2.1.2.5 Portfolio management

70. 1) Introduction - Portfolio management encompasses “managing portfolios in accordance with mandates given by clients on a discretionary client-by-client basis where such portfolios include one or more financial instruments”.1 The expression “discretionary” is an important part of this definition.2 The investment firm needs to have the discretionary authority to perform the portfolio management function for its client. Without this discretionary authority, the relationship with the client will most likely be an advising relationship or a relationship that purports to render the investment services of transmission or execution of orders.3 Firms performing the investment service of portfolio management are often referred to as “asset managers”. The investment firm manages the assets of its client and buys or sells financial instruments for the risk and account of that client. The investment firm should, therefore, manage the funds of its client on a discretionary basis.4 The portfolio manager is responsible for meeting the agreed returns within the framework of the agreed investment mandate for its clients. To be able to perform this function for its clients, the investment firm will have to have direct access to the funds and financial instruments belonging to its clients. Without direct access to the funds and assets of clients, the investment firm is not able to manage the portfolio but can only transmit orders or give the client advice on the basis of which the client executes its own orders.

71. 2) Relevant risks - Since the portfolio manager has direct access to the funds and assets of the client, the actual risk of misconduct for the client increases, which then increases the legal or liability risk to which the investment firm is exposed as a result of its actions performed for its clients. Having access to funds or assets belonging to its clients has another effect which has a more profound influence on the risk profile of the investment firm. Depending on the type of asset segregation5 applied in the various European member states, the investment firm can either hold these funds and assets for the risk and account of its clients or in its own name for those clients (with funds or assets being included in its balance sheet) and thus bear credit and market risk on these positions. In the Netherlands the asset segregation rules have been implemented in such a manner that an investment firm is not allowed to hold the funds or securities of its clients itself. A Dutch investment firm either has to use a separate legal entity which holds the funds or securities of its clients, or work with tripartite structures involving a credit institution that holds the client monies. This Dutch approach is not common, however, in other European countries and asset segregation can also be applied to financial instruments held for the risk and account of the clients of the investment firm but which are included in the balance sheet of the investment firm, or using a trust structure. The specifics of these different asset segregation methodologies will be further explained in Chapter 4.

72. The way asset segregation is applied is thus of direct influence on the risks the investment firm is exposed to. The risk profile of an investment firm also depends on the position the investment firm takes in the chain of transactions. If the investment firm interposes itself between its client and the buyer/seller of the financial instrument, it can conclude the transaction through its own balance sheet. If payment of the financial instrument occurs at the same time as the delivery, the investment firm is not subject to market risk,6 but will be subject to settlement and delivery risk for those transactions that the investment firms concludes OTC or on an exchange. As discussed, in the Section concerning the service of order execution, transactions that take place outside of regulated markets and are therefore OTC can pose a greater risk of issues occurring, whereas centrally cleared transactions should not be subject to this risk. If payment and delivery do not occur simultaneously, the investment firm will be subject to market risk. The investment firm can also choose not to interpose itself between buyer and seller. For a portfolio manager this means the investment firm has a mandate to trade in the name of its clients from the bank or investor account the client holds with a bank or broker. Using this mandate means that the investment firm will not be subject to market risk, nor to settlement risk as the bank or the broker will bear these risks.

73. 3) Framework for assessing risks – According to Moloney, “agency costs [for investment firms providing portfolio management], arising in particular from conflict-of-interest risk and competence failures, can be significant where an agency mandate is given over discretionary client assets. Good client outcomes are accordingly in part dependent on the resilience of MiFID II’s generic conduct, asset protection, order handling, best execution and conflict- of-interest management requirements”.7 Investment firms providing the portfolio management investment service thus incur agency costs in any event. These agency costs are primarily addressed by the MiFID II conduct requirements, as noted by Moloney, but a residual prudential risk will still remain and should, therefore, be regulated concurrently with market conduct regulations. There will always be the risk that, despite the MiFID II requirements, errors are made by the investment firm and compensation8 has to be paid to the investor.