difficult times.
People need, therefore, to stop and think about the experiences of other industries. In a complex world product recalls will happen. But when a crisis like that does come about, as Charles says, the industry has to stop and take it very seriously and Luxembourg’s approach is reflected in the Alfi Madoff taskforce, which has been looking at the whole value chain in fund management to see where improvements can be made.
Müller: The aim was to look at the value chain to see what could be improved and there were guidelines issued concerning depositories. The Alfi Code of Conduct was also updated. In addition, the Madoff taskforce was also in contact with lawyers and with investors. We created an investor forum to look at our industry from the investors’ point of view. There will be a dedicated internet site going live in March and other activities will follow.
Bob Kneip, Kneip: I think that the ultimate role of the regulator is to provide investor protection and we have to ask ourselves, as an industry, whether we are doing the right thing to protect investors. When it is a global market place yet the regulators are local, how can this be put together under one hat?
I’m quite impressed by the pragmatism of the CSSF. Luxembourg isn’t only about regulation, it’s about a cluster of people that has successfully moved on together throughout the years, perhaps due to the fact that we were the first movers in the regulatory framework when Ucits was born. It’s not only about regulation, it’s about people, it’s about competencies, it’s about the companies that set up here having these aspects altogether around this common theme of cross-border distribution. I’m not saying there isn’t another one, but I don’t know any centre or regulator who has those competencies elsewhere on the planet.
Ferguson: Certainly not in the area of international fund distribution.
Kneip: Other jurisdictions outside Europe are suffering. If fund promoters are looking for a safe, secure haven to domicile their funds and to offer their investors the best levels of protection and transparency, Luxembourg is still the first choice.
Cuff: The financial crisis and Madoff are two different things that happened to coincide, which was particularly problematic for all of us in the industry and for investors who suffered as a result of it. However, an example of a regulatory response that I am aware of is that the CSSF is looking into the details of individuals a lot more now by requiring more elaborate CVs.
I also understand the CSSF is hiring more staff and that audit firms are asking more questions around their ‘long form’ report. I think that everybody, whether you’re a risk manager, an auditor, or a fund manager, is stopping to look at what processes they have got in place to ensure they are good enough. This will also mean that the bar is raised. In any industry, one of the positives to take out of a crisis is that you’ve raised the bar as a result of it.
Fessey: To echo Charles’ point, this was a US fraud. In principle, people closer to Madoff’s operation could and should have spotted it. There were numerous red flags. However, I think that any manager that invests a substantial sum in another manager’s fund needs to take its due diligence obligation very seriously. Madoff reminds us that due diligence involves careful inquiry into the target manager; it is not simply a formality.
Funds Europe: Luxembourg is a major centre for fund and asset servicing. It serves both fund managers that largely outsource their operational infrastructure, and fund managers who choose to keep many functions in-house.
What operational demands were put on fund managers and their asset servicing partners in Luxembourg by the financial crisis?
Fessey: Around the time of the Bear Sterns collapse, clients wanted to know which of our funds were exposed to Bear, by how much and in what form.
Demand for exposure reports accelerated through 2008 with requests about Countrywide, Freddie Mac and Fannie Mae, Lehman, Bank of America, Merrill Lynch, AIG, Citi, Royal Bank of Scotland and just about every major financial firm in Europe and the US.
Such was the extraordinary level of concern that we set up a dedicated service to answer clients’ requests for information. At one point we received a question from a large financial institution that asked, ‘What are your funds’ worldwide exposures to financial institutions of every kind, be they a bank, building society, thrift, insurance company, etc?’
The level of scrutiny around companies that were in distress in that period really became quite acute. It was intense, and I think that fund promoters that were able to answer those questions and provide information that could help their clients to understand and manage their risk will be at a competitive advantage in the longer term.
Cuff: Yes, the questions were very much about what assets were in funds and what exposures resulted from this.
Funds Europe: In the crisis how well did your service providers support you? Do they need to improve? What do you think of the possibility that custody-related costs may increase post-crisis as a result of the greater risks that custodians run now in terms of liability?
Cuff: In our situation we do run largely an outsourcing model in a number of locations, but in other locations we are in-house. I would say looking across Europe, not just in Luxembourg, our partners responded well.
I’ve got a particular view of how to manage outsourcing and partnering, which is very much of a hands-on, ‘X-ray vision’ approach. By that I mean that if I give something sophisticated to someone else to do, I fully expect to remain very involved with it.
So in the crisis, the way we responded to it was to fully involve our X-ray vision approach. We put demands on providers and to be fair to our providers across Europe, they responded well to these demands in terms of timeliness.
We moved to a daily pricing committee whereas normally we run this monthly. We went daily for six months the day after Lehman Brothers failed, and we worked with our partners on the daily pricing committee until markets and panic started to calm down.
Do service providers need to improve? Yes, they always do, and they always will need to. Fund managers have a fundamental duty in my mind that even if they outsource they have to really keep their hands in the business.
So overall we were pleased with the support that we got, but I think part of that was because we took an extremely proactive approach rather than sat back and said, “How are you dealing with the crisis over there?”
Fessey: I thought that our principal service provider, JP Morgan, was superb, really absolutely spot on. They do a lot of the valuation work for us and we have a fair sized supervisory team upstairs, so we understand the process well. They provided information on time; they provided additional information as we needed it; they provided us with plenty of information about JP Morgan itself and its status through the crisis; and they kept the services open late, indeed very, very late as we needed them to, even when it created some significant data processing problems for them.
Net asset value accuracy during the crisis was as good as, if not better, than in normal years, so we didn’t pay any penalty that way. That’s really important when you’re dealing with a global distribution network and clients who are working overtime to understand their position in the middle of world financial disorder; they were not going to forgive you for a pricing error at that point in time. Everybody was going to get very nervous if you started throwing off pricing errors.
We have a number of other suppliers too and I would say that during 2008 and 2009 everybody that we work with, our main auditors PwC and our other fund service partners, had a very good year in terms of the quality of their support.
Cuff: To the second point of your question, about charging more money, I think the crisis has helped to make more transparent and bring to the top of the agenda issues that have been latent for some while. Does that mean that because these issues are now more transparent and more debated that the fees paid by fund managers to custodians should increase?
Maybe, but maybe not. I don’t think we can sit here and say no, definitely not, but I don’t think there’s an automatic response to be more sympathetic about the greater risk they are taking on. After all, is it more risk than what they took on before?
I’d like to see the definition of ‘more risk’. Is it clearer where the risk is and what the risk is? I think that’s a different point, but has this changed how the economic spoils should be shared? I don’t think there’s a one-for-one logical match there but there is a debate to be had. Is it more risky now? Or is it just that the risks are a little bit clearer?
Fessey: The risk the custodians see is in them being sued in the event that a fund turns out not to have good title to its assets, or if the assets aren’t what they purport to be.
Cuff: But the services they’re doing, the contracts they’re working to and what we are asking them to do – what’s changed?
Funds Europe: The crisis revealed Ucits funds to be volatile in terms of fund inflows and outflows, possibly because of how retail investors reacted to uncertainty. How exposed to the retail investor is Luxembourg?
Ferguson: Luxembourg funds did indeed suffer certain outflows and a shift from fixed income and equity to cash/money market funds as a result of the credit crisis. However when it comes to retail investor decisions, there is the never-ending question around education – and Luxembourg needs to ask what role it can and should play here.
In addition one should remember retail investors withdrew money from funds because of, and to a great extent based on, advice received. Some of this advice came from those who wished to repair their own balance sheets. This then leads to the question, for example, should we have an EU version of the RDR [retail distribution review]?
Fessey: I’m not sure that a European RDR is a solution to the issue of how best to communicate to investors the concept that a mutual fund is a suitable investment proposition, and potentially a better one than a bank or savings account.
Ferguson: Perhaps not but the question is, would it not lead to a greater level of transparency around how revenue flows and how connected parties are related in the distribution chain?
Fessey: Funds are probably the most transparent part of the financial services industry.
Cuff: It will be interesting to see what happens in India. India has now implemented one of the main tenets of RDR, which has changed the pricing of mutual funds and this will potentially affect the way distributors are rewarded for selling funds. Obviously Indian market dynamics are totally and utterly different to a mature market, but nonetheless it’ll be interesting to see how the Indian regulators push for these products to be bought rather than sold. We will also get some experience of that in the next couple of years in the UK too.
Fessey: Back to the point on communication and the quality of our dialogue with investors. As an industry, we prepare rather worthy, earnest but dull documents explaining mutual funds to investors. We put them on our trade association websites and hope that investors will read them. I think that we should be realistic; this approach is unlikely to stimulate the level of interest that we need to improve public understanding of mutual funds.
Müller: We have to look at where the investor is coming from, what he already knows about funds and what we can do to improve his knowledge. There is a lot being done to understand these, also at the level of Efama [European Fund and Asset Management Association].
Before the crisis, the investor did not really care where his performance came from and so you could basically throw any fund literature at him and he wouldn't read it no matter how sexy it was. I think that is something that has to be acknowledged.
Along with the crisis there came an additional awareness on the part of investors, though.
This turnaround has had two impacts. Just informing the investor about the regulatory and legal means imposed by different distribution markets is just not good enough anymore. It's more about doing the right thing according to each and every market that the distribution schemes, the type of investors, and the types of products are in. We also have to be in closer contact with distributors who have to understand the products well in order to advise their clients in an appropriate manner.
Fessey: I agree with the principles about improving investor communication. But what we fail to do as an industry is to establish the emotional connection with our investors and to lay the foundations about what investing in a mutual fund can mean to them.
End of part 1
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