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It's risky to leave risk unmanaged

Mohan R. Lavi

Mohan R. Lavi on the new risk management manual from AMFI and PwC for the mutual fund industry

SINCE inception, the mutual fund industry in India has grown leaps and bounds. Though not as widespread as in the US, investing in mutual funds is catching on, especially among the middle class. Expectations from the funds are high. However, since the performance of a fund is largely related to that of the stock market any gloom in the latter gets reflected in the financial performance of the funds too. At this stage, the launch of an operating manual on risk management by the Association of Mutual Funds in India (AMFI) in association with PricewaterhouseCoopers (on September 30, 2002, by the Mutual Funds Department, SEBI) comes as a welcome development.

The manual segregates risks into: a) fund management; b) operations; c) customer service; d) sales and marketing; and e) other business risks.

Across this framework, four specific dimensions of risks have been identified: a) policies and procedures; b) systems; c)

organisation; and d) specific. Further, the manual gives weightage each risk, as: a) to be mandated by SEBI; b) existing industry practice; and c) recommended best practice.

Fund management risks: These are often ranked the highest in the risk portfolio of a fund. The manual lays emphasis on the establishment of a documented investment policy, which is an existing industry practice. It also recommends establishment of best practices that would cover implementing a front-office system that is integrated with the back-office system.

The manual also recommends having a segregated research, portfolio management and dealing teams. It identifies volatility in performance, unexpected change in market conditions, quality of investment research, style drift and portfolio concentration, liquidity issues such as specific fund management risks, and provides specific risk management measures to mitigate these. Surprisingly, it is silent on risk management measures for volatility in performance.

Operations risks: The manual recommends SEBI to mandate mutual funds taking insurance cover to cover first-party losses. Here also, the manual wants the establishment of strong front-office and back-office systems.

Customer service: In this segment, the manual recommends the registration and transfer agent to take a separate cover for errors and omissions. Electronic interfaces with its banking system would permit automatic instructions for payment and reconciliation. It picks out errors in deal processing, other investor services and fraud as specific customer service risks.

Marketing and distribution: The manual does not specify about policies and procedures, systems and organisation for marketing and distribution. It limits itself to providing risk management measures for specific risks such as new produce development and selling and distribution.

Other business risks: The manual identifies the HR function as the key risk in this category. It recommends having a documented HR policy and a compliance manual that is accessible to all employees.

Considering all these, the AMFI Board on July 3, 2002, mandated SEBI to ensure that every mutual fund has a separate risk management committee. All funds, their agents and custodians should have an off-site back-up facility and a business contingency plan that allows the AMC to perform critical functions from day one.

It also recommends insurance cover to be taken by funds to cover third-party losses arising out of errors and omissions. The minimum cover should be for Rs 5 crore, except for funds that have assets less than Rs 100 crore.

The manual documented by AMFI would serve as the beginning of the risk management functions for a mutual fund in India. Risk management is a very detailed topic and measurement of risks is possible using Sharpe Ratios, Treynor Measures and Sortino Ratios.

The risk management system is also to be made a part of internal audit w.e.f. April 1, 2003. It would be useful if the regulatory bodies provide training in risk management measures to auditors to enable them perform their function effectively.

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