Investment compliance Function broadly can be defined as adherence to investment restrictions laid out by investors, Regulatory bodies or other stakeholders in order to mitigate risks associated with various investment strategies. Investment Compliance has been on the receiving end of a lot of attention in recent years and in the following article, we would try to take a closer look and understand the reason behind this well placed attention :

Before moving directly on to investment compliance, we need to have a good understanding of investment management agreements and the need for IMAs. While your money is managed by Asset managers you can control their action through Investment Management Agreement.

What is an Investment Management Agreement (IMA)?

Investment management agreements (IMAs) are legal papers that delegate authority to investment managers to manage assets on behalf of investors. They spell out the terms and conditions laid down by the investor while agreeing to pay investment management service fees and direct expenditures. Other usual elements in an IMA include management fees, the scope of activities, and managerial indemnification.

Without Investment restrictions in IMA :

1. No control and visibility over your investments
2. Risk of getting exposure to markets and instruments which we would not want.
3. No clarity over the resolution of issues in terms of financial losses
4. Potentially unlimited risk
5. Your portfolio is based on the risk appetite and financial goal of your asset manager instead of you.

With Investment restrictions in IMA

1. Control your investments and limit your risk to different markets and instruments.
2. Investment restrictions define your risk appetite and not your asset managers.
3. In terms of financial losses due to an error on the manager’s part, we have a clear understanding of the resolution action.
4. Greater visibility of your investments via manager’s compliance attestations.

Coming soon

Why pre-trade and post trade compliance critical to Investment Compliance

Pre-Trade Compliance

Why Pre-trade compliance is critical to Investment Compliance

Post-Trade Compliance

Enough is enough, though we have completed Pre-Trade Compliance why do we need to do Post trade compliance

Now that we have established the importance of Investment restrictions in an IMA, it is equally important on the part of an asset manager to adhere to these restrictions, failing which, the asset manager is exposed to various risks such as :

Financial risk: The manager would have to bear any loss arising due to non-adherence to the investment restrictions.

Reputational risk: Expertise builds reputation and reputation brings in the money. Losing reputation due to non-adherence might have a ripple effect in this already competitive state where people tend to park their money with managers that have a standout name for themselves in the market.

Operational risk: Certainly, if we are in breach of investment restrictions, it is time for introspection on what went wrong internally. what piece of this well-oiled machinery malfunctioned or where did the operations break. instances like this bring out the David that takes down the Goliath of a process down.

Weren’t we discussing Investment Compliance!!

Now that we have established the importance of Investment restrictions in an IMA and the equal importance of adhering to those restrictions, we can move to the function that helps the asset manager in establishing controls, being compliant and mitigating above mentioned risks: Investment compliance

Investment Compliance is responsible to assure that all the investment related controls spelled out in Investment Management agreement are adhered to.

For the purpose of this article, let’s try to break the investment compliance workflow into different stages :

Interpretation: IMA is a legally binding document and with every legally binding document comes legal language that is relatively subjective, could be open to interpretations and certainly not layman’s language. Hence, interpretation becomes the first and utmost important step in investment compliance that if not done correctly may have a domino effect downstream to your rule coding, monitoring and certifications.

Interpretation does not mean translating legal/financial language for everyone to understand. It means also translating to a language that your monitoring system would understand.

Investment compliance is monitored over sophisticated software, be it different Order management systems or any execution management system or an electronic trading platform. hence it is important to not only reduce the legal text to more objective, quantifiable text but also in a way that best utilizes your system capabilities.

Steps for Interpretation :

Understanding the text – The compliance office should have a clear understanding if what the investment restriction is trying to achieve, for eg: the text reads “With respect to seventy-five per cent of its total assets, more than five per cent of its total assets in securities issued by the issuer of the security;” Analyst should have clarity regarding what is the ASK in this case.

Rephrasing the text: Once Restriction text is understood, it is important to spell out the restriction in plain language that is more objective and quantifiable. for eg: the above text can be rephrased as “ Aggregate exposure from all issuers contributing more than 5% of total assets should not exceed 25% of fund’s total assets.” here we have clearly stated that we are combining exposure from all issuers contributing above 5% exposure and evaluating their aggregate against 25% compliance limit.

Identifying instruments & valuation methodology: Defining the instruments that fall under our interpretation and their valuation is also a crucial element as this information may or may not be readily available in your IMA but carry the potential to break your operational controls. Defining the instruments and valuation involve :

1. Identify what all financial asset types fall under the scope of your rule.
2. Identifying the type of valuation for each instrument type. For eg : market value vs notional vs book value/net assets vs total assets
3. Identifying any grouping requirement and capital hierarchy to group your instruments such as direct issuer vs ultimate parent level.

Implementation: Congratulations, now that you have all the information available from step 1, you are ready to implement this restriction in your preferred Order management or trading system. For the purpose of this article, we will be implementing this restriction in an order management system.

Any order management system is built to maintain and regulate order workflow, facilitate part of the trade life cycle, evaluate compliance and generate reporting data for efficient portfolio management.

While implementing investment restrictions in your OMS, it is important to have a good understanding of security set up in your environment as well as a working knowledge of how compliance rules are built in your environment. One can construct the rules in their OMS based on instruments and valuation methodology identified in the previous step and define if they want to monitor this restriction in real-time or overnight as well to factor in any breaches caused by market movements.

It is in this step that all our theoretical understanding of restriction and instrument is translated into hard syntax and this syntax in turn act as a line of defence in identifying any potential breaches on investment guidelines.

Maintenance: Once the rule is coded and tested in the previous step, we enter into an often overlooked aspect of monitoring which is maintenance. Compliance is an ever-changing space where new financial instruments are regularly introduced or regulatory framework may change demanding a re-evaluation of your compliance rules against the changing financial environment. It is of high importance that our rules are vetted against any such change in the financial space that has the potential to alter how we presently monitor the restrictions.

Attestation: Finally, attesting your portfolio to be in compliance with the investment guidelines either in form of certifications or disclosure to your client or to your regulatory body adds a layer of transparency to the whole investment management process and also helps strengthen against the risks highlighted in the sections above.

Considering the above elements and contribution of investment compliance in strengthening firm’s operations around investment monitoring, assets managers are pacing themselves to build a robust compliance environment which not only helps them to be more accountable for their investments but also bring transparency in their financial conduct, which is the need of the hour in this dynamic investment space.