Giles Drury and Tom Brown discuss how fund managers can move on after the credit crisis

The summer of 2007 brought the so-called credit crisis. As well as the banks, the fund management sector has felt the ramifications of such dramatic market activity. KPMG and the Economist Intelligence Unit recently published a report examining the impact of the credit crisis on fund managers and how they are responding.

The report has highlighted the feeling that fund management firms need to re-evaluate what kind of business they are conducting and the risks they are running.

Complexity defines the fund management industry today. This survey of fund management and investment professionals reveals that 57%of fund management firms use derivatives in their portfolios and 61% manage complex hedge fund strategies. Half of fund management firms manage private equity strategies, nearly half manage asset-backed securities and more than one-third manage collateralised debt obligations (CDOs) - hit hardest by the credit crisis. Fund managers still believe that (excepting CDOs), all the above strategies and asset classes will rise over the next two years. But 70% of the respondents say their appetite for complex products is reduced.

As a result, well over half of fund managers say investment returns have fallen and report falling subscriptions. Six out of 10 respondents believe trust in fund managers has been eroded due to the effects of the credit crisis.

Some aspects of fund management require urgent attention. Staff skills have failed to keep up with growing sophistication. One in five fund managers invested in complex derivatives, CDOs or structured products, admit to having no in-house specialists with relevant experience; and one in three institutions invested in complex instruments admit they have no specialised, in-house expertise of these products. Rating agencies are seen as providing little support: one third of the respondents agree that rating agencies provide an accurate assessment of whether an instrument will default and just 1% think rating agencies are very accurate in predicting defaults.

One solution to the skill-set issue is a migration of experienced people from investment banks to investment management firms, especially in derivative operations and risk management. The requirements of a derivative operation are so fundamentally different from running a long-only business that it is very difficult to develop sufficient skills in-house.

Incentive plan design needs to evolve to take more account of long and short-term performance as well as risk and investor satisfaction. This will require a significant shift in organisational behaviour and performance management.

Fund management firms need to re-evaluate the kind of business they are conducting and associated risks. Four out of 10 firms say they have already formalised risk frameworks in the past two years as a result of managing more complex strategies, with a similar number planning to do so over the coming two years. One third of firms has reviewed valuation method activity, while a further third will do so in the next two years. Some 38% of respondents, have reviewed governance arrangements - particularly concerning risky instruments to enhance returns on supposedly low volatility funds - and a further quarter will do so in the next two years.

While many investment management firms have developed sophisticated risk management programmes, there is still a shortfall, especially where firms are using complex instruments and strategies in their funds. Analysis of complex products, scenario and stress testing, price validation and liquidity risk management are all key areas to focus on in funds as well as fund of fund treasury structures.

Another lesson learned is the import-ance of treasury and credit risk management (and how to best manage surplus cash in fund structures), as well as liquidity risk management (and how to best manage extreme redemption scenarios). The area of treasury and investment risk management is where we expect to see significant investment and increased focus in future.

In a time of increasing uncertainty and investor conservatism, they need to demonstrate their added-value proposition. Investors will reject further innovation, particularly if it involves complex strategies and instruments. In all, 70% of investors say the credit crisis has reduced their appetite for complex products. The fund management industry will need to develop products and services that perform well over the cycle as well as in changing economic environments. All-weather strategies, lifestyle funds, insightful asset allocation advice and sound risk management and governance practices are all likely to be at a premium in future.

As the credit crisis has unfolded, investor confidence has taken a hit and their appetite for investment risk has been diminished. The fund management industry has been criticised for being too product-led and not sufficiently customer-focused. In order to rebuild investor confidence and attract long-term savings, firms should clearly explain how products will perform and with much greater levels of investor assurance about governance and risk management. Firms will need to pay more attention to customer demands; for example, if clients want simple products, then that is where the client proposition needs to be focused.

Investors  themselves need to understand the risks and features of what they have invested in or permitted their investment managers to invest in. Reliance on rating agencies is not enough. Proper analysis and risk assessment is required.

The growth of complex financial instruments in recent years has been due to the search for yield. To generate the required yield for investors in a market where funding was readily available, product developers turned to complex structured financial instruments. An example is the ‘CDO squared' (a structured credit vehicle that invests in other structured debt notes). Over the last decade there has been the demand for such instruments, but it is now unclear as to whether growth in this market will return and if so whether the design of the instruments will have to change.

What is clear, however, is that funds are increasingly using derivatives as part of their investment strategies. The credit crisis, and its effect on structured credit products, has highlighted the importance of fully understand the pricing and risk of such investments. Funds that will be successful are those that have differentiated investment strategies (that is, there may be demand for an allocation to a specialist structured credit fund, but investors should not expect money market funds to invest in such products). In addition, funds that can provide transparency of the underlying valuation risk will meet the increased investor demand to understand the risk in their portfolio.

Investors have had a hard time in the structured finance market and very few new structured finance-related transactions are currently being carried out. We do not expect the markets to return for a while and whenever they do return, the transaction volume will be lower and the structures should be less complex and easier to understand.

Improved transparency is required for the market to pick up, but exactly what changes need to be made remains to be seen. Interestingly, existing transactions were accompanied by disclosure documents consisting of hundreds of pages of information about the transaction and its risks. Yet the transparency from these documents did not prevent the credit crisis from happening. The road ahead needs to be a move to simplify and standardise what information is needed to help investors make better investment decisions. Only by close co-operation from all market participants will this goal be reached.

The investment management industry will continue to grow and flourish over the medium term, driven by necessity as age and wealth increases in developing economies. But, yet again, we find that investors have suffered substantial losses as a result of over-exuberance. This, in turn, is having a knock-on effect in the real economy, as liquidity remains tight.

Sophisticated instruments and techniques have a place in the investment management industry, and can help investors better manage and control their risks. These tools and techniques, however, must be well understood before they are employed, and there is no justification for a manager investing clients' assets in securities which, by their own admission, they do not fully understand.

A full copy of the report ‘Beyond the Credit Crisis' can be downloaded at 

Tom Brown is partner and deputy global head for investment management and Giles Drury is senior manager, alternative investments group, both at KPMG