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.

The potential downside for an investor exposed to an investment manager with an inadequate operational risk management structure in place can far outweigh the downside from being overweight Rio Tinto instead of BHP Billiton.

The reputational damage a superannuation fund can suffer from being associated with a manager who experiences operational difficulties can also be significant. Examples of these potential risks include those associated with poor accounting controls and procedures, valuation policies and controls over net asset value calculations, and lack of independent investment risk monitoring.

Arguably, investors should now be paying more attention to this than any time in recent decades. Investment managers are facing increasing pressure on their revenues from flat to declining markets and client demands for lower fees. Cost cutting is for many the only way to protect profitability. Investment managers are always very reluctant to be seen to be reducing costs in their front office so they are forced to look elsewhere for savings. Investors need to be very wary of investment managers looking for savings in their back and middle office as this often leads to higher levels of operational risk being taken.

Despite these risks and warnings, investors typically spend a fraction of the time they spend on frontoffice- manager research evaluating operational risk management. It is not uncommon for a superannuation fund’s operational due diligence to amount to no more than reading a standard questionnaire and having a five-minute tour of the office after a four-hour meeting with the portfolio manager. The level of investment risk being taken by an investment manager can be monitored on a daily or even hourly basis. The level of transparency on the operational risk taken by a fund manager on the other hand is minimal on a daily basis. The need for thorough and regular on site due diligence and monitoring of an investment manager’s operational activities is therefore critical.

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Paying your dues

There is no single reason why so many institutions pay inadequate attention to operational due diligence. For some, it is a case that they simply aren’t aware of or understand the risks; for others, it is that they haven’t the expertise or resources to conduct the necessary level of due diligence. Another reason can be complacency, which can occur if an investor assumes that if the manager already has a reputable client base, then one of these clients must have already done operational due diligence. Finally, it may be considered more interesting to talk about markets and investment processes with a star fund manager than it is to talk about operational risk and compliance matters.

Institutional grade operational due diligence requires more than just ticking the boxes on a checklist. An operational due diligence framework needs to cover six key areas:

The process followed within this framework should involve a number of steps from agreeing on exact review requirements with the client through to receiving and reviewing requested information from the investment manager, conducting on-site due diligence meetings and preparing a final report including recommendations for improvement. An important part of the process is providing feedback to the investment manager on areas of concern and agreeing with her/him a plan and timeframe for addressing these issues.

An investment with any investment manager exposes an investor to both investment and operational risk. No level of research can eliminate either of these risks completely. However, thorough due diligence can improve understanding of the risk and control environment of the manager and provide the trustees with additional comfort that risks have been adequately assessed. There is no shortage of advice available to investors on which asset class or investment manager to invest with.

Quality advice on the operational risks investment managers are taking is less plentiful but investors and trustees should be aware of the potential consequences of not giving it the level of attention it requires and deserves.

Philip Hope is director and chief executive officer, and Luke MacRedmond is a senior executive at Morse Consulting.