Investment Funds flourish with ethical behaviour

3 mins read

As the Investment Funds Industry in Cyprus continues to expand and record growth, the responsibility for high standards of ethical professionalism becomes more pertinent than ever.

Investment professionals across all levels within the Funds Industry must demonstrate high ethical behaviour to mitigate risks of not acting in the best interest of their clients.

Whether they refer to Fund Managers, Fund Administrators, Fund Depositories, Distributors and the AIFM/UCITS Management Companies (“providers”), it is widely acknowledged the AIFMD, AIF, and UCITS Directives legally ensure that clients in the Funds Industry are treated fairly and transparently.

Both Directives establish the framework for Fund activities within the EU, introducing a detailed regulatory regime with a comprehensive set of rules.

It is widely accepted that the risk of non-compliance to these can cause severe financial losses and reputational damage.

Introducing the importance of ethics, it is vital to understand why the risk of non-compliance lurks in the first place.

This risk – an ultimate threat posed to a company that can emerge from breaching the law, code of conduct or standards of practice – can emerge when stakeholders’ demand (in our case, fund investors) rapidly increases, resulting in providers having more pressure to scale their services and remain competitive.

This pressure can cause companies to ignore their long-term strategy and focus on short-term gains.

A “strategy” that urges market participants to act not in the best interests of their clients, with neither transparency nor fairness as they try to prevail in the short-term horizon.

Participants are also consumed with creating obstacles to their competitors to increase barriers to entry: again, neglecting the importance of serving their clients’ best interests.

When market participants forsake the importance of client service and only act in their short-lived interest, unethical behaviour is cultivated.

Ethical traps

Behavioural Finance recognises that on many occasions, well-intentioned professionals encounter hidden dangers on falling into “ethical traps”.

Within the Funds Industry, retail and institutional investors acknowledge the importance of their investment managers’ ethical code.

According to the CFA Institute’s survey before the Covid-19 crisis, performance was not the most important factor for investors choosing finance professionals.

It was whether they act ethically with honesty and transparency and have systems and operations to prevent them from failing to do so.

Most retail investors (75%) believe their financial advisers are legally required to act in the client’s interest above their own, while among institutional investors, only 25% think the investment firms they cooperate with actually put client interests first.

Within the Investment Funds Industry, providers can fall into the loopholes of acting unethically for the sake of promoting their services for short-term gain, ignoring the long-term strategy they should initially have in place.

An important example that has been examined and pointed out is transparency.

Fund investors argue that transparency on fees is most important in assessing which funds to add to their investment portfolios.

Providers acting in good faith must demonstrate the full layer of fund costs without any hidden layer of fees and commissions.

Directives point this out, but eventually, it is up to their code of ethical behaviour to fully disclose and explain these to their end investors.

We need greater transparency, less complex products and better fee arrangements.

We have to prove to the industry that this is not altruism but enlightened self-interest.

Avoid complexity. Investors, mostly from the retail spectrum, need the fund providers to avoid complexity and promote simplicity, so transparency prevails.

Providers, including from the top-level management to the lowest level of operational staff, must act ethically to mitigate risks of non-transparency and unfairness against their clients.

Investors do need their providers to act fairly.

Fund providers must deal fairly and objectively in a systematic manner with all clients when engaging in their activities.

Furthermore, an element of ethical behaviour is loyalty.

Fund providers must act to benefit their clients and not have their skills and abilities from depriving their protection, creating conflicts and causing harm.

Considering why unethical behaviour can exist on transparency, complexity, fairness, loyalty in all Investment Funds Industry activities can be observed through moral rationalisation.

Professionals can fall into the trap of taking small unethical decisions that they eventually justify and not consider harmful to their clients.

An important impediment to ethical behaviour is improper framing, where professionals can bypass the ethical consequences of a decision by only recognising the economic outcome.

All of the above result in an issue that can become severe for the Investment Funds Industry if not strictly considered.

Professionals can turn to the law and attempt to structure and standardise.

However, ethical behaviour goes beyond that.

It would be nearly impossible to legislate and regulate ethical decision making and behaviour.

So, what would be a solution to act ethically for the benefit of clients and the Investment Funds Industry?

A straightforward method would be for the industry to adopt and follow a code of ethics and professionalism that guides providers to adhere to ethical dilemmas.

The CFA Institute has created the “Code of Ethics and Standards of Professional Conduct”, for which all of its charter holder members are required to follow.

Any code to be adopted must also include real-world examples on how to apply.

A code of ethics can be a meaningful moral compass of every individual working for the industry that guides and helps them build their self-control.

Providers must also discuss and explore practices consistently but look at the client’s perspectives and not only on the industry level.

Leaders must raise their standards and demonstrate ethical courage for others to follow and eventually for all to act in the best interest of the clientele base.

By Zenon Papaphilippou, CIFA Ethics and Risk Management Committee Member, CFA Society Cyprus Board Member & Advocacy President