The responsibilities of superannuation trustees are many and varied. One of these responsibilities is being accountable for the robustness of the risk, compliance and operational processes of service providers appointed by the fund. The position of the Australian Prudential Regulation Authority (APRA) on this matter is very clear. Accountability for any functions, including investment management, cannot be abdicated through the appointment of an external service provider.
Despite this, the level of operational due diligence carried out on investment managers is typically very limited in scope and provides little comfort for trustees. Trustees should be challenging management and their investment consultants on the level and scope of operational due diligence being performed on investment managers prior to appointment and regularly thereafter. Performing operational due diligence is a specialist skillset, very different to that used to select an investment manager with a sound investment process and performance track record.
Superannuation funds need to ensure that the individuals conducting this due diligence have the necessary skills and experience. Furthermore, as more superannuation funds look to bring investment management functions in-house, trustees’ expectations from an investment-performance and operational perspective should be no lower for an internal than an externally appointed investment team.
Beyond the selection process
Every investor from the largest industry superannuation fund through to the smallest self-managed super fund (SMSF) deliberates long and hard before appointing an external party to manage any of their investments. After asset allocation, the selection of the right investment manager is the next most important decision an investor has to make. The large superannuation funds and their asset consultants can spend up to 40 hours over the course of multiple meetings with a portfolio manager and his or her team of analysts before making a decision to appoint an external manager. This level of due diligence is necessary as the impact on member returns can be severely negatively impacted if the investment performance of the manager appointed consistently falls short of expectations.
The risks funds are exposed to when appointing an external manager, however, go beyond the portfolio manager choosing the wrong stocks or securities. The additional risk relates to the operating structure of the investment manager from a back, middle office and support functions perspective.
The definition of operational risk according to Basel II regulations is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. While this is a banking sector definition, it equally applies to the investment management industry.