The purpose of this article is to highlight the essence of ethical behaviour which goes beyond the law.

Whether they refer to Fund Managers, Fund Administrators, Fund Depositories, Distributors and the AIFM/UCITS Management Companies themselves (“providers”), it is widely acknowledged that the AIFMD, AIF and UCITS Directives legally ensure that clients in the Funds Industry are treated in a fair and transparent manner. 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 as to deliver 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. Several participants are also consumed with creating obstacles to their competitors, in order 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. Behavioural Finance, an Economics sector on psychological biases that affect the investors and professionals’ decisions, thoroughly analyses unethical behaviour and dilemmas that participants come across. This sub-field recognizes that in many occasions, well-intentioned professionals encounter hidden dangers on falling into “ethical traps”. Within the Funds Industry, investors, both retail and institutional, acknowledge the importance of their investment managers’ ethical code. According to the CFA Institute’s survey that took place just before the Covid-19 crisis on what investors look for in the investment management industry, the results were not as profound as would someone expect. Performance was not the most important factor for investors choosing their finance professionals but instead, whether they act ethically with honesty and transparency and that they have systems and operations to prevent from failing to do so. In addition, 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.

In the context of this article, within the Investment Funds Industry providers can fall into the loopholes of acting unethically for the sake of promoting their services for the short-term gain, ignoring the long-term strategy they should initially have in place. An important example which has been examined and pointed out is transparency. Fund investors argue that what they find most important in assessing which funds to add in their investment portfolios is transparency on fees. Providers, acting in good faith must be able to demonstrate the full layer of fund costs without any hidden layer of fees and commissions. Directives do point out these through the detailed reports providers must present but eventually it is up to their code of ethical behaviour as to not only fully disclose but to also explain these to their end investors. In the recent past the CFA Institute, through its Chief Executive Officer and President, had stated: “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”. By this, another important aspect of ethical act derives: Avoid complexity. Investors, mostly from the retail spectrum need the fund providers to avoid complexity and rather promote simplicity as at the same time the most important previously stated factor can prevail: transparency. Providers, including from the top level management to the lowest level of operational staff must act ethically in order to mitigate risks of non-transparency and unfairness against their clients. As someone can easily observe, another important factor is added: fairness. Investors do need their providers to act in a fair manner. Fund providers must deal fairly and objectively in a systematic manner with all clients when engaging in their activities in order not to violate their ethical duties to them. Furthermore, an element of ethical behaviour is loyalty. Fund providers must act for the benefit of their clients and not having their skills and abilities from depriving their protection, creating conflicts and causing harm.

Considering why unethical behaviour can exist on transparency, complexity, fairness, loyalty and in all of the Investment Funds Industry activities, this can be observed in several barriers, one of which is moral rationalisation. Professionals can fall into the trap of taking small unethical decisions that they eventually justify and not consider them as harmful to their clients. An also important factor of impediment to ethical behaviour is improper framing, where professionals can bypass the ethical consequences of a decision by only recognizing the economic outcome.

All of the above result in an issue that can become severe for the Investment Funds Industry if not taken into strict consideration. Professionals can turn to the law and attempt to structure and standardize. However and as stated in the purpose of this article, 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 as to inevitably act in an ethical manner for the benefit of clients and the Investment Funds Industry? A straight-forward method would be for the industry to adopt and follow a code of conduct on ethics and professionalism that provides guidance to providers to adhere to ethical dilemmas that can occur in their daily activities. 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. It is important that any code to be adopted should also include real-world examples on how to apply. A “comply or explain” method (as EU mandates on corporate governance) can be endorsed.  

A code on ethics can be a meaningful moral compass of every individual working for the industry that not only acts as guidance but also helps them to build their self-control governing action. Providers must also discuss and explore on practices on a consistent basis but looking on the client’s perspectives and not only on the industry level. Lastly, 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 in the evolving era of the Funds Industry.

Author: Zenon Papaphilippou, CFA, Head of Institutional Wealth Management, Bank of Cyprus PCL CFA Society Cyprus Board Member & Advocacy President CIFA Ethics and Risk Management Committee Member