Going global can have its consequences for financial companies. Financial scandals around the globe from Enron in the US to Norbourg in Canada and Westpoint in Australia have highlighted the need for sound fiduciary practices. By Gillian Bullock
Most financial scandals come down to a person who is responsible for managing someone else’s money betraying that trust for personal profit. According to the Foundation for Fiduciary Studies, a not-for-profit organization established in the US in 2000, there are an estimated five million people in the US alone who are legally responsible for managing other people’s money.
These include trustees and investment committee members, brokers, bankers and investment advisers. While the Foundation (also known as Fiduciary 360) has been providing training for players in the marketplace for a number of years now, it is only more recently that there has been a move towards certifying and rating fiduciaries.
The idea is that if there were commonly accepted benchmarks for the financial industry in terms of fiduciary responsibility, then this would inject an element of trust into the marketplace. And trust is something that has been in short supply in recent times. It is believed that many investors shun using financial advisers because they simply don’t trust them.
There is some irony here that at a time when the baby boomers in particular have greater need for prudential advice because of their higher levels of discretionary funds, the steady flow of malpractice from those in the industry is turning more and more people away from seeking professional help. Research by the Financial Services Consumer Panel in the United Kingdom (UK) in its study on Consumer Confidence in the Financial Services released last year observed that “the link between mistrust and lack of engagement with financial services is not a myth” and suggested that regulation goes some way to reduce this mistrust.
Emerging regulations, increased guidance, greater corporate governance around the world and more socially responsible investing have all been stepping stones along the road to best practice standards. In Australia, for example, there are a number of bodies regulating the market place including the Australian Securities and Investments Commission, the Australian Prudential Regulatory Authority and the Australian Competition and Consumer Commission. The equivalents in the US would be the Securities and Exchange Commission (SEC), NASD and the New York Stock Exchange along with state regulators and attorney generals.
But regulations are table stakes; establishing benchmarking using the industry’s best practices provide the means to build a strong trust between the investor and the fiduciary.
> Global fiduciary initiative
This overarching need to make people trust in fiduciaries and provide an unbiased assessment of players in the marketplace led to a global initiative in January this year.
Four parties joined forces to create the Centre for Fiduciary Excellence (CEFEX), an independent global certification and ratings organization for fiduciaries to promote best practices within the financial industry through certification and ratings measuring both trustworthiness and risk.
The four bodies comprise CSA Group, a not-for-profit organization based in Canada; SAI Global based in Australia; Fiduciary 360 in the US; and Rating Capital Partners in Europe.
CEFEX also has an association with AFAQ /AFNOR International, a leading certification organization headquartered in France. CEFEX is one of the first companies in the world to be certifying organizations in this area. As Carlos Panksep, General Manager of CEFEX says, the organization sees itself as having a role similar to the ratings agencies Moody’s and Standard and Poors (S&P).
“Our vision is to provide investors with practical tools to evaluate fiduciaries. There’s a strong need for such ratings as it provides value to the investing public,” says Panksep.
>Types of fiduciaries
There are three main types of fiduciary ratings, according to CEFEX – investment stewards, investment advisors and investment managers.
Investment Stewards are those people or organizations with the legal responsibility for managing investment decisions. Generally this would include trustees and investment committee members. Stewards usually hire advisors and managers.
The benefits for stewards of applying the fiduciary practices principles include establishing evidence that the fiduciary is following a prudent investment process.
It can also potentially help increase long-term investment performance by identifying appropriate procedures for diversifying the portfolio across multiple asset classes and peer groups, evaluating investment management fees and expenses, selecting investment managers and terminating those managers who are no longer appropriate.
Investment Advisors are those professionals responsible for managing comprehensive and continuous investment decisions, such as wealth managers, financial advisors, trust officers, financial consultants and financial planners.
The benefits of applying fiduciary practices for investment advisors are threefold: risk management, competitive advantage and distinction as a fiduciary specialist.
For instance, advisors who can communicate clearly how they manage investment decisions to a defined fiduciary standard will enjoy a major advantage over their competitors.
Investment Managers, meanwhile, are professionals who actually make the investment decisions and select the securities to implement a specific investment mandate.
In the long term, a CEFEX rating will save the investment manager time and money by needing fewer audits typically required during institutional Requests for Proposals.
CEFEX offers fiduciaries both a certification and a ratings service. Panksep says that one of the main reasons for going down the certification path would be to differentiate yourself from others players in the market. “If I were an adviser or manager, then I would be looking for ways to demonstrate that I have prudently managed operations so that investors can better understand the level of risk they are taking with me.
A better informed client will feel better about using my services,” says Panksep. “However, if I were a steward, I would be looking less to differentiate. But, because I would be watching over my employee’s funds as a pension plan sponsor for example, then I would want to get certified in order to show I was taking good care of their money.” Certification also serves a purpose if you were to be sued by a client and ended up in court.
“Certification shows that you are conscientious with your fiduciary responsibility,” says Panksep. “Demonstrating that you have implemented good practices and follow those standards will put you in a far more defensible position in the event you are sued. Numerous lawsuits have shown that it’s all about how it happened, not what happened. For example, if a client asked me to invest $100, looking for a high return and a month later I lost this money, yet had properly documented to show that my client requested a risky investment and was informed of the possibility of a loss, then I would not be seen as negligent.” Certification is an independent recognition of a fiduciary’s compliance with all fiduciary practices and criteria laid out in CEFEX handbook.
The handbook sets out practices in four different categories – organise, formalise, implement and monitor.
> Organize
Under “organise”, for example, your company needs to show clear lines of authority and accountability and that the mission, operations and resources of the firm operate in a coherent manner. Panksep says this practice is weighted heavily among the
other “organize” principles because the overall coherence of an investment manager will affect its performance. “Every person in the governance and investment processes must work in high collaboration in order to generate the intended alpha,” says Panksep. “A research analyst must know the style requirements of the portfolio manager who must, in turn, get upto-the-minute advice from the trader. Each person understands how he or she can enhance value and the coherence leads to improved results.”
If a company is lacking in this area, then the answer may well lie in implementing an effective performance appraisal system. While a poorly defined system may lead to incoherent behaviour between individuals, an effective one will align objectives so
everybody is motivated and ultimately rewarded for achieving similar or related goals. Other principles in the “organize” section include the need for senior management to demonstrate expertize in their field, having a clear succession plan in place and that the organization has capacity to service its client base.
> Formalize
The “formalize” category includes the principle that the investment manager will have a balanced perspective on the decision it makes. “It is important for the investment manager to manage the inevitable biases which arise in the investment industry due
to ownership, business relationships and other factors,” says Panksep. “Knowledgeable external and independent individuals ensure the firm maintains its course for optimal performance while assuring a sustainable operation. This leads to stable results which translate to better long-term investor returns.”
If there isn’t a balanced perspective in the company, then one solution might be to appoint individuals external to the company’s ownership, or management to the board of directors to achieve this. Also in the “formalize” category, the disclosure of adequate
resources to sustain operations is seen by Panksep as an area that may prove a sticking point for a number of organizations. “While it is still early days in terms of the number of companies we have certified, financial disclosure appears to be emerging as an area of weakness,” says Panksep. “Firms need to disclose financial statements, but since many money managers are privately owned they generally keep their financials private. This can be an area of possible non-conformance, although one way around it is to use audited financial ratios that don’t disclose the full figures but demonstrate a firm’s profitability.”
> Implement
The “implement” category requires that the asset management team’s investment system is defined, focused and consistently adds value to generate returns on investment (alpha). “While gut feel is an important intangible aspect, which is usually based on he manager’s experience, the firm as a whole must exhibit a process which can be successfully repeated,” says Panksep. “This will de-risk the generation of good returns.” If a company were to fail on this principle, it might well be that it does not have an investment committee. Without such a committee, a firm can end up with a lack of consistency in how it creates value. “Investment committees enable a formal and regular interaction, thereby forcing team players to methodically review ways to improve performance and identify opportunities,” says Panksep.
Other principles under “implement” include the need for the asset management team to operate in a sustainable, balanced and cohesive manner and that the research process is defined, focused and documented. Monitor Principles under “monitor” revolve
around periodic reviews of the firm’s processes. For instance, it requires participants to have a defined process for the attribution and reporting of costs, performance and risk. This practice is heavily linked to value-add as it addresses the monitoring of the investment process to help identify where value is created. With an effective monitoring system, the manager can improve the consistency of generating higher returns.
Other principles in the monitor category include making sure control procedures are in place to periodically review policies for best execution, soft dollars and proxy voting and to have a process to regularly review the organization’s effectiveness in meeting its fiduciary responsibilities. The certification process takes between eight and 10 weeks to complete. It is necessary to reapply for a certificate every year in recognition of how organizations change over time. Once you seek certification, a CEFEX analyst will conduct an onsite pre-assessment to determine your firm’s state of readiness for certification.
> Risk-based assessment
Applying for a rating from CEFEX is a step up from certification. The ratings are an independent risk-based assessment of an organization’s ability to meet investor expectations, using quantitative and qualitative criteria. It involves a 12-pointscale rating your company from excellent through adequate to unsatisfactory for both a fiduciary governance rating and a fiduciary investment rating. The fiduciary governance rating analyzes the structural risk at the organizational level – basically the review of business
management within a firm. The fiduciary investment rating analyzes the investment risk of asset management including research, trade execution, portfolio construction and strategic and tactical asset allocation.
“Ratings provide far greater insight as to the level of adherence and may be more necessary for institutional investors who need a great deal of information on money managers,” says Panksep. “Ratings identify strengths and weaknesses in comparison to best-in-class practices.” According to Panksep the first rating bestowed on a company can be kept confidential so they can address their weaknesses, but future ratings need to be made public. Building a robust business CEFEX has focused much of its attention in these early months on the North American market, although there have been inquiries from places as far flung as Mexico, Saudi Arabia and New Zealand.
One of the New Zealand companies seeking certification is Strategic Asset Management, an associate company of Plan B Financial Services in Australia. Plan B Managing Director, Denys Pearce, is a strong supporter of fiduciary certification and hopes to be the first company to receive CEFEX certification in Australia. “We would like to get certification for both Plan B and Strategic Asset Management by the end of the calendar year and a rating from CEFEX for our investment management subsidiary thereafter,” says Pearce.
And he has good reason to want certification. “We believe that by having a clear understanding of fiduciary practices, you can build a more robust business,” he says. “Your business becomes more legitimate and more sustainable if you have strong principles as its basis. This is a benefit for the businesses shareholders.” But Pearce also believes that certification will allow his firm to deliver a higher level of service to its clients by adhering to the CEFEX principles. “A fiduciary is somebody who stands inside the body of the client, looks outside through their eyes and always does what is in the best interests of their client. You are acting in a position of trust and that really means that with everything you do, you should act as if you were the client. It’s quite different from acting as a broker.”
And he believes that despite the level of regulatory compliance in Australia, there is still a long way to go to reach global standards. For instance, in the US you have to declare whether you are a broker or a fiduciary. If you are employed by a product
producer, then you are a broker and you have to state that your advice may not necessarily be in the client’s best interest. In Australia you merely have to exercise disclosure which should not automatically exonerate you from any conflict of interest.
“Fiduciary standards go beyond best interest,” says Pearce. “They drive us to exercise our duty of care to clients.” Clearly there is a demand from both the general public and the industry for all fiduciaries around the world to embrace global standards. It’s not only of benefit to the client, but also provides for a robust business structure for the players in the market.
Thornburg Investment Management was the first cab off the rank when it gained its CEFEX certification in August this year. It’s not surprising that Thornburg was the first company to receive CEFEX certification, given the firm’s long-held interest in
fiduciary responsibility. “One of the basic founding principles of Thornburg back in 1982 was simply to do the right thing for our clients,” says Jack Gardner, Managing Director. “Although we have always been very comfortable being guided by our
collective and corporate consciences, we realised that fiduciary standards were historically poorly defined and commonly misunderstood in the investing community.
“Then in 2002, Don Trone and the Centre for Fiduciary Studies developed their prudent practices for fiduciaries while also creating the Accredited Investment Fiduciary (AIF) designation. During the same timeframe, Thornburg published its first of three books on fiduciary awareness, Understanding ERISA. “It was then that we decided as a firm to take a leadership role in the investment community, educating our investment advisors and the investment steward clients on fiduciary responsibilities.” First cab off the rank Thornburg, based in Santa Fe, New Mexico has more than $US24 billion under management. The company manages five equity funds, eight bond funds and separate portfolios for select institutions and individuals.
Gardner sees that the CEFEX certification process is the next logical step in distinguishing those in the investment community who ‘get it’ relative to their fiduciary responsibilities to those who don’t. There continues to be confusion in the marketplace relative to the roles and relationships that advisors, investment stewards and investment managers have with their clients. “I believe the CEFEX certification will help alleviate some of the confusion,” says Gardner. Gardner believes that the CEFEX certification will gain momentum in the community as investment stewards begin to use it in their initial screening processes for advisors and investment managers. “I have already spoken with several very sophisticated investment advisory firms who will be seeking the CEFEX certification by year end,” says Gardner. “In addition I have heard of several municipal government industry groups who will be adding CEFEX into their initial screening processes next year. This top-down awareness and demand from investment
stewards will be a refreshing and defining change for the marketplace.”
To complete a CEFEX certification Thornburg initially underwent a selfexamination process referred to as SAFE – Self Assessment of Fiduciary Excellence – to see how his firm was doing against the global standards. “Once comfortable with our own capabilities, we then engaged the ROLAND CRISS Fiduciary Services via CEFEX to conduct the Consultants Assessment of Fiduciary Excellence (CAFÉ),” says Gardner. “ROLAND CRISS performed an in-depth quantitative and qualitative assessment of
our firm’s adherence to the 24 prudent practices defined for investment managers. The final step in the certification process was when ROLAND CRISS prepared a very thorough analysis of their review and findings of Thornburg to the CEFEX certification board in Toronto for final sign off.”
The entire process took some eight weeks in total. However, as Thornburg was the first investment manager to undergo this process it required some learning of everyone’s part. “In addition to the benefits we expect to be derived from obtaining the
certification, the process itself was a terrific learning process for everyone involved at Thornburg.”