News that financial services business and fund manager IOOF Holdings Limited (ASX: IFL) is in hot water over multiple potential breaches of the financial services laws and its regulatory obligations should be a lesson to all investors.
Vertically integrated financial services businesses like IOOF offer a wide range of services to retail and professional clients from sales and distribution to funds management, broking, research, advice, and trustee services.
Professional clients will generally use trustee services to outsource the administration of their investment funds with back office functions generally split between the custody of assets and investment administration.
The investment administration would generally include fund accounting, unit pricing, settlements, reporting, due diligence, reconciliations, rehypothecation, corporate actions like distributions, and unit registry services.
The custody of the underlying assets for a managed investment scheme is always legally separated under the general financial services laws and will sit as a separate function within financial service providers.
That's why custody and investment administration services can be reasonable money-spinning sidelines for businesses like IOOF primarily involved in money management.
A business like IOOF will also have middle and front office roles liable to operational errors like dealing, performance reporting, research, marketing, distribution, institutional business development and the portfolio management functions.
The key takeaway for managed funds investors is that there are a lot of moving parts to financial services businesses like IOOF and operational errors like some of those reported by the Fairfax press are not uncommon.
Usually the errors are the result of fat fingers, misunderstandings, untrained staff or other human failings that checks and controls are insufficient to prevent.
The other common source of errors are timing issues around late trades, settlements, unit pricing, third party services, or other operational failings leading to breaches of general financial services regulations.
A simple example is executing a buy order when a sell order is required, in this instance the trade can be reversed, but usually at a loss or fortuitous gain.
Alternatively a fat finger could impact a unit price, buy sell spread or distribution to investors. Notably these errors can go unnoticed for a long time and it's likely some are never picked up.
ASIC's regulatory guides state that if these types of errors or breaches are deemed significant they must be reported to the regulator on a timely basis.
Whether a breach is classified material or not generally comes down to the discretion of a firm's risk and compliance function with agreement from other senior stakeholders.
The IOOF story shows how the easy option is to brush these issues under the carpet on the basis that the error can be rectified and an uninformed regulator or client are unlikely to ever find out.
Another general principle for financial services groups like IOOF is that in the event of an error then clients impacted must be put back in the position (financial or not) they would have been but for the error.
Generally operational losses are worn by the business line responsible and fortuitous gains on reversing a trade for example are retained. Arguably fortuitous gains should sit or be split with the client, although this is rare in practice and not a regulatory requirement.
IOOF has also been accused of far more serious issues than failing to report material breaches and Mike King covers those issues in this article.
For investors the lessons around the potential for errors in managed funds and other third party operated collective investment schemes remain the same though:
- Check distributions like you would check a credit card statement to make sure they are in line with what you expect
- Make sure you are 100% comfortable with the integrity and reputation of your managed funds services provider as issues like unit pricing or buy /sell spread errors are generally impossible to pick up externally
- Don't be afraid to query anything you don't understand
- Check whether performance returns are inclusive or exclusive of fees and charges
- Best of all educate yourself to take control of your own finances and investments without having to worry about the incompetence of fee-charging financial services providers…
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