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Buyer beware – addressing modern risks

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By Robin Sarkar, State Street – In the case of liquid alternatives, investors would be especially smart to pay heed to an age old piece of advice: buyer beware. That's because, despite their differences when compared with traditional alternative investment vehicles, liquid alternatives present higher risk factors, such as the use of leverage and illiquid securities, than do conventional mutual funds. As investors consider whether liquid alternatives make sense for their portfolios in light of their particular investment goals, they should educate themselves about, and monitor, the risks that underlie these funds.

For example, it's critical to be familiar with a fund's investment structure and to identify the risk elements it presents. Liquid alternatives require active management, calling for investors to focus carefully on suitability and experience. In addition, investors should understand a fund's expense ratio and the components of its fee structure to determine their potential impact on performance. Liquid alternatives also point to the value for investors of turning to risk analytics tools tailored to the unique features of these funds in light of the specific requirements of each portfolio. This is especially important given the inadequacy of risk measures applied to conventional investments. 
The UCITS alternatives market already provides a useful opportunity to review lessons learned from investors' experience with liquid alternatives so far in Europe. These risk-related lessons, addressed in UCITS V, emphasise the importance of ensuring independent and conflict-free depositaries with custody of a fund's assets, tightening up due diligence rules for depositaries, clarifying compensation policies for fund managers, and revisiting sanctions for violations. 
This increased use of alternative investment strategies by registered funds is also catching the regulators' attention. Over the last five years, alternative strategies have grown significantly – more than 30% in the past year and projected to account for 14% of total mutual funds and the wider UCITS market in Europe over the next five to ten years. Another trend is the growing use of derivatives, both in volume and complexity. 
In December 2014, Mary Jo White, Chair of the Securities and Exchange Commission, spoke at The New York Times DealBook Opportunities for Tomorrow Conference. She highlighted upcoming enhancements to risk monitoring in support of the SEC's long-standing mission to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. 
The SEC has regulated the US asset management industry since the passage of the Investment Companies Act in 1940, and White emphasised that evolution is necessary to keep up with market trends and lessons learned from the past financial crisis. The SEC will continue to assess the industry and ensure that firms are addressing the risks of modern portfolio composition. 
As the SEC reviews these new strategies and products, they're recalibrating the rules to address potential risks. In her speech, White set the stage for regulatory changes in 2015 to address modern concerns such as liquidity risk, leverage limits, market exposures, enhanced reporting and fund disclosures, and board oversight obligations. 
The Office of Compliance Inspections and Examinations (OCIE) has been conducting national sweep exams of large fund managers and advisors managing registered alternative funds, as a first step towards enhanced regulation. The goal is to gain insight into how fund managers are planning and executing their own risk management framework procedures within the 1940 Act recommendations around key areas like liquidity, leverage, disclosure and board oversight duties. 
While White foresees significant work before final rules are in place, the SEC's Guidance Update on risk management in changing market conditions reveals potential enhancements. In their update, they review several systematic risks, such as potential interest rate increases, reduced market-making capacity and resulting liquidity issues that might arise.

European regulators are similarly putting pressure on fund managers to explain to investors that liquidity in the fixed income market is low. The UK's Financial Conduct Authority (FCA) issued a warning last July asking investors to consider various risk factors associated with corporate bond funds, including their ability to withdraw money during difficult market conditions. BaFin, the German regulator, stated in April it recognises that low liquidity in bond markets could have a severe impact on the liquidity profile of a corporate bond fund. The Authorite des Marches Financiers, France's financial regulator, highlighted the current exceptional market conditions to compliance and risk officers at a March industry convention.

Hedge fund managers are advised to consider the potential market volatility when planning mutual fund strategies, and should consider portfolio composition, concentrations, diversification and liquidity. Fund managers should plan to meet redemptions during both normal and stressed market conditions and assess potential fund liquidity over 1-day, 5-day, and 30-day periods. It is also important to communicate with oversight committees or fund directors, to keep them informed of risk exposures and the liquidity position of the fund, and the fund's ability to manage through a potential crisis.

State Street can help directly address several of the regulators' key concerns leveraging our proprietary Global Exchange risk management platform. Our liquidity risk reporting solution allows clients to assess overall fund liquidity and their ability to meet potential funding liabilities, such as redemption requests, in both normal and dislocated markets. Reports are tailored to meet specific requirements, and detailed background information on the outcomes of each test is provided to deliver additional insight into the impacts of different types of liquidity events. 
Our turnkey solution manages the data aggregation, data quality and delivery of these oversight reports on a daily basis, providing timely and easy to consume transparency across all strategies. These reports can be used to help fund advisors in multiple ways ranging from investment decision support to effective board communication. 
With over $3 trillion of assets processed across client portfolios, we attribute our success, in part, to a service model that equally emphasises end-to-end data management, advanced and evolving technology and client customisation supported by seasoned investment, risk and data management professionals.
As the OCIE finalises all of the information from the recent sweep exams, it appears Chair Mary Jo White and the SEC will be translating recommendations into commission action. 
In May 2015, the SEC proposed new rules and forms as well as related amendments to various existing rules and forms to modernise the reporting and disclosure of information by registered mutual funds. The Proposed Rules include two new reporting forms (Form N-PORT and Form N-CEN) and requires more frequent detailed disclosure of holdings information including but not limited to information about the pricing of securities, repurchase agreements, securities lending, counterparty exposure and terms of derivative contracts. 
The SEC also requires information relating to certain risk metric calculations that measure a fund's exposure and sensitivity to changes in market conditions including changes in asset prices, interest rates and credit spreads. State Street is committed to providing industry-leading solutions to these new reporting proposals across several thousand in-scope mutual funds that we service, including over 40% of the US liquid alternatives market.

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