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TMI BlogRisk Management SystemX X X X Extracts X X X X X X X X Extracts X X X X ..... ctices followed by all the mutual funds. They have made certain recommendations to ensure a minimum standard of due diligence or risk management system for all the mutual funds in various areas of their operations like fund management, operations, customer service, marketing and distribution, disaster recovery and business contingency, etc. Operating Manual for Risk Management System AMFI and Pricewaterhouse Coopers have prepared an operating manual for risk management system for the mutual funds. A copy of the operating manual has been sent to you by e-mail and is also available on SEBI website under the Mutual Funds Section. The risk management practices in various areas of operations of mutual funds are covered in the operating manual under three categories: (i) Existing industry practices (ii) Practices to be followed on mandatory basis, and (iii) Best Practices to be followed by all mutual funds. Details are given below: (i) Existing Industry Practices: Under each head of risk area, the manual covers the exemplary practices followed by some / most of mutual funds in India. It may be mentioned that though there are exemplary practices covered in this category, the extent a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... onstant basis about the adequacy of risk management systems. Their reports shall be placed before the Boards of AMCs and trustees who shall make comments on the adequacy of systems in the quarterly and half-yearly compliance reports filed with SEBI. These guidelines are being issued in accordance with the provisions of Regulation 77 of the SEBI (Mutual Funds) Regulations, 1996. Yours faithfully, P.K. NAGPAL ANNEXURE OPERATING MANUAL FOR RISK MANAGEMENT FOR INDIAN MUTUAL FUNDS TABLE OF CONTENTS I. INTRODUCTION * II. RISK MANAGEMENT FRAMEWORK OVERVIEW * III. FUND MANAGEMENT * IV. OPERATIONS RISKS * V. CUSTOMER SERVICE * VI. MARKETING AND DISTRIBUTION * VII. OTHER BUSINESS RISKS * APPENDIX A: FINAL RECOMMENDATIONS AS APPROVED BY THE AMFI BOARD ON 3 JULY 2002 * I. INTRODUCTION Risk management can be defined as the "overall process of identifying and understanding the full spectrum of an organisation's risk and taking informed actions to help it achieve its strategic objectives, reduce the likelihood of failure and decrease the uncertainty of overall business performance". This document sets out an enterprise-wide risk management framework for a Mutual Fund ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on various factors like the risk appetite and business strategy of the organisation, the philosophy regarding risk should be developed. This philosophy should then be transmitted throughout the organisation in the form of concrete and detailed policies, procedures and guidelines. The policy and procedures documents should build a framework for the effective and efficient management of the fund and should include: * Investment Policy, including Risk Philosophy (existing industry practice) * Operating Procedures (existing industry practice) * Compliance Manual (existing industry practice) * Code of Conduct (existing industry practice) * Disaster Recovery and Business Contingency Plan (to be mandated by SEBI) * Reporting Framework (existing industry practice) 2. Systems The establishment of an enterprise-wise integrated systems architecture will substantially reduce operational risk. The systems of a Mutual Fund should include the following applications: * Integrated front and back office systems for fund management, dealing, trade confirmation and settlement (recommended best practice) * Fund accounting system for calculation of net asset values (NAVs) (existing ind ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... management and should report to the Chief Executive Officer of the AMC. The function could be carried out in a number of ways: * As an additional function of an existing employee of the AMC, e.g. the Compliance Officer or Internal Auditor; * Through a Risk Management Committee; * Outsourced to an external agency; or * As the Trustees of the mutual fund may deem fit. III. FUND MANAGEMENT Policies and Procedures Existing Industry Practice * The Mutual Fund should have a documented investment policy. This should: * * articulate its investment strategy and risk philosophy (i.e. its attitude towards risk, and the amount of risk it is willing to take as part of its investment strategy) * define the objectives of the Mutual Fund schemes, asset allocation targets and model portfolios (if used) * define the investment process * define limits and mechanisms for monitoring limits at various levels : asset class, industry sector, security, counterparty (these should be consistent with SEBI Regulations, where applicable) * define exceptions and their monitoring * include an approved list of brokers * provide guidelines for transactions with associate companies ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ns Existing Industry Practice * The Mutual Fund should, at the minimum, adhere to all SEBI regulations relating to investment limits. * The Mutual Fund should carry out daily or weekly performance measurement, comparing Mutual Fund performance to a specified benchmark or peer group. * The Trustees should review the portfolio on a quarterly basis as required by SEBI Regulations. Recommended Best Practice * Funds should consider using portfolio management tools for risk measurement, in keeping with international trends. These tools should be used to manage risks more effectively, and should be capable of carrying out the following analytics: * Quantification of exposure using measures such as Value at Risk (VaR), duration, and tracking error * Risk adjusted performance measurement using Sharpe Ratios, Treynor Measures and Sortino Ratios * Risk benchmarking, i.e. the exposure arising between the actual managed portfolio and the benchmark portfolio * Stress testing and back testing of exposure calculations.e.g., Sharpe's Ratio, Treynor Measures, beta, FAMA decomposition, VaR, etc). The mutual funds should consider using equity derivatives for hedging and rebala ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... o and review all exceptions. * The Investment Committee should review on a daily or weekly basis the actual portfolio vis-à-vis the model portfolio. * The Investment Committee should have a stated strategy and action plan for rebalancing the portfolio. * Interest rate movements * Inconsistent / low returns vis-à-vis similar schemes in the market Existing Industry Practice * The Mutual Fund should have daily profit-and-loss reporting at securities and portfolio levels to the Investment Committee. Recommended Best Practice * The Mutual Fund should consider using interest rate derivatives to manage risk and rebalance portfolios. * Liquidity issues * Delays or inability to meet redemptions leading to non-compliance with SEBI regulations * Low investor confidence leading to erosion of assets under management. Existing Industry Practice * All SEBI regulations with regard to redemption periods for different scheme types must be adhered to. * The Investment Committee should monitor the portfolio on a daily basis and periodically review it to track illiquid assets and take corrective action. * The Mutual Fund should segregate corporate and reta ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... al or unnatural disasters such as fire, flood, burglary, etc.) as well as financial or data losses. They also include losses due to acts of infidelity by employees of the insured and computer based crimes such as hacking or virus attacks that may impact the data of the Mutual Fund. * Compliance should review all trading activities at frequent intervals. * Operating procedures should lay down reconciliation activities and their frequency: * * End-of-day broker confirmations with records of deals * End-of-day reconciliation of positions with custodian data * At least once a week complete reconciliation of fund accounting system records with custodian records * Daily reconciliation between Mutual Fund and others (banks, counterparty, etc). * The Mutual Fund should establish a personal trading policy and a code of conduct for employees. Systems Recommended Best Practice * The Mutual Fund should consider implementing integrated front and back office systems which will facilitate: * * Straight-through processing to allow one-time capture of trade details * Pre-trade compliance checking * Automatic time-stamping of deals * Maker-checker authorisations ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rs by the custodian. * The Mutual Fund should move towards trading on the Negotiated Dealing System (NDS) for government securities. Recommended Best Practice * The back office system should facilitate daily fund projections to ascertain liquidity and settlement requirements. * NAV and fund pricing errors * Incorrect NAV's lead to units being bought and sold at the wrong price and investors may be disadvantaged. * Misleading performance information to the investors. * Non-compliance with regulations. Existing Industry Practice * The Mutual Fund must adhere to all SEBI regulations relating to valuation norms and daily or weekly disclosure of NAVs. * The Mutual Fund should appoint a Valuation Committee which meets periodically to review valuation policies. * The Mutual Fund should maintain documentation of all NAV procedures and methodologies and ensure that the documentation identifies all elements critical to NAV calculation. * The Mutual Fund should should ensure that the fund accounting systems used (in-house or by the fund accountant to whom this activity has been outsourced) facilitate: * * validation of NAV calculations * automated and manual pri ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ructure and personnel requirements. Such a contingency plan should allow the AMC to perform, at the bare minimum, the critical functions of mutual fund operations on "Day 1". These should include: * * Calculation of daily NAVs * Redemption processing * Outstanding trade settlements. Existing Industry Practice * The Mutual Fund should address issues of security and virus protection by using firewalls, access controls and appropriate virus control procedures for its systems and servers. * The Mutual Fund should carry out due diligence on all third-party systems before engaging them and ensure that they have appropriate business contingency plans in place. * Obsolete systems * Operational errors, delay in meeting regulatory requirements, inefficient processing of customer related processes. Existing Industry Practice * The Mutual Fund should carry out a periodic systems audit to ensure required functionality vis-à-vis products and regulatory requirements. * The Mutual Fund should carry out periodic stress testing of systems to ensure the ability to process large volumes at acceptable speeds. * The Mutual Fund should implement applications th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... inted. * The Mutual Fund should ideally establish electronic interfaces its with banking systems to allow for automatic instructions for payment and reconciliation. Specific Risk Management Measures for Customer Service Risks Impact Risk Management Measures * Errors in deal processing * Failure to correctly and timely process customer transactions leading to loss of investor confidence and non-compliance. Existing Industry Practice * The Mutual Fund should establish procedures for accepting applications and sending out end-of-day confirmations for transactions. Procedures should include scanning of all customer applications. The Mutual Fund should also consider tools such as bar-coding, optical character recognition (OCR), intelligent character recognition (ICR) and the use of pre-filled forms. * The R&T system should facilitate maker-checker authorizations. * The R&T system should facilitate reconciliation of cash and units. * The Mutual Fund should establish controls for alternate channels of distribution such as the telephone and Internet, if used. For transactions carried out over the telephone, call scripts should include confirmations of transaction detai ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... poor customer service leading to loss of investor confidence. Existing Industry Practice * A new scheme should adhere to all required SEBI regulations which require every new scheme to be approved by the Trustees and the Board of Directors, and the offer document to be reviewed by SEBI. * The Mutual Fund should have a new product process in place. * All new schemes have to obtain clearance of the compliance officer and the regulator before they are launched. * Comprehensive market research should be undertaken by the Mutual Fund before the launching of a new product in order to assess the product's viability in the market. * The launch of a new product should have close involvement of the R&T agent and the IT teams, to enable evaluation of all infrastructure for its capacity to handle unexpectedly large volumes generated by a new scheme. Contingency arrangements should be made to handle overflow volumes. * Selling and distribution * Financial loss or delayed returns to investors due to mis-selling, loss of reputation to the Mutual Fund. Existing Industry Practice * The Mutual Fund should continuously pursue training and certification of all its distributors. It ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Mutual Fund should have well documented policies and procedures. * The HR plan should aim to identify and build a second line for key positions. * The HR plan should also cover holiday planning in case of key employees going on leave. * Skills shortage * Low growth and poor performance vis-à-vis other mutual funds in the market. * Lack of knowledgeable personnel in the organisation leading to a lackluster or negative image of the Mutual Fund in the market. Existing Industry Practice * The Mutual Fund should have a training plan for employees to update their existing skills and equip them with new skills. The training plan should identify both in-house and external institutions training requirements. * The Mutual Fund should ideally have a dedicated knowledge management function within the organization to disseminate knowledge on new products, markets and developments. This function should maintain links to important information sources relevant for the industry. * Non-compliance * Inability to meet with regulatory requirements leading to a loss of reputation and loss of investor confidence. Existing Industry Practice * The compliance officer should ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... lement problems, NAV and fund pricing errors, inaccurate financial reporting, fraud, failure of mission critical systems and infrastructure, obsolete systems * Customer Service: errors in deal processing, other investor services, fraud * Marketing and Distribution: new product development, selling and distribution * Other Business Risks: critical knowledge loss, skills shortage, non-compliance, third party risks. The function should be separate from fund management and should report to the Chief Executive Officer of the AMC. The function could be carried out in a number of ways: * As an additional function of an existing employee of the AMC, e.g. the Compliance Officer or Internal Auditor; * Through a Risk Management Committee; * Outsourced to an external agency; or * As the Trustees of the mutual fund may deem fit. A Risk Management Framework manual detailing the policies and procedures, systems, organisation controls and specific risk management measures for the above risks will be prepared by AMFI. The creation of such a function should be mandated by SEBI, with an implementation time frame of 3 months from the date of such mandate, or 1st January 2003, whicheve ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e measurement using Sharpe Ratios, Treynor Measures and Sortino Ratios * Risk benchmarking, i.e. the exposure arising between the actual managed portfolio and the benchmark portfolio * Stress testing and back testing of exposure calculations. * Front Office and Dealing Systems Funds should consider implementing integrated front and back office systems which will facilitate straight-through processing, thereby reducing the possibility of input errors at any stage in the investment, dealing and settlement process. More importantly, a front office system with a robust compliance module will facilitate pre-trade compliance checks, thereby reducing the possibility of regulatory or internal limits being breached. * Dealing and Best Execution Currently, most players are too small to warrant a segregation of duties between fund managing and dealing. However, as the industry matures and volumes increase, this will be an area that should be looked at more closely, with a view to setting clear guidelines for best execution. * Money Laundering In the absence of any money laundering regulation in India, funds should, at a minimum, adopt the following measures: * Cash applicatio ..... X X X X Extracts X X X X X X X X Extracts X X X X
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