Applying an Enterprise Risk Management (ERM) Framework to Fund Governance* Masao Matsuda, CAIA Introduction through calculated risk taking. In this sense, Lainston International there is no reason that an ERM framework It is not yet common practice to apply Management cannot be suitably applied to fund governance an Enterprise Risk Management (ERM) in a way that helps maximize values for fund framework to the governance of investment investors. funds.1 Upon reflection, however, one realizes that funds are generally structured as Top management of a corporation/ corporations, and each fund has shareholders enterprise and its board of directors bear (fund investors), and the mission of each fund oversight responsibility for ERM processes is to maximize shareholder values. Even if a in their organizations. Similarly, directors fund is of a contractual type, a fund still can be of investment funds owe fiduciary duties to viewed as an enterprise, and also faces similar investors, and they need to ensure that an corporate governance issues. Overlaying fund integrated risk management process be in governance then with ERM processes can be place and the process be monitored. In the beneficial. paragraphs below, this paper discusses how an ERM framework can be applied profitably Contrary to what some may assume, risk to the governance of investment funds. The management is not a means of risk avoidance. author argues that applying an ERM framework Rather it is a means of implementing proper is not only desirable, but also critical in risk taking and, hence, contributing to value order for a fund director to fulfill his/her creation. ERM’s goal is value-creation through responsibilities. enterprise-wide integrated and holistic risk management. Thus, an investment fund can At the same time, applying an ERM framework be viewed as an enterprise that creates value to fund governance should not create an undue 65 Applying an Enterprise Risk Management (ERM) Framework to Fund Governance burden on fund directors. Fortunately, fulfilling duties normally administrator, an accounting firm, and investors (sometimes expected of fund directors in a conscientious and systematic different classes of investors). These stakeholders often have fashion coincides with satisfying most of the key components of diverging interests as do various silos or business units within an ERM processes. Helping to foster a risk-aware culture among the enterprise or corporation. stakeholders of a fund is arguably the only new ERM oriented Fund Directors and ERM task that a fund director needs to perform in addition to fulfilling other commonly expected responsibilities of a director. In effecting the enterprise’s ERM process, board members and top management must foster risk aware culture throughout the What is ERM? enterprise. Moreover, they are expected to set the tone of risk An often cited definition of enterprise risk management (ERM) culture at the enterprise.3 It is of paramount importance to note is given by the Committee of Sponsoring Organizations of the that “culture is not merely an intangible concept—its elements can Treadway Commission (COSO): be defined and progress in moving toward a desired culture can be measured.”4 Douglas Brooks cites the following three issues [ERM] is a process effected by an entity’s board of directors, when a strong risk-aware culture is absent: management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may • Not all relevant risks may be identified and assessed. affect the entity, and manage risk to be within its risk appetite, • Decision makers may not be aware of some risks as to provide reasonable assurance regarding the achievement of an decisions are being made. entity’s objectives.2 • Decisions may be made ignoring certain risks. While this definition presumes that ERM is applied to regular enterprises, most of the expressions are also relevant Thus, board members, including independent fund directors, to investment funds. The only exception might be “strategy must exercise leadership in fostering a risk-aware culture for a setting” mentioned in the second line, as the “corporate strategy” fund, as should be done at an enterprise. or “objective” of an investment fund is made explicit prior Despite sharing common objectives, the roles of the board and to launch of the fund. Even then, to the degree that a fund’s senior management are not identical. For instance, unlike senior strategic objective can drift or formally change under certain management, boards “cannot and should not be involved in the circumstances, the issue of strategy setting may be relevant. actual day-to-day management of risks.” Instead, the role of the This definition highlights several important points that have board is “to ensure that the risk management process designed relevance in the application of an ERM framework to investment and implemented by senior executives and risk management funds. professionals employed by the company act in concert with the organization’s strategic vision, as articulated by the board and • The board of directors and management of an executed by senior management."5 investment fund are responsible for “effecting” the fund’s ERM process. The Independent Directors Council and Investment Company Institute jointly published a paper titled Fund Board Oversight of • The ERM process needs to identify potential events Risk Management in 2011. In the paper, the board’s fundamental that may affect the fund. responsibilities are delineated as follows: • The ERM process needs to manage risk within the • Director’s responsibilities to oversee risk management fund’s risk appetite. are derived from their general fiduciary duties of care • The ERM process helps provide reasonable assurance and loyalty and are part of their overall responsibility 6 regarding the achievement of fund objectives. to oversee the management and operation of the fund. • A fund’s board is not responsible for overseeing the Absent an effective ERM process, risk management tends to management of the [investment] adviser’s risks or occur at division or business unit levels, each often referred to those of its parent or affiliates. …Nevertheless, the as a “silo.” The problem with the silo approach is that there is no fund board’s focus on the fund’s risks will necessarily coordination among different silos and there is no way to form entail an understanding of the adviser’s risk that an assessment of the total risk which the enterprise faces. This may impact the fund as well as the associated risk is true, even if diligent risk management is implemented in each management process.7 silo. Another key expression in the COSO definition of ERM is “across the enterprise.” It is not difficult to deduce that without a • A board does not manage [a] fund’s investments or risk management process which is applied across the enterprise, its business operations, nor does it manage the risks 8 board members and top management cannot pursue integrated associated with these activities. risk management. Similarly, the Cayman Islands Monetary Authority (CIMA) issued It is true that, unlike a business enterprise, an investment fund has a Statement of Guidance for Regulated Mutual Funds — Corporate typically no, or virtually no, employees or departments that may Governance, in December 2013. The guidance lists the key form silos. However, this does not diminish the importance of responsibilities of the governing body of a fund, along with those the ERM process. Instead of internal silos, a fund has a different of operators (fund directors). Among other duties, the guidance set of stakeholders such as an investment advisory firm, a fund describes the risk management oversight role of the directors in Paragraph 9.9 as follows: 66 Quarter 2 • 2017 Applying an Enterprise Risk Management (ERM) Framework to Fund Governance The Operator should ensure it provides suitable oversight of risk Market Risk (Investment Risk) management of the Regulated Mutual Fund, ensuring the Regulated Unlike other types of enterprises, the role of investment funds Mutual Fund’s risks are always appropriately managed and is to take proper market risk11 or more generally speaking, mitigated, with material risks being discussed at the Governing investment risk, so that risk exposure will translate into Body meeting and the Governing Body taking appropriate action investment returns. For this reason, it is nonsensical to try to where necessary.9 eliminate or mitigate market risk; when no market risk is taken, Thus, for funds domiciled in the Cayman Islands, operators there will be no investment returns. (fund directors) are mandated to oversee the risk management With respect to market risk, “[the] board should be especially of the fund they serve; in this case it is equivalent to serving as a sensitive to so-called ‘red-flags,’ or violations of existing risk board member of an enterprise and facilitating its ERM process, limits established by the risk management team.”12 These days, including overseeing a more narrowly defined “risk management most funds make use of risk management software. This type of process.” software typically calculates value-at-risk (VaR) and/or other risk The board of a corporate entity faces an array of strategic issues parameters on a daily basis. When a pre-determined risk limit such as defining corporate missions, setting strategic objectives threshold is violated, a red-flag is raised. It is the responsibility and responding to changing competitive landscapes. The board of the management team to take remedial action or, at minimum, also oversees the operational aspects of its entity. While ERM is take note of red-flag exceptions, and report the exceptions to the usually not directly involved in the strategic aspects of an entity,10 board. it plays a key role in helping the board to meet the objectives of an Statistically speaking, exceptions are designed to occur with entity.