Mainstream fund managers lack appetite for complex financial instruments

The study said 20% of managers that invested in complex financial instruments had no in-house specialists with relevant experience. A majority (65%) of the companies surveyed said they had already formalised risk frameworks over the last two years or will be putting controls in place.

The report, written together with the Economist Intelligence Unit, is based on a survey of senior executives from the global fund and investment community, clearly points out the lack of expertise and understanding by many asset managers in institutions of the increasingly multifarious financial vehicles offered by the market.

At the same time the report revealed that just over half of the mainstream fund managers, excluding hedge funds and other alterative investment funds, plan to run long/short funds of the 130/30 style in future.

One of the most important points made by the report related to a clear skills gap identified for in-house fund managers who are tying to use complex instruments and strategies, according to Tom Brown, European regional head of KPMG’s investment management practice and who chaired the editorial board for the report said.

He said the report shows clearly that many managers did not have the needed expertise to manage operational risk.

He suggested that more companies would be looking at risk management procedures and undertaking a re-think of their procedures over the next couple of years. He points out that the discipline seen in hedge funds regarding risk management was needed in the wider fund management sector.

Other key areas he said the report highlighted concerned investor confidence and risk appetite. “A lot of investors got burnt,” he said referring to the subprime problems. Many investors, he said, are reassessing their policies and are more likely to avoid investing in any funds using complex instruments in future.

He also said investors will need to be better informed in future and expects hedge funds will need to do some degree of ‘education’ of investors so that they understand the strategies and complicated trades and instruments used by the alterative investment sector.

Interestingly the report revealed that hedge funds, as well as traditional equity funds globally will be increasing their use of derivatives by over 30% on average over the next two years. Close to a majority said they would have no change in the use of these products over the period. The report said complex strategies that lost out in the credit crisis include enhanced money market funds that invested in hedge funds and CDOs to increase returns. Some fixed income funds adopted the same strategy and suffered. Private equity activity has also been impacted heavily and large leveraged buyout deals are now rare, the report said.

Rating agencies and investment banks were criticised over transparency of products. An overwhelming majority (86%) or respondents said they think conflicts of interest is a concern in respect of rating agencies while 88% think the lack of understanding of the instruments they rate is a concern.

Despite clear problems and a need for better education of mainstream fund managers, 55% of the respondents believed the fund management industry will manage more assets over the next two years. Half of them think fund managers will have sufficient in-house skills to run strategies outside their core activities within the next two years. The KPMG survey respondents included mainstream fund managers (44%), alternative investment managers (20%, investors (13%) and other managers (23%) with about a third based in North America, 29% in Western Europe and 23% in Asia Pacific.