The investment management of a mutual fund’s assets is subject to compliance with the aims and policies stated in the prospectus (or equivalent offering document or explanatory memorandum) and to limitations imposed by regulations or, if more constraining, by the terms of the fund’s constituting deed or instrument of incorporation. This is the case if the investment management is carried out by the fund’s own sponsoring manager or management company, or by a third party appointed under contract to be portfolio manager or investment adviser.

Investors must be protected from unexpected and undesired changes in the purpose and practices of their chosen investment vehicle. Regulations therefore impose both a fiduciary responsibility and prescriptive rules on the operators of mutual funds to ensure there are no unauthorised or imprudent dealings.

Normally, investment is restricted to transferable securities that are listed on a recognised stock exchange, and, for funds that are to be marketed to the general public, investment in gold, oil, sugar and other physical commodities is generally not permitted but investment in property may be. The regulations usually reflect the general principles of collective investment, which are that the fund and its management should have the following characteristics:

Funds1. Spread and diversification

The fund must operate on the principle of spreading risk, meaning that the portfolio must be invested in the securities of several issuers, with no single holding or category of holdings exceeding prescribed percentages of the total portfolio -’the eggs must not all be in the same basket.

This general rule, although sound, is limited in its effectiveness to mitigate risk, as it does not require diversification across geographic, economic or industrial sectors - indeed many authorised funds are funds that specialise or concentrate on investing in just one sector. Similarly, it is likely not to require diversification across different classes of asset, such as bonds, equities or property. The absence of such a requirement allows specialist funds to be established to invest wholly in Government securities, for example, or in technology stocks or physical property, or to concentrate on specific country or regional economies.

Nevertheless, even these funds are usually required to comply with the principal risk-spreading requirement to hold a number of different securitiesfinancial advice, including, for example, a Government securities fund required to hold a number of different issues of its chosen Government’s stock, even though the entire portfolio may be stock issued by a single Government. Conversely, a fund specialising in property investment may be barred from being fully invested in physical property, for reasons of liquidity, and required to hold marketable securities issued by property companies to a given percentage.

A recent development in Europe via amendment to the UCITS Directive has been to allow (but not require) greater diversification across asset classes, such that previous prohibitions on mixing property with securities, for example, or restrictions on mixing direct investments with investments via funds of funds, have been lifted, or will be once Member States implement the terms of the Directive or make mandatory the new rules, as the UK has done for effect from February 2007.

2. Concentration/influence

No individual investment should be of such a size that it allows the fund to exercise significant or undue influence over the management or operation of the underlying business or exposes the fund unduly to the fortunes of the underlying business. Although, under principles of corporate governance, fund managers are quite understandably being encouraged to exercise their voting rights, their business is investment management not the running of the businesses they invest in. A common restriction is for a fund to be restricted to holding no more than 10% of the issued capital of a company it invests in.

3. Contingency cover

Underwriting, rights issues, convertible and partly-paid securities each create a contingent liability or asset. Most jurisdictions impose conditions on the extent to which a fund may hold such securitiesfinancial advice or enter into arrangements that could lead to securities being acquired or payments being called for. Normally, the fund can include such securities or rights or underwriting commitments, but only if the manager can demonstrate to the custodian’s or trustee’s satisfaction that, in the event of having to take up the underwriting, or the rights, or convert or make further payments on the securities, these actions could be undertaken from current resources and without the resultant portfolio breaching any of the governing regulations.

4. Use of derivatives

Use of derivatives, such as stock or currency futures, options or index contracts may be restricted to specialist funds or, if allowed for general funds, limited to specific types of transaction, which are non-speculative, such as for the covered hedging of portfolio risks. The EU’s latest UCITS Directive goes further than previous fund regulations by allowing both exchange-traded and the counter ‘the counter’ (OTC) derivatives to be the main asset class of a fund, provided the manager has in place a sound risk management process. This relaxation of the restrictions on using derivatives allows the conventional ‘long-only’ fund to adopt strategies more common in the management of hedge funds.

5. Liquidity and borrowing

To ensure that investors can enjoy timely settlement when they redeem their shares or units and when they are due to benefit from other payment obligations imposed upon the manager, particularly the payment of income, it is crucial that an appropriate portion of a fund’s assets can be held in cash or in securities that can be readily realised and converted into cash. Consequently, regulators tend to impose a restriction on the proportion of the portfoliofinancial advice> that can be held in securities that are not listed on a recognised or approved exchange, or, as was noted above, in immovable assets such as property.

Conversely, regulations may require that the amount of liquid assets held in the fund’s portfolio, such as uninvested cash or short-dated Government securities, is not excessive in relation to known or anticipated obligations, on the grounds, for example, that an equity fund should be invested in equities. The EU’s latest UCITS Directive takes a different stance and reclassifies money market instruments and cash as permitted asset classes in their own right, rather than being ancillary liquid assets.

Generally, except to provide liquidity in well-specified circumstances, an open-ended fund is prohibited from borrowing, and even permitted borrowing must not be continuous. Closed-ended funds, which are typically exchange-traded companies, are, by contrast, often allowed to gear by structured borrowing through the issuing of debt securities. Unregulated funds are not subject to any such restrictions and may have an extremely high proportion of their assets funded by borrowings - hedge funds frequently are highly geared and introduce interest rate risk on top of security and market risk.

Generally, the various conditions described above must he met both at the time individual assets are acquired and throughout the life of the fund. To provide flexibility when price movements cause inadvertent breaches after acquisition, the manager may be offered a period of time to achieve correction; six months is normally allowed in Europe, for example.

Finally, regulations may require that before personnel may engage in fund portfolio management without supervision, they must have acquired a demonstrable level of knowledge and competence by way of examinations passed and observed records of achievement in carrying out the function while under supervision.

Possibly related posts: (automatically generated)
Funds Investment Management