Asset Management Standards

Asset Management
Standards
Corporate Governance for Asset
Management
Otto Loistl and Robert Petrag

ASSET MANAGEMENT STANDARDS
Asset Management Standards
Corporate Governance for Asset
Management
OTTO LOISTL AND ROBERT PETRAG

© Otto Loistl and Robert Petrag 2003
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Preface to the First English
Edition
Asset management standards are now a core topic for capital market
participants. Coupled with proposals to reform pensions throughout Europe,
the rapid pace of capital market regulatory developments has prompted us to
commission an English translation of this second edition of our successful
German work Asset Management Standards – Regelungen in den USA und in den
EU, which we hope will support decision-makers in their efforts to achieve the
best possible solution for Europe.
The arguments for establishing asset management standards in Europe
remain as forceful today as they did when the first edition was published.
EFFAS, the European Federation of Financial Analysts’ Societies, has
established its own Asset Management Standards Commission to provide the
organisational basis for developing these standards.
In this new edition, we have added or expanded our treatment of the
following topics in particular:
x shifting demographic structures, especially as they are affected by
replacement migration;
x current progress in pension reforms in Europe, for instance Germany and
Sweden;
x the fundamentals of portfolio management: active and passive portfolio
management, style investment, the costs of fund management, and a
comparison of the European and US interpretations of the prudent man
and prudent expert rules;
x the new FSA rules in the United Kingdom.
The synopsis in this updated version also represents a reliable preliminary
study for developing asset management standards for Europe.
v
PREFACE TO THE FIRST ENGLISH EDITION
We would like to express our gratitude to the DVFA, the German Society of
Investment Analysis and Asset Management; without DVFA’s noble financial
and spiritual support it would have been impossible to publish the “Asset
Management Standards”.
Our thanks also go to MLP for their significant contribution to the translation
expenses incurred.
Besides thanking our invaluable supporting parties, we would also like to
mention the good cooperation with our competent translator Mr. Robin
Bonthrone. Together we have finally overcome the bothersome
incompatibilities between the German and English versions of Microsoft Word,
thus also giving English-speaking experts guidance on how to solve this
current global issue.
Vienna, March 2002

Otto Loistl
Robert Petrag
vi
Contents
Preface to the First English Edition v
Illustrations xi
Executive Summary xvii
Chapter 1 Setting the Scene 1

1.1 Introduction 1
1.2 The problems 2
1.3 Structure of the study 2
Chapter 2 The Scenario Today 5

2.1 Structural change in the asset management business in the EU 5
2.1.1 Inherent weakness in pay-as-you-go state pension schemes
increases the need for personal retirement planning 5
2.1.2 The pioneers in mutual fund-based retirement planning 21
2.1.3 Harmonisation of the European capital markets and the
Single Currency 24
2.1.4 No traditional equity culture in German-speaking countries 27
2.2 The need for asset management standards in the euro zone 34
2.2.1 Avoiding capital misallocation 34
2.2.2 The US asset management industry as the prime competitor 34
2.2.3 The risk of impracticable legislation and opaque case law 35
2.3 The basis for asset management standards in the euro zone 37
2.3.1 Existing and planned legislation in the EU and Germany 37
2.3.2 Existing US standards 41
vii
CONTENTS
Chapter 3 A Description of the Structural Components of the

Systematic Classification of the Synopsis 53
3.1 Investor risk 53
3.1.1 Management risk – Confidence risk 53
3.1.2 Investment risk – the risk inherent in the investment 54
3.2 Rules for reducing the investor’s risk 54
3.2.1 Investment rules 54
3.2.2 Separation of functions 55
3.2.3 Disclosure 56
3.2.4 Control and enforcement of rules 56
Chapter 4 The Regulation of Management Risk 58

4.1 Investment rules 58
4.1.1 Prohibition of transactions in the USA involving conflicts
of interest 58
4.1.2 Prohibition on transactions involving conflicts of interest
in the EU and Germany 64
4.1.3 The essence of future standard-setting 64
4.2 Separation of functions 65
4.2.1 Institutional separation of the management company,
the fund, the board of directors and the custodian in the
EU and the USA 65
4.2.2 Assuring the effective separation of the board of directors
from the management company by means of independent
directors 67
4.2.3 Chinese walls and firewalls at the management company 72
4.2.4 Proxy voting 73
4.3 Disclosure 76
4.3.1 Disclosure of all material facts in the USA, in particular in
conflict of interest cases 76
4.3.2 Valuation of fund assets 77
Chapter 5 The Regulation of Investment Risk 79

5.1 Investment rules 79
5.1.1 Prudence, not extensive quantitative restrictions, in the
EU and the USA 79
5.1.2 Modern Portfolio Theory 90
5.1.3 Active portfolio management as an example of a structured
portfolio management approach to implementing
qualitative investment rules 95
5.1.4 Style management 103
5.1.5 The use of financial derivatives 105
viii
CONTENTS
5.1.6 Quantitative restrictions 108

5.1.7 Special criteria for defined benefit plans 114
5.1.8 The fiduciary’s responsibility in defined contribution plans 121
5.2 Disclosure 123
5.2.1 SIP – Statement of Investment Principles/Policy 123
5.2.2 Content of a prospectus 130
5.2.3 Annual and half-yearly reports to shareholders and
supervisory authorities in the EU and the USA 135
5.2.4 Stricter disclosure requirements for pension funds in
the EU 135
5.2.5 Performance Presentation Standards (PPS) 136
5.2.6 Consideration of the effects of taxes on returns in the USA 143
Chapter 6 Control and Enforcement of Rules and Regulations 145

6.1 Board of directors 145
6.1.1 Definition 145
6.1.2 Organisational structures 146
6.1.3 Compensation 147
6.1.4 Prohibition on delegating the board’s fiduciary duties in
the EU and the USA 148
6.1.5 Transactions requiring approval in the USA 148
6.1.6 Oversight of internal fund procedures in the USA 150
6.1.7 Personal liability of fund directors in the USA 151
6.1.8 Fees and Expenses 152
6.2 Supervisory authority 165
6.2.1 Responsible authorities in the EU and the USA 165
6.2.2 A-priori and a-posteriori controls in the EU and the USA 166
6.2.3 The regulatory regime in the EU 168
6.2.4 Conscious focusing on the board of directors as the
primary instance in the regulatory 169
6.2.5 The new Financial Services Authority (FSA) Handbook
providing the regulatory framework in the UK 170
6.3 The management company’s compliance department 182
6.3.1 Definition 182
6.3.2 Legal basis 183
6.3.3 Design 184
6.4 Shareholders 186
6.4.1 The possibility of reporting perceived anomalies to the
supervisory authority in the EU 186
ix
CONTENTS
6.4.2 The right to sue personally liable board directors in the USA 186
6.4.3 Direct influence on fund management 186
6.5 Other parties involved in supervision 187
6.5.1 Obligations of auditors and actuaries to the supervisory
authority in the EU 187
6.5.2 The duties of the custodian in the EU 188
6.5.3 Professional bodies 189
Chapter 7 Summary of Findings 191
Annex A Replacement Migration 195
Annex B FSA Handbook Timetable 199
Bibliography 201
Notes 211
Index 271
x
Illustrations
FIGURES
Figure 1: Age structure 1992 9
Figure 2: Age structure 2040 (worst-case estimate) 9
Figure 3: Historical net migration to the EU between 1990 and 1998
compared with the three major future immigration
scenarios for the EU for 1995 to 2050 11
Figure 4: Proportion of migrants to total population in 1990, and
projected to 2050 for scenarios A to C (EU) 12
Figure 5: State support under the German Old-Age Provision Act 18
Figure 6: State pension subsidies based on allowances or tax
savings in 2008 for an annual income subject to statutory
pension insurance contributions of DM 80,000 19
Figure 7: Per capita invested assets at end-1999 (e) 27
Figure 8: Private financial assets in Germany, indexed presentation
with 1990 = 100 28
Figure 9: Growth in number and percentage share of US
households owning mutual funds between 1980 and 2000 29
Figure 10: Net new cash flows to mutual funds in the USA between
1984 and 2000 30
Figure 11: Volume of US mutual funds by fund type 1984 to 2000 31
Figure 12: US retirement assets between 1990 and 1999 32
Figure 13: Mutual fund share of US retirement assets between 1990
and 1999 32
Figure 14: Examples of dynamic reallocation profiles 40
Figure 15: Structure of a mutual fund under US law 42
Figure 16: 401(k) plan assets 1990 to 1999 (USD billions) 46
Figure 17: Mutual fund share of total 401(k) plan assets 1990 to 1999 46
Figure 18: Risk/return for various investment horizons (1802–1995) 82
xi
ILLUSTRATIONS
Figure 19: Risk/return of five differently structured portfolios for

1, 3, 5 and 10-year holding periods 83
Figure 20: Worst case equities scenario over 35 years: expected
return 10% p.a. with 18% volatility, worst case is one
standard deviation below the expected return 84
Figure 21: Best case bonds scenario over 35 years: expected
return 5.5% p.a. with 4.5% volatility, best case is one
standard deviation above the expected return 84
Figure 22: Worst case equities versus best case bonds, 25-year
horizon 85
Figure 23: P-V2 curve of efficient portfolios 90
Figure 24: The efficient frontier and the capital market line 91
Figure 25: The security market line 92
Figure 26: The market for active portfolio management 97
Figure 27: Curve shifts on the market for active portfolio
management 97
Figure 28: Classification of the structure of an investment process 103
Figure 29: Relative development of the STOXX Europe index from
31 Dec. 1986 to 20 January 2002, using the STOXX Broad
Europe index as the benchmark 105
Figure 30: Overview of financial derivatives 105
Figure 31: Example of a flexible Minimum Funding Requirement
with max. 10% underfunding and max. 20%
overfunding 115
Figure 32: Markowitz efficient sets with incorporation of a
minimum return as a constraint 118
Figure 33: Markowitz and shortfall line for overfunding 119
Figure 34: Development of assets and liabilities in case of
underfunding 120
Figure 35: Development of assets and liabilities after optimisation 120
Figure 36: Comparison of the curtosis of various distributions 121
Figure 37: Diversification levels of asset allocation in the broader
sense 125
Figure 38: Typical fee table for a US mutual fund 131
Figure 39: Typical part of a US mutual fund’s fee table listing the
ongoing expenses 132
Figure 40: Typical fee table of a US mutual fund illustrating the
costs of the investment in this fund for one to ten years 133
Figure 41: Relationships between key standards 138
Figure 42: Classification of various measures of return by risk
measure used and application 140
Figure 43: The board of directors in the responsibility matrix 147
Figure 44: Common types of US fund committee 148
xii
ILLUSTRATIONS
Figure 45: Sales-weighted total shareholder cost ratio for equity

funds (per cent), 1980–1997 160
Figure 46: Population age structure trends in Germany 2000 to 2040 198
EQUATIONS
Equation 1: German pension formula 17
Equation 2: Cumulative return 83
Equation 3: Cumulative standard deviation 83
Equation 4: Variance of a risk-efficient portfolio (after Markowitz) 91
Equation 5: Number of variances and covariances to be estimated to
establish portfolio variance (after Markowitz) 91
Equation 6: Security market line 92
Equation 7: Beta 92
Equation 8: Expected rate of return in the single index model 93
Equation 9: Ex ante information ratio 100
Equation 10: Ex post information ratio 101
Equation 11: Value added 102
Equation 12: Optimum residual risk 102
Equation 13: Shortfall risk 117
Equation 14: Semivariance 117
Equation 15: Lower partial moment of the nth order 117
Equation 16: Components of investment return as defined by
DVFA PPS 139
Equation 17: Detailed annual fund operating expenses 154
TABLES
Table 1: Birth rates (children per woman) between 1950 and 2050
by country or region 6
Table 2: Potential support ratio (for assumed zero immigration
after 1995) between 1950 and 2050 by country or region 7
Table 3: Changes in contribution rates to the statutory pension
scheme as a percentage of gross wages/salaries in Germany 8
Table 4: Change in population and in the proportion of the total
population aged 65 years or older for the EU countries
that must expect a shrinking population between 2000
and 2050 10
Table 5: Retirement age that would be necessary in 2050 in the
case of zero immigration between 1995 and 2050 to
maintain the same potential support ratio as in 1995 (by
country or region) 12
xiii
ILLUSTRATIONS
Table 6: The “three pillar model” – sources of retirement income

for employees in the EU 13
Table 7: Real interest rates and real wage growth in Germany
between 1970 and 1995 13
Table 8: Change in the share of sources of retirement provision in
total EU pension benefits between 1994 and 2020 14
Table 9: Share of pension fund assets of the 15 EU Member States
in total assets of all pension funds in the EU at end-1997,
total volume e1,627.35 billion 14
Table 10: Forecast growth in EU-wide pension fund assets
until 2020 26
Table 11: Private financial assets in billions of euros in Germany
1990–1998 28
Table 12: Growth in new cash flow and volumes of various fund
types in billions of e in Germany between 1998 and 1999 29
Table 13: Retirement planning investment in mutual funds in
billions of USD 33
Table 14: Growth in the number of fund companies that are
members of the Investment Company Institute
between 1979 and 1999 33
Table 15: Worldwide assets of open-end investment companies in
millions of USD between 1994 and 1999 35
Table 16: Differing terms for the same concepts in the EU and
the USA 50
Table 17: Real average rates of return (in local currencies) of the
pension fund portfolios of selected countries between
1984 and 1998 87
Table 18: Comparative returns of German equities and bonds 88
Table 19: Returns above corresponding bond market returns
achieved in selected equity markets (in local currencies) 88
Table 20: Correlation of the CRB Index with S&P, EAFE Index
and US treasuries 126
Table 21: Alternative financial market scenarios 127
Table 22: Alternative asset allocations 128
Table 23: Analysis of alternative asset allocations for the
alternative financial market scenarios 128
Table 24: Shareholder fees 131
Table 25: Allocation of the cost of mutual fund services and
components of the expense ratio 155
Table 26: Impact of return, expense ratio and holding period
on the future value of a fund investment 156
Table 27: Operating expense ratios in 1997 of the 100 largest
equity funds established prior to 1980 157
xiv
ILLUSTRATIONS
Table 28: Expense ratio growth 1979 to 1999 for all classes of fund
shares/units 157
Table 29: Classes of no-load funds 158
Table 30: Classes of load funds 158
Table 31: Volume and percentage share of total US mutual
funds taken by individual fund types 159
Table 32: Expense ratios of individual US fund types 159
Table 33: Fee structure of the 100 largest US funds showing
breakpoints between 1997 and 1999 161
Table 34: The FSA Principles for Businesses, post-consultative
version, October 1999 174
Table 35: Annual net new migration between 1990 and 1998
by country or region 199
Table 36: Total net new migration from 1995 to 2050 by
country or region 199
Table 37: Average net new migration per year from 1995 to
2050 by country or region 200
Table 38: Number/percentage of immigrants in 1990 by country
or region 200
Table 39: Percentage of immigrants to total population
between 1995 and 2050 by country or region 200
xv
Executive Summary
THE MARKET OPPORTUNITY

The current situation on the market, with shifts in demographic structures,
state pension systems in crisis and the growing popularity of investing in
securities, offers the EU fund industry a unique, historic opportunity to assume
market leadership in Europe in the lucrative field of investment saving for
wealth accumulation and retirement provision. Confronted with a saturated
domestic market, the US fund industry has correctly identified the massive
growth potential in Europe. It is striving for market leadership in Europe, and
its array of marketing instruments includes US asset management standards; it
is promoting these as being superior to any other standards because they have
been practised for years in the USA and still have no European counterparts.
The establishment of primary asset management standards for investment
and pension funds that both ensure efficiency and inspire investor confidence
is crucial to the future existence of Europe’s own fund industry. It can only
hold its own against its US competitors and exploit the tremendous
opportunities for volume and return offered by the European market if it
adopts its own standards. By developing Euro-centric standards, the EU fund
industry will be able to compete on its own terms. They will also counteract any
attempts by European or national authorities and governments to impose an
exaggerated and irrelevant regulatory regime.
The high growth potential inherent in the retirement planning market and
fast growing competition (especially with the introduction of the single
currency in the euro-zone) are just two of the factors dictating the rapid
establishment of competitive standards for investment funds, and in particular
for pension funds, in the EU.
Following the pension reform instituted in mid-May 2001, which will cap
pillar one of the pension system and strengthen the two other pillars, the
current situation in Germany appears to be a particularly favourable
xvii
EXECUTIVE SUMMARY
opportunity for establishing asset management standards, particularly because

pension funds will be permitted for the first time.
The regulatory regime in the United Kingdom has been undergoing a process
of reform since 1998, with the objective of bringing all financial service
providers together under a single regulatory authority, the Financial Services
Authority (FSA). This regulatory regime will then be enforced on the basis of
the still incomplete FSA Handbook. This Handbook is hierarchically structured,
consisting of relatively abstract, high-level generic principles that are then put
into more concrete form by sector-specific regulations. Both of these levels
contain numerous topics of relevance to asset management standards.
The present study aims to provide a well-founded basis for developing the
content of attractive asset management standards. It contains not only an
overview of standards in the USA and the EU, but also outlines planned
developments and discusses the underlying problems.
THE USA AS PIONEER AND COMPETITOR

Fiduciary duties in the USA are defined in detail in a wealth of often highly
complex requirements and prohibitions. Even senior executives and board
members in the US fund industry need expert (legal) advice on how to
implement them.
Simply transferring the opaque US rules to the EU would be neither feasible
nor desirable, based as they are on case law and driven by an excessively
litigious environment that entails substantial legal advice costs for the fund
industry and thus for fund providers, as well as incalculable litigation risks.
Although the federal US rules governing the fiduciary duties of pension fund
managers are certainly strict, they must be countered by compelling European
and national regulations.
CURRENT AND PLANNED LEGISLATION IN THE EU

In mid-October 2000, the European Commission published its proposals for
regulating pension funds at EU level for the first time. The proposals envisage
the Member States transposing these rules into national law by the end of 2003.
In compliance with the principle of subsidiarity, the European Commission has
only adopted broad minimum asset management requirements in its proposed
directive, thus giving the Member States a substantial degree of latitude as
regards interpretation and implementation. It is now up to the fund industry to
fill these gaps with clear concepts and proposals to block any moves towards
sub-optimal implementation.
Both the draft Pension Fund Directive and the (amended) UCITS Directive,
which regulates investment funds at a more general level, are aimed more at
products than providers, and contain little in the way of regulations governing
management companies and relationships with customers (investors).
xviii
EXECUTIVE SUMMARY
PROPOSALS FOR STANDARDS
Systematic classification
The synopsis illustrates the core problems affecting future standards and
discusses the fundamental ways in which they can be solved, classifying them
into four areas: investment rules, separation of functions, disclosure
requirements and supervision. The objective of the rules is to manage and
communicate investor risks.
The potential tasks facing standard setters are outlined below.
Investment rules
x Supplementing strict quantitative investment rules with flexible
investment strategies to enable the suitable implementation of profitable
passive or active portfolio management models.
x Rules governing conflicts of interest affecting fund managers. These
voluntary rules aim to avoid abuse of the status of fund management
company membership. These rules, for instance transferring oversight
functions to the fund board, will also help avoid any potential official
over-regulation in this area.
Separation of functions
x Organisational separation of the management company, the sponsor, the
custodian and the auditors.
x Rules governing the appointment, compensation and minimum
representation of board directors.
x The establishment of Chinese walls within the management company to
control information flows and prevent inside information abuses.
x Precise definition of the duties of consultants.
Disclosure requirements
x Transactions entailing conflicts of interests should not only be supervised,
but as a rule should also be disclosed. Prohibitions should be provided for
borderline cases.
x Fund assets should be marked to market as a matter of principle, but
standards governing fair value measurement should also be provided for
justified exceptions.
x There should be a duty to disclose both a Statement of Investment
Principles (SIP) prepared by the fund board and the minimum content of
such a SIP.
x The size of and language used in prospectuses should make them easy to
read, and there should also be rules for improving their user-friendliness.
x Obligation to comply with established Performance Presentation
Standards.
xix
EXECUTIVE SUMMARY
x Transparency about transaction and management costs, soft dollar rules

and referral or preferencing arrangements.
Supervision
x The objective should be a lean, state-of-the-art supervisory regime that
can respond quickly to rapid market change, so that time-consuming
legislative processes and costly over-regulation do not pose a risk to
competitiveness. The establishment of the standards should also aim to
avoid the extensive use of expensive legal advisers that is so vital in the
USA.
x Establishment of a fund board partly composed of independent directors
that will act as a watch dog to directly safeguard investors’ interests and
will be bound by fiduciary duties. The duties and powers vested in the
board should be sufficiently strong to counter any doubts about its
integrity and effectiveness. However, weighing the board down with too
many trivial oversight duties would be counter-productive.
x Development, disclosure and oversight (by the fund board) of a code of
ethics imposing special fiduciary duties on the employees of the
management company.
ORGANISATION
Standards will only be generally accepted on the market if the details are
developed jointly by all market players involved.
As a neutral, professional organisation, the DVFA is best positioned to act as
a focal point for developing the standards. It has already successfully
established a number of committees to act as the market platform for standards.
The rules should ensure transparency about the rules of conduct governing a
fund and its management company so that investors can make a well-informed
decision.
xx
CHAPTER 1
Setting the Scene
1.1 INTRODUCTION
Changes in the EU’s demographic structures, in particular rising life expectancy
and falling birth rates, represent a growing risk to the established pay-as-you-
go state pension schemes. Coupled with other current developments, such as
the gradual withdrawal of the state from its social security commitments, the
increasing popularity of (indirect) investment in equities and the spread of non-
state pension provision, especially in the USA, this forms part of a raft of factors
that are both a challenge to – and an opportunity for – the EU financial services
industry to establish its (pension) investment funds as a supplement to state
pensions.
Together with the draft EU Pension Fund Directive, the current political
debate in Germany on reforming the existing state pension system, by
encouraging or forcing the working population to contribute to supplementary
occupational or personal pensions, illustrates that the political establishment
too has moved beyond merely analysing the problem and is now actively
working on the implementation of a three-pillar pension system.
The directives and legislative initiatives containing rules and regulations at a
more general level need to be shaped and given more detailed substance by
appropriate, workable standards. Although the US fund industry promotes its
decades-old asset management standards, their application to solve the
problems that Europe is facing would require substantial modifications to be
made. A critical task for the European fund industry is therefore to develop its
own voluntary EU asset management standards, so that it can reinforce
investor confidence in its fund products – and thus its own competitive
position – and avoid legislators taking action to fill supposed gaps in the
regulations.
The establishment of EU-wide asset management standards is of overall
importance for the European fund industry, even for those countries relying
1
SETTING THE SCENE
primarily on funded pension schemes. The description of the situation in

Germany is representative of those countries that have traditionally organised
their pension provision around pay-as-you-go schemes, with the aim of
illustrating the growing importance of both the fund industry and asset
management standards for these countries as well.
The development of standards hinges crucially on transparency in the
following areas:1
x selection of the investment vehicles;
x the investment strategies applied;
x explicit investment rules;
x defined investment objectives;
x transparent incentive schemes.
In addition to these areas, we will also look at issues of organisation and
supervision, as well as deriving proposals for the content and structure of such
future EU-wide standards from a synopsis of US and European asset
management standards currently in force or planned for the near future. The
objective of this study is to provide both an anchor and an overview for what
must surely be the next step – the elaboration of actual draft guidelines and
recommendations for Europe’s own asset management standards.
1.2 THE PROBLEMS

This study aims to answer the following questions:
1. What is the overall environment that demands that Europe develop its own
asset management standards?
2. What existing or planned statutory and voluntary rules and regulations in
the EU and the USA can be used as a basis for developing European asset
management standards?
3. How can the objectives and rules of these standards be classified into a
coherent system?
4. What are the fine details of existing or planned rules in the USA and the EU
for achieving these objectives?
5. What recommendations for future European standards can be derived from
a synopsis of the US and EU rules, taking account of the strengths and
weaknesses in each case?
1.3 STRUCTURE OF THE STUDY

In Chapter 2, we establish the need to develop European asset management
standards and list the most significant current and draft regulations, describing
their structure and core content.
We examine the structural weaknesses of the state pay-as-you-go pension
model resulting from the risks posed by demographic trends, and briefly
2
SETTING THE SCENE
present successful international examples of supplementary funded pension

schemes. This is followed by a description of the shifts in savings trends in
Germany – away from conservative forms of savings that are poorly suited to
supplementary retirement provision, and towards growth-oriented
investments. We also examine the harmonisation of the EU’s capital markets
that is supporting this trend. We then discuss how requirements for capital
market efficiency, competitive pressure from the USA and the negative
experience gained from sub-optimal regulatory regimes are supporting moves
by the EU fund industry to seize the initiative in establishing voluntary asset
management standards.
The chapter closes with an overview of asset management regulations in the
EU and the USA, and a description of the relatively new rules on fund-based
retirement provision in Germany using AS-Fonds.
Chapter 3 describes the structural approach for the synopsis of existing/
planned asset management rules in the EU and the USA: the primary goal of
standards is investor protection against management and investment risks. The
concrete rules can be classified into the four regulatory areas of investment
rules, separation of functions, disclosure and control/ implementation
(supervision). This chapter centres around the definition of the two types of
risk and the four regulatory areas.
Based on these findings, the individual rules are then classified into two
levels: firstly by the type of risk to be managed by the standard, and then by
the type of regulatory area. Because most of the rules affecting supervision
cannot be clearly assigned to either management risk (Chapter 4) or investment
risk (Chapter 5), they are covered in a separate Chapter 6. Similar rules existing
in both the EU and the USA are discussed together, but are treated separately if
the differences are significant. Numerous rules exist in only one of the two
regulatory regimes and are therefore discussed without any direct comparison.
For each of the regulatory areas, this is then followed by a summary (“The
essence of future standard-setting”) of the recommended relevant future EU
standards for the area concerned, based on the rules outlined above. This
summarises the problems that need regulation, describes the strengths and
weaknesses of existing/planned EU and US rules in the area, and then assesses
their appropriateness as a basis for EU standards, either alone or in
combination. Inadequacies or gaps in the rules of the regimes that make neither
of them suitable are highlighted, and potential solutions are then discussed.
Chapter 4 describes the investment rules, the separation of functions and the
disclosure rules for controlling management risk, and translates these rules into
proposals for future standards, as described above.
Chapter 5 applies the same structure as Chapter 4 to investment risk. The
only difference here is the omission of the separation of functions, because
these serve solely to master management risk.
Chapter 6 covers the rules for supervising and enforcing the rules from
Chapters 4 and 5, because these are normally used for controlling both
3
SETTING THE SCENE
management and investment risk. Each section then concludes with

recommendations for standards in the same way as in Chapters 4 and 5. These
chapters are classified by institutional aspects, describing in detail oversight by
the board of directors/fund board, the regulatory authority, the compliance
department, the shareholders,2 and finally other parties.
Chapter 7 concludes the study with a summary of the results and findings.
4
CHAPTER 2
The Scenario Today
2.1 STRUCTURAL CHANGE IN THE ASSET

MANAGEMENT BUSINESS IN THE EU
2.1.1 Inherent weakness in pay-as-you-go state pension

schemes increases the need for personal retirement
planning
Changes in demographic structures threaten pay-as-you-go
systems
Overview of the problems

Statutory pension schemes, which constitute “pillar one” of the EU pensions
system, are financed by the state from current revenue on a pay-as-you-go
(PAYG) basis. At present, first pillar pensions are still by far the most important
form of retirement provision, with state pensions accounting for an EU average
of well over 80% of pension payouts,3 and 75% in Germany.4 The long-term
goal of many pension reform initiatives is to grow the second and third pillars
of the pension systems to relieve pressure on pillar one (see Table 8).
The numerous advantages of the pay-as-you-go method, such as ease of
introduction, are offset by serious drawbacks that are becoming increasingly
important,5 now that the ability of the pay-as-you-go systems to continue
functioning properly is jeopardised by two long-term demographic trends:
firstly falling birth rates (see Table 1), and secondly rising life expectancy6 in
the industrialised countries.
The existing and looming inequalities inherent in the PAYG system pose no
risk to the functioning of the system, but they will jeopardise social peace in the
long term and the continued existence of the “intergenerational agreement”,
5
THE SCENARIO TODAY
because in most cases, contributions do not match the social security benefits.
This means that today’s pensioners enjoy relatively high pensions compared
with the contributions they paid in the past, but the opposite holds true for
today’s contribution-payers, assuming that the current situation will continue.7
The demographic effects are being exacerbated by early retirement schemes
frequently motivated by employment policy considerations. Experts have
suggested a range of solutions to the early retirement problem:8
x Joseph Stiglitz, former chief economist at the World Bank, proposed
indexing the pensionable age on the basis of (rising) longevity.
x Klaus Zimmermann, Director of the Institute for the Study of Labour
(IZAS) in Bonn and also President of the German Institute for Economic
Research (DIW), advocates changing the financial incentives to encourage
a longer working life. If this is insufficient, he thinks that it may be
necessary to extend the statutory retirement age.
x By contrast, Friedrich Breyer, an economist based in Constance, favours
the immediate elimination of all state subsidies that encourage early
retirement.
Country or Region 1950– 1965– 1995– 2020– 2045–

1955 1970 2000 2025 2050
France 2.73 2.61 1.71 1.96 1.96
Germany 2.16 2.32 1.30 1.58 1.64
Italy 2.32 2.49 1.20 1.47 1.66
Japan 2.75 2.00 1.43 1.73 1.75
South Korea 5.40 4.71 1.65 1.90 1.90
Russian Federation 2.51 2.02 1.35 1.70 1.70
United Kingdom 2.18 2.52 1.72 1.90 1.90
USA 3.45 2.55 1.99 1.90 1.90
Europe 2.56 2.35 1.42 1.67 1.78
EU 2.39 2.52 1.44 1.45 1.80
Table 1: Birth rates (children per woman) between 1950 and 2050 by country or
region9
Both the UN and the OECD assume that there will be an improvement in
this unfavourable birth rate trend in future,10 but this should not be interpreted
as sounding the all-clear. Neither are there any indications that the rise in
longevity will slow down, although this is, of course, very much to be
welcomed, notwithstanding the resulting impact on pensions. This growing
longevity will also see people being fitter and healthier than their predecessors
were at the same age, a trend that not only increasingly makes a mockery of
most early retirement, but also makes an increase in the pensionable age appear
sensible and justifiable. Life expectancy in the EU has risen by eight to ten years
6
THE SCENARIO TODAY
since the 1950s, for example, but the percentage of 60- to 64-year-old men still
working has fallen over the same period from 80% to 30%.11
The extent of these demographic shifts can be illustrated by a number of
striking facts ranging over three centuries: in the early days of Bismarck’s
pensions system in the German Reich during the last quarter of the 19th
century, only one in six persons reached pensionable age. Immediately after the
Second World War, British men died on average one year after retiring,
whereas today, they enjoy 19 years of retirement.12 At the end of the 1990s,
there were on average four to five wage and salary earners in the EU for each
pensioner, but there will be only two in 2040.13 This ratio of people of working
age to pensioners is termed the (potential) support ratio, whose development
from the 1950s to a projection for 2050 is illustrated in Table 2. Among other
things, it shows that overall, this demographic trend and the associated
pension problems also affect the USA14 and Japan.15 It is compounded by the
sustained high levels of unemployment since the mid-1970s, not only in
Germany, but throughout most of Europe. These high jobless rates have firstly
cut contribution income and secondly increased the pressures on the benefits
side, because the number of persons taking early retirement due to
unemployment has risen sharply.16
On the other hand, the demographic trends forecast by the UN for the USA
over the next few decades differ appreciably from its projections for the EU,
with the US population expected to grow by 82 million and the EU population
expected to decline by 41 million.17
Country or Region 1950– 1965– 1995– 2020– 2045–

1955 1970 2000 2025 2050
France 5.79 4.65 4.10 2.82 2.26
Germany 6.90 4.29 4.11 2.45 1.75
Italy 7.92 5.29 3.72 2.40 1.52
Japan 12.06 8.60 3.99 2.24 1.71
South Korea 18.16 16.25 10.67 4.43 2.40
Russian Federation 10.49 7.66 5.51 3.63 2.41
United Kingdom 6.24 4.50 4.08 2.93 2.36
USA 7.83 6.15 5.21 3.09 2.57
Europe 7.99 5.67 4.65 3.03 2.04
EU 6.97 4.84 4.06 2.66 1.89
Table 2: Potential support ratio18 (for assumed zero immigration after 1995)
between 1950 and 2050 by country or region19
Adhering to the principles of the pay-as-you-go model essentially means

choosing between only two future alternatives that are feasible in practice, but
offer highly uncomfortable prospects: either cutting benefits,20 i.e. smaller
pensions or a later pensionable age,21 or increasing contributions.22 The latter
7
THE SCENARIO TODAY
route has already been taken in many EU countries (for Germany see Table 3,
p. 8), so there is now an increasing trend towards cutting back benefits.
One alternative that is frequently advocated is increased immigration:
“replacement migration” is the term used to describe the immigration necessary to
counter the effects of a declining population, a shrinking workforce and ageing.23
Another conceivable option is to increase government spending, but public
spending in the EU is already very high,24 and the Maastricht Treaty and the
subsequent Growth and Stability Pact demand strict budgetary discipline. Any
Member State breaching these agreements because of excessive budgetary
deficits would trigger higher inflation, that would then be “exported” to other
Member States in the euro zone, making intervention by the European Central
Bank inevitable in the form of a higher discount rate. Long-term interest rates
would also rise on the back of a risk premium on euro-denominated bonds.
Higher interest rates depress capital investment and consumer spending, thus
reducing economic growth and increasing unemployment across the entire
euro zone, including those countries that pursue a responsible fiscal policy.25
26
Year(s) Contribution Year(s) Contribution rate
26
rate
1957–1967 14.0 1987–31 Mar. 1991 18.7
1968 15.0 1 Apr. 1991–1992 17.7
1969 16.0 1993 17.5
1970–1972 17.0 1994 19.2
1973–1980 18.0 1995 18.6
1981 18.5 1996 19.2
1982– 18.0 1997 20.3
31 Aug. 1983
27
1 Nov. 1983–1984 18.5 2015 19.0–27.0
1985 18.7 2030 22.1–36.627
1 June 1985–1986 19.2
Table 3: Changes in contribution rates to the statutory pension scheme as a
percentage of gross wages/salaries28 in Germany29
Estimated demographic trends in Germany

Figure 1 and Figure 2 illustrate the differences in the age structure of the
German population between 1992 and 2040.30 In 1992, there were around 50
million people of working age and only around 19 million pensioners in
Germany, but the worst-case scenario expects this proportion to deteriorate by
2040 to around 35 million to 22 million. The number of young and working-age
people will thus fall sharply over the next few decades, while the number of
over-60s will probably rise by a good half by 2040.
8
THE SCENARIO TODAY
>79 >79
60-79 60-79
45-59 45-59
35-44 35-44
25-34 25-34
15-24 15-24
0-14 0-14
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Figure 1: Age structure 1992 Figure 2: Age structure 2040 (worst-case

estimate31)32
Replacement migration
One of the views voiced now and again during the political debate on the long-
term stabilisation of pension systems in the industrialised economies is that
there would be no need for second or third pillars to support the existing pay-
as-you-go system,33 if instead the mostly highly restrictive immigration laws
were liberalised so as to enable the rejuvenation of the population structure
through immigration.
A recent UN study that asks whether immigration is a workable solution for
the (PAYG) pension systems of the developed countries that are threatened by
adverse demographic developments up to 205034 came to the following key
conclusions that cast serious doubts on the workability of the political position
outlined above:35
x During the first half of the 21st century, the populations of most of the
countries and regions surveyed will shrink and get older (Table 4 shows
that the percentage population decline in the individual EU countries will
be up to 28% (in the case of Italy) between 2000 and 2050) because of
“below-replacement fertility” (i.e. less than 2.1 children per woman,36 see
Table 1) and increased longevity (Table 4 also shows that the number of
people aged 65 and above in the individual EU countries will rise by
between 53% (Sweden) and 117% (Spain) by 2050).
The notion of using immigration to rejuvenate a population centres
around the belief that the age structure of immigrants tends to be younger
than the population of the host country. However, research for the USA
comes to the conclusion that the “rejuvenating” effect of immigration on
the population there is only minimal.37
x Although birth rates may pick up again in the coming decades, it is highly
unlikely that they will return to replacement levels. Moreover, measures
to increase fertility in the short to medium term (roughly in the twenty
years following the introduction of the measures) have no effect on the
potential support ratio.
9
THE SCENARIO TODAY
Population Population Proportion 65 Increase in

(in thousands) decline years or older persons
Country aged 65
2000 2050 in 1000 % 2000 2050 years or
older (%)
Austria 8,211 7,094 –1,117 –14 15 30 106
Belgium 10,161 8,918 –1,243 –12 17 28 65
Denmark 5,293 4,793 –500 –9 15 24 59
Finland 5,176 4,898 –278 –5 15 26 72
Germany 82,220 73,303 –8,917 –11 16 28 73
Greece 10,645 8,233 –2,412 –23 18 34 92
Italy 57,298 41,197 –16,101 –28 18 35 92
Luxembourg 431 430 –1 0 14 27 84
Netherlands 15,786 14,156 –1,629 –10 14 28 104
Portugal 9,875 8,137 –1,738 –18 16 31 99
Spain 39,630 30,226 –9,404 –24 17 37 117
Sweden 8,910 8,661 –249 –3 17 27 53
United Kingdom 58,830 56,667 –2,163 –4 16 25 56
Table 4: Change in population and in the proportion of the total population aged
65 years or older for the EU countries that must expect a shrinking
population between 2000 and 2050
Taken across the average, the USA and the EU will be able to maintain stable
populations during the period under review with a level of immigration
comparable38 to that of recent years.39 For the EU, this prediction applies in
particular to France and the United Kingdom. In the case of Germany, it should
be noted that immigration levels in recent years cannot be seen as being
representative of the long-term trend because special circumstances pushed
them well above long-term levels. The other countries and regions studied
would need a level of immigration much higher than historical migration levels
to stabilise their populations.
x If immigration is to be used to prevent a decline in the working-age
population, the numbers of migrants will have to be significantly larger
than those needed to offset total population decline. The EU would need
an annual average of almost 1.5 million new immigrants, for example,
with Germany alone accounting for around 450,000.40 Estimates put the
cumulative total migration needed for the EU at almost 80 million
migrants, with more than 25 million going just to Germany.41 The practical
difficulties that would be involved in dealing with such high immigration
levels mean that this strategy could be no more than a short- to medium-
term solution to the pensions problem.
x The immigration levels needed to maintain the potential support ratio at
its current level would be so high that they would be unfeasible, both
politically and socially: around 700 million people would have to migrate
10
THE SCENARIO TODAY
to the EU by 2050 (or almost 13 million per year), and more than 188
million to Germany (almost 3.5 million per year).42
Figure 3 compares historical immigration to the EU in the 1990s with the
future immigration needed in the EU using the three scenarios – constant
total population (scenario A), constant working-age population (scenario
B) and constant potential support ratio (scenario C) – and shows firstly
that the scenario maintaining a constant total population largely matches
the historical migration figures, that the scenario maintaining a constant
working-age population is not too far out of reach, but that the
immigration needed to maintain the potential support ratio demands
immigration that is 10 to 30 times historical levels.
13,000,000
12,000,000
11,000,000
10,000,000
9,000,000
Historical
8,000,000
Constant working population size
7,000,000 Constant potential support ratio
6,000,000 Constant total population
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
0
1990 1991 1992 1993 1994 1995 1996 1997 1998
Figure 3: Historical net migration to the EU between 1990 and 1998 compared with
the three major future immigration scenarios for the EU for 1995 to 2050
Especially for scenario C, not only the absolute figures but also the ratio
of immigrants (and their descendants) to the local population reveals a
number of migrants that far exceeds what is politically possible: Germany,
for example, would see migrants and their descendants accounting for
80% of its population in 205043 (1990: 6.4%44). With a ratio of just under
70%43 (1990: 10.4%44), France would not be far behind. Even the relatively
low immigration ratio – measured against the other large EU countries –
of just short of 60%43 for the UK would be an unrealistic prospect.
Figure 4 shows a direct graphical comparison of historical and projected
immigration levels for the EU, contrasting the 1990 figure with the
projections for scenarios A to C: the figure of around 75% migrants in 2050
11
THE SCENARIO TODAY
as a consequence of net immigration of around 700 million people

between 1995 to 2050 (see above) for scenario C speaks for itself.
80% 74.7%
70%
60%
50%
40%
30% 25.7%
20% 16.5%
10% 5.8%
0%
1990 Constant total Constant working Constant potential
population size population size support ratio
Figure 4: Proportion of migrants 45 to total population in 1990, and projected to

2050 for scenarios A to C (EU)
x A potential alternative to high levels of immigration is an increase in the

retirement age; 75 would be the desirable age in 2050 (see Table 5).
x The demographic trends demand reform not only of the pension systems,
but also of the healthcare system (insurance contribution levels, quality of
benefits), as well as an increase in the labour force participation rate.
Country or Region Retirement age (years)

France 73.9
Germany 77.2
Italy 77.3
Japan 77.0
United Kingdom 72.3
USA 74.3
EU 75.7
Table 5: Retirement age that would be necessary in 2050 in the case of zero
immigration between 1995 and 2050 to maintain the same potential
support ratio as in 1995 (by country or region)46
12
THE SCENARIO TODAY
Funded pension systems to supplement the pay-as-you-go system

(three pillar model)
An alternative to benefit cuts and contribution hikes to remedy the impending
pensions shortfall, i.e. the fact that it will not be possible to maintain in the
future the standards of living that people have become used to with statutory
pension pensions alone,47 would be to supplement the existing pay-as-you-go
system by funded schemes – the thinking behind the “three pillar model” (see
Table 2).
Funded schemes work on the principle that regular contributions are used to
build up a savings “pot” that is then invested to fund the future pension.
Contributions are either paid jointly by the employer and the employee
(occupational pensions, pillar 2), or privately by the beneficiary alone (private
pensions, pillar 3). Some funded schemes also cover biometric risks in addition
to retirement provision.
Pillar Type of pension and financing

Pillar 1 flat-rate benefits, social security pensions (pay-as-you-go)
Pillar 2 occupational pension schemes (funded)
Pillar 3 private pensions, predominantly life insurance
Table 6: The “three pillar model” – sources of retirement income for employees in
the EU48
In addition, past experience shows that the effective return on securities

investments, i.e. the factor that determines the level of benefits from a funded
pension scheme, grew almost one and a half times faster than real gross earned
income between 1970 and 1995, the factor49 that determines pension payouts
under the pay-as-you-go system.50
Year Effective return on Growth in real gross earned income

securities investments
1970–1994 4.1 2.4
1970–1979 3.2 3.9
1980–1989 4.7 1.3
1990–1994 3.9 1.8
1990–1995 4.5 1.6
Table 7: Real interest rates and real wage growth in Germany between 1970 and
199551
13
THE SCENARIO TODAY
1994 level 1998 level Target level for 2020

Pillar 1 88.8% 83.5% 64.0%
Pillar 2 7.0% 11.6% 28.5%
Pillar 3 0.9% 1.5% 4.5%
Means-tested welfare benefits 3.3% 3.4% 3.0%
Table 8: Change in the share of sources of retirement provision in total EU pension
benefits between 1994 and 202052
It is still the case that the first pillar accounts for by far the greatest share of
pension benefits in the EU, but this will no longer be possible in the future – for
the reasons outlined above – and private-sector providers of pillar two and
three products53 will become increasingly involved. They could well increase
their current share of around 13% of total retirement provision to 33% in 2020,
with the second pillar accounting for 28.5% and the third pillar 4.5%. A
condition for this is that participation in the largely voluntary54 second pillar
practically triples from its current approx. 23% to 60%.55
A number of EU Member States have already reached or even exceeded this
level of supplementary pensions. In the Netherlands, the second pillar now
accounts for around one third of all retirement income.56 United Kingdom,
Denmark and Ireland are also playing a leading role in the EU in the
establishment of funded pension schemes.57 Taken together, the British, Irish
and Dutch pension funds currently account for more than 75% of the total
assets of all pension funds in the EU (see Table 9).58
Projections by the Bank of England for the assets of pillar two and three
pension systems in the EU indicate that between 1996 and 2001, pension fund
assets will grow from $630 billion to $1,800 billion, insurance company assets
from $2,600 billion to $6,300 billion, and mutual fund (unit trust) assets from
$1,680 billion to $3,230 billion.59
Country Share (%) Country Share (%)

United Kingdom 53.4 Spain 1.29
Netherlands 20.15 Finland 1.04
Germany 7.81 Belgium 0.59
Sweden 4.79 Portugal 0.59
France 3.95 Greece 0.2
Denmark 2.21 Austria 0.185
Ireland 1.91 Luxembourg 0.005
Italy 1.88
Table 9: Share of pension fund assets of the 15 EU Member States in total assets of
all pension funds in the EU at end-1997, total volume €1,627.35 billion60
The pillar 2 supplementary61 pension systems are generally financed by

pension funds,62, which in turn are broken down into defined benefit (DB)63 or
14
THE SCENARIO TODAY
defined contribution (DC)64 schemes:65 only in the latter case do pension

benefits depend on the returns generated from the contributions, and the
solidarity principle no longer applies. The upside of this arrangement, though,
is that employees therefore have an opportunity to benefit from potentially
higher returns than they might receive from DB schemes.
In the USA, there are also various hybrid forms in addition to these two
“pure” types of pension savings plans:66
x Combined plans consist of a guaranteed minimum pension (the “floor”),
supplemented by a pension savings plan with defined contributions.
Many employees in the USA have this sort of pension savings plan, with
401(k) plans mostly used for the DC component.
x Cash balance plans are technically DB plans, but also incorporate some of
the features of DC plans, such as a lump-sum payout instead of a regular
pension, and the beneficiary bearing the longevity risk. The volume of
these plans is still low at present.
x The benefit payout of pension equity plans depends on the age and final
salary of the beneficiary.
x Target benefit plans are DC plans that emulate the payout arrangements
of DB plans, although the actual benefit may be higher or lower than the
target benefit.
Pillars two and three have much in common, but are not (yet67) subject to the
same rules because of the differences between pension funds (pillar 2) and life
insurance products (pillar 3):68
x Pension fund liabilities are more long term because of the longer
maturities, the general impossibility of early surrender and because loans
cannot be extended, in contrast to life insurance policies (with the life
insurance policy serving as collateral). They therefore invest in long-term
assets.
x Pension fund liabilities are often tied to salary developments (defined
benefit), while life insurance policies are oriented on a nominal value.
x DB pension funds will pursue an investment policy so that they can fulfil
their “benefit guarantee” whatever the actual investment return. Life
insurance companies rarely offer this sort of guarantee.
Although they are as a rule highly sceptical about the notion of state welfare,
even the Americans have no desire to abolish their Social Security system69 and
replace it by private pensions. They mirror the predominant view in the EU
that the state pension system should be retained as the first of three retirement
provision pillars, with occupational pensions representing the second pillar and
private pensions the third, and that its long-term stability should be secured.
What is quite clear, however, is the belief that the second and third pillars
should be expanded to reduce the growing strains on Social Security due to
demographic shifts.70
15
THE SCENARIO TODAY
DB and DC schemes are also widespread in the USA, but there has been a
“dramatic” shift in pension fund assets towards DC plans since the late 1990s.71
The total volume invested by Americans in pension plans was more than $2.9
trillion in 1996.72
Germany’s latest pensions reform
Overview
Mid-1999 saw German policymakers mulling the introduction of a system of
obligatory funded occupational pensions to supplement the state pension
system, whose contributions and benefits could then be reduced
appropriately.73 Political backing slipped away, however, following public
attacks on the compulsory nature of the proposals.74 On 31 May 2000, German
labour minister Walter Riester put forward a new reform strategy that now
proposed a voluntary top-up pension,75 although the final draft legislation also
provides for state subsidies.76
Based on the expected higher return from a funded scheme than an
unfunded scheme (see Table 7), the proponents of a supplementary pension
model believe that total (and in future lower) contributions to the state pension
scheme plus contributions to the supplementary occupational pensions would
be lower than contributions to the state pension scheme at their present,
unchanged level.77 One of the arguments used to counter critics of the funded
approach, who think that it is more risky than the pay-as-you-go system, is that
even the worst-case scenarios involving the sort of prolonged stagnation or
recession that both empirical experience and a variety of (economic) cycle
theories suggest is likely to recur will produce a level, albeit modest, of long-
term growth that is in any event higher than the performance of the unfunded
system, which experience shows would be close to zero.78 Section 5.1.1:
Prudence, not extensive quantitative restrictions, in the EU and the USA, discusses in
greater detail the conflict between risk and reward in the long-term investment
horizons that typify pension funds.
The Altersvermögensgesetz (AvmG – Old-Age Provision Act)79 passed by the
Bundestag on 26 January 2001, which represents the legal basis for the pensions
reform and is scheduled to come into force on 1 January 2002, was initially
rejected by the Bundesrat, the upper house of the German parliament, on 16
February 2001; following negotiations in the mediation committee,80 though, it
was finally enacted on 11 May 2001.81 One of the stated objectives of this reform
is to cap increases in the pension insurance contribution rate, with a ceiling of
under 20% until 2020 and a maximum of 22% by 2030. The law obliges the
German government to intervene if these levels are exceeded.82 The main
points of this legislation are:83
x Development of supplementary funded pensions (pillar 3).
x Employee entitlement to an occupational pension financed by salary
deductions with immediate statutory vesting (pillar 2).
16
THE SCENARIO TODAY
x Introduction of a needs-driven basic provision.84

x Pension insurance institutions will have to inform policyholders once a
year about the status of their pension rights.
x Long-term reduction in pensions from 70% to around 67% to 68% of final
earnings in 2030.85 To achieve this objective, the pension formula (see
Equation 1) will be modified so that the link between pensions and net
pay will in future be restricted.86 However, experts point out that since
1999, European law has changed the way pensions are calculated, so that
a guaranteed 67% level corresponds to a 64% level using the previous
methodology.87
Monthly pensiongross = Personal earnings points · Pension type factor · Current

pension value
where:
x Earnings points are calculated as the ratio resulting from the division
of annual income by average income.
x The pension type factor governs the provision objective of the pension
type under consideration, i.e. the extent to which the pension
concerned is designed to replace a salary. For example, old-age
pensions and occupational disability pensions designed to replace
salary in full have a pension type factor of 1.
x The current pension value is the amount corresponding to the monthly
old-age pension after one year’s average income. For the year
starting 1 January 2002, the current pension value in western
Germany is €25,31406, and €22,06224 in eastern Germany.88
Equation 1: German pension formula89
This pensions reform has received a poor rating from many experts,
however, because they say that the assumptions underlying the reform are
either over-optimistic or contain a number of contradictions:
x The assumptions for life expectancy, immigration (190,000 immigrants per
year), unemployment (3%) and retirement age result in the provision
shortfall being seriously underestimated at a mere two per cent, instead of
the expected 20 per cent. This means that the maximum statutory pension
insurance contribution rate in 2030 will not be 22% (see above), but rather
25% to 27%.90
x The forecast that the proportion of working women will be the same as for
men in a few years would imply a significant change in the present
situation, where 90% of men aged between 30 and 60 are working,
compared with only 70% of women in the same age group. In addition,
there is no reason to expect that the number of contribution payers in
eastern Germany (the former GDR) will remain constant as assumed, as it
is likely to fall by 25% by 2030 and to even halve by 2050.
17
THE SCENARIO TODAY
In view of the by now very commonplace gaps in working life, the

assumption of “standard pensioners” with 45 contribution years is also
unrealistic.
With the number of pensioners set to rise by 10 million by 2050, but the
number of contribution payers projected to fall by 16 million – even if
immigration hits 170,000 per year – this means that either the contribution
rate would have to be hiked to 46% by that year or pension levels slashed
to 30%. The maximum 4% top-up pension contribution (2008 onwards)
now adopted in the new law appears woefully inadequate to make good
this shortfall.91
x Economics Nobel Prize winner Franco Modigliani has criticised the
savings rate of initially 1% (2002) rising to a maximum of 4% of gross
income from 2008 (see below); this is so low, he thinks, it is practically
“nothing”.92
x The planned reduction in pensions to around 67% by 2030 (see above) is
not sufficient, as such a level cannot be financed in the long term, says Kai
Konrad, Professor of Public Finance at the Free University of Berlin.93
Funded supplementary private pension (pillar 3)
1. State support: The retirement provision contributions are a combination of
contributions by the employee and monthly state allowances,94 that depend
on marital status and the number of children (see Figure 5):
Pension contribution as
percentage of gross Annual allowance
95
income (tax-deductible or
as a special personal per
96 per child
deduction) employee
from 1% €46
2002 €38
€76 €92
from
2%
2004
€138
from 3% €114
2006
€185
€154
from 4%
2008
Figure 5: State support under the German Old-Age Provision Act97
18
THE SCENARIO TODAY
x The basic allowance rises from €38 in 2002 and 2003 gradually to €154
starting in 2008.
x The child allowance rises from €46 per child in 2002 and 2003 gradually to
€185 per child starting in 2008.
These payments are reduced if a defined percentage (rising from 1% in

2002 and 2003 gradually to 4% starting in 2008) of the previous year’s income
subject to statutory pension insurance contributions up to the maximum
income threshold for contribution assessment in western Germany
(currently €52,500/year) is not invested in pension provision (personal
contributions + allowances). Even where the allowances themselves account
for 4% of this calculation basis, a certain minimum personal contribution
must be paid, irrespective of the number of children.98
For a married couple with two children and only one breadwinner earning
€25,000 gross per annum, for example, this means that 4% of €25,000, i.e.
€1,000, is scheduled as a contribution to the supplementary pension up to
2008. If the personal contribution is €322, the state will contribute €154 for
each parent and € 185 for each child, producing a total of €1,000.99
In the final phase starting in 2008, all these state support measures will cost
around €10 billion a year.100 The German labour ministry has presented a
similar model calculation based on an annual income of DM 80,000 (€40,903)
and three different scenarios regarding marital status, demonstrating both
the effects of the allowances and the alternative tax savings101 by deducting
the pension cost (see Figure 6).
State allowance State top-up ratio
3500 DM Actual personal contribution
3000 DM
26%
2500 DM
35%
2000 DM 41%
1500 DM
1000 DM
500 DM
0 DM
Single, no children Married, no children Married with 2 children
Figure 6: State pension subsidies based on allowances or tax savings in 2008 for an
annual income subject to statutory pension insurance contributions of
DM 80,000102
2. Subsidised investment products are pension insurance policies, funds and

bank savings schemes (with payout plans and compulsory annuitisation of
19
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the rest103), existing contracts and residential property104 under certain

conditions.
As the certification agency, the German Federal Insurance Supervisory
Office will examine whether an investment product satisfies the eligibility
criteria (listed below) for pension products. However, this certification does
not represent any government seal of quality for the return and security of
the investment product concerned.105 Allianz AG emphasises the security-
related aspects of these criteria when it states that “speculative forms of
investment” are excluded from the state subsidy scheme.106
The requirements set out in the criteria are:107
x The benefit is not paid out until the beneficiary is entitled to a
retirement pension or an occupational disability pension or reaches the
age of 60.
x The plan must involve an annuity or a payout plan with annuitisation
of the remaining capital.
x Guaranteed life-long constant or increasing benefits.
x At the start of the payout phase, at least the contributions paid (nominal
value maintenance), and during the payout phase the continuing
payments, must be guaranteed.
x Protection against assignment and pledging of the pension assets.
x Initial commission and selling costs must be spread over ten years.
x The saver must receive the following information at the time of closure:
amount and distribution over time of the initial commission and selling
costs, asset management costs, cost of switching to another product.
x Continuing annual disclosure obligations to the insured persons:
utilisation of contributions, capital accumulation, costs and revenues, as
well as whether – and to what extent – ethical, social and ecological
aspects are considered when using the contributions paid.
3. Deferred taxation:108 During the savings phase, payments of up to 4% of the
income threshold for contribution assessment can be paid from untaxed
income. Interest and income are also tax-exempt in the savings phase. Only
the monthly payments in the payout phase will be taxed.
Supplementary occupational pensions (pillar 2), especially pension funds
Direct insurance, staff pension schemes (“Pensionskassen”) and pension funds
are eligible for government support.109
The regulatory requirements for pillar 2 are largely identical to those for the
third pillar, except that the pension contributions are paid by the employer. In
the case of staff pension schemes (“Pensionskassen”) and pension funds, they are
permanently free of taxes and social security contributions up to the amount of
4% of the maximum income threshold for contribution assessment for the state
pension scheme. This means that only pension funds and staff pension
schemes can derive the benefits of deferred taxation. Direct insurance policies
are excluded, which is why Allianz-Lebensversicherungs AG threatened to
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challenge the constitutionality of this arrangement in mid-April 2001, citing

what it saw as a breach of the constitutional principle of equality of tax
treatment.110 At stake here are the substantial additional investments in
insurance and fund products that will be triggered by the pensions reform: an
estimated €25.6 billion per year starting in 2002, rising to €64.4 billion by 2008.111
The German government explicitly emphasises the advantages of pension
funds:112
x employees have a legal claim on the pension fund as the external sponsor
of the pension scheme.
x if employees switch jobs, their entitlements continue and are portable,
encouraging workforce mobility.
x they strengthen Germany as a financial centre, because the long-term
nature of retirement savings plans increases investment in real assets such
as equities.
x Instead of a benefit commitment,113 a commitment to maintain the
nominal value is all that is required in future. Highlighting this as a benefit
is questionable because there is no mention whatsoever of the possibility
of a DC system.114 Moreover, the requirement to guarantee the nominal
value necessarily restricts investment opportunities, resulting in a less
than optimum risk/reward combination for the investment.115
The German government believes that pension funds enjoy “greater
investment discretion”116 and are able to invest “relatively freely on the capital
markets”,116 which is why it calls for the establishment of mandatory
“international risk management standards”116 with the aim of “matching the
investment strategy to the profile of the obligations to the members of pension
schemes”.116 Pension funds can be structured as DB113 or DC114 schemes.117 In
addition, the Federal Banking Supervisory Office will examine the solvency of
the fund manager.118 Prudential supervision will be governed in its entirety by
the Versicherungsaufsichtsgesetz (Insurance Supervision Act) despite the fact that
pension funds are subject to more liberal investment rules than insurers.117
2.1.2 The pioneers in mutual fund-based retirement

planning
USA – the global pacesetter
The US Social Security system accounts for only 40% of pensions in the USA,
which is consequentially seen as the “home” country for funded personal
pensions.
Private pensions in the USA comprise both second pillar pension funds,
normally structured as 401(k) plans,119 and pillar 3 provision through Individual
Retirement Accounts (IRAs).119 Both of these schemes are portable across
employers.120 They are taxed on an Exempt-Exempt-Taxed (EET) basis,121 can be
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paid out either as a pension or in a lump sum, and may also be extended to
cover biometric122 risks.123
The United Kingdom leads the field in Europe

As in the USA, the second and third pillars now shoulder the main burden of
retirement provision in the United Kingdom, with pillar one pension payments
now reduced to no more than around 20% of average wages. The status of
equity investments for pension provision is even stronger than in the USA,
with 80% of funds invested directly in equities – or indirectly through mutual
funds/unit trusts – in 1995, compared with a mere 13% invested in bonds.124
The most important instruments for retirement planning are:
x Personal Equity Plans (PEPs). These were introduced in 1986 to encourage
the development of personal equity (fund) portfolios. Originally, equities
were the only investment instruments allowed for PEPs, but investment
funds and corporate bonds were added at a later date. Up to £9,000 can be
invested annually tax-free (i.e. exempt from income tax and capital gains
tax). A condition for tax exemption is that the PEP is invested in securities
issued by EU companies, with the exception that up to a maximum of
£1,500 can be invested each year in other securities. The law was changed
such that no new PEPs can be taken out effective 6 April 1999, almost
certainly as a result of the loss in tax revenue due to the exceptionally
generous tax breaks. Existing PEPs can be continued tax-free for a further
five years. PEPs have not been replaced by Individual Savings Accounts
(ISAs), which offer fewer tax breaks. By mid-1999, there were 13.3 million
PEPS in place with a total investment volume of £56.9 billion.125
x Individual Savings Accounts (ISA). Introduced in 1999, these allow less
equity-centric investment, and funds can also be invested in bonds,
money market funds and life insurance policies. Up to £7,000 can be
invested in an ISA from taxed income, and gains are not subject to income
or capital gains taxes.126
Similar to the USA – albeit only since the late 1980s – DC schemes are
gradually overtaking DB models.127
Modest first pillar in the Netherlands supplemented by pension

funds
The Dutch first pillar only covers basic needs, with the basic state pension
currently equivalent to a maximum of 70% of the statutory (monthly) minimum
wage, around €500.128 This means that around half of retirement income comes
from public funds.129 It is supplemented in particular by pension funds, which
account for around one third of Dutch pension payments. DB systems are
standard – and increasingly now hybrid DB and DC schemes130,127 as well –
featuring mandatory annuitisation and EET.
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Around 80%131 to 90% of the workforce is covered by non-statutory

supplementary occupational pension plans, with the remainder covered almost
entirely by third pillar pension plans. The occupational pensions are not
required by law, but are based on a consensus between the “social partners” –
the employers’ associations and the trade unions – that has seen the
establishment of industry or company-specific pension plans, a process that is
still continuing.
These pension plans are administered as pension funds jointly by employers
and union representatives132 using the prudent man rule.133
The mid-1980s saw a trend away from bond-centric investment policies
towards increased investment in equities.
Sweden’s 1998 reforms as a model for Scandinavia

Sweden implemented a far-reaching reform of its pensions system in 1998,
which has also served as a model for restructuring the pension systems of other
countries such as Norway and Latvia.
Sweden now has a hybrid system centred around the traditional pay-as-you-
go system, but supplemented by a funded DC system.134 Pension contributions
are fixed at 18.5%, with 16% paid to the unfunded system and 2.5% invested in
pension funds.
Apart from special allowances for people in low-income brackets, the reform
has now established a clear link between contributions and later benefits: the
higher the contributions and the return generated on them, and the later the
retirement age, the higher the pension will be, all other things being equal. This
encourages retirement at a later age because pension payments are then higher
– firstly because contributions can be invested for a longer period, and secondly
because remaining life expectancy on retirement, which is also a factor that
determines pension levels, is lower. The minimum retirement age is 61, with no
ceiling above this age.135
Compulsory occupational pensions in Switzerland

Since 1985, the Swiss state pension has been supplemented by a compulsory
occupational pension scheme covering around 90% of all employees. Amounts
over and above a certain minimum provision can be invested in DC schemes134
that are increasingly gaining the upper hand.
Strict statutory investment rules oblige plans to follow a bond-centric
investment policy: a maximum of 30% can be invested in Swiss and 25% in
foreign equities. All forms of equity instruments together may account for no
more than 50%.
Both occupational and certain forms of personal pensions are subject to an
EET regime.136
Benefits are normally paid out as a pension. Lump-sum payouts are possible
only if the occupation pension is less than 10% of the minimum pillar one old-
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age pension, or the plan sponsor provides for one-time payments in its
regulations.137
Experts believe that the Swiss now have one of the best pension systems with
a highly even-handed distribution of the pension burden across the three
pillars. At present, the statutory unfunded system accounts for 42%,
occupational pension schemes 32% and personal pensions 26% of total pension
obligations.138
2.1.3 Harmonisation of the European capital markets and the

Single Currency
Since 1998, the EU has been working on a “Financial Action Plan”139 together
with the Member States and industry;140 the aim of this initiative is a
fundamental reform of the entire European financial services sector, with
implementation scheduled to be completed in 2005.141 The European
Commission attaches great importance to the financial markets, including from
an employment perspective, and points out that financial services currently
account for around 6% of EU GDP and 2.5% of its workforce.142 The
Commission approved this Action Plan on 11 May 1999. It contains proposals
for a variety of political objectives and specific measures to improve the single
market for financial services over the next five years,143 focussing on the
following core aspects:144
x increasing the liquidity of the European capital markets to benefit both
investors and issuers,
x simplifying the cross-border marketing of financial services, in particular
by removing remaining barriers to cross-border provision of retail
financial services, while maintaining and improving consumer protection.
This also aims to complete the single market for UCITS145 and other
investment vehicles. In particular the introduction of a “single European
passport” will give service providers an opportunity to operate throughout the
EU on the basis of authorisation in their home country.146
Pension funds – the only significant financial services segment that is not yet
governed by a specific EU regulatory framework147 – will be harmonised148 by
draft directives149 covering their supervision150 and taxation.151 The European
Commission finally published its rather sparse proposal for a Pension Fund
Directive on 11 October 2000, structured as follows:152
Article 1 Subject-matter
Article 2 Scope
Article 3 Application to institutions operating social security schemes
Article 4 Optional application to institutions covered by Directive 79/267/EEC
Article 5 Small pension schemes and statutory schemes
Article 6 Definitions
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Article 7 Activities of the institution

Article 8 Legal separation between the plan sponsor and the institution for
occupational retirement provision
Article 9 Conditions of operation
Article 10 Annual accounts and annual report
Article 11 Information to be given to the members and beneficiaries of the schem
Article 12 Disclosure of investment policy principles
Article 13 Information to be provided to the competent authority
Article 14 Powers of intervention of the competent authority
Article 15 Technical provisions
Article 16 Funding of technical provisions
Article 17 Regulatory own funds
Article 18 Investment rules
Article 19 Management and custody
Article 20 Cross-border activities
Article 21 Implementation
Article 22 Entry into force
Article 23 Addressees
For taxation, an EET system would appear to offer the greatest benefits to the
tax authorities of all EU Member States. Under this system, contribution
payments, investment income and capital gains would be tax-free, while the
benefits (pensions or lump sums) would be taxed. The reason for the
advantages is that the bulk of the retirement provisions existing at the time the
beneficiary retires come not from the contributions, but from investment
income and capital gains,153 in other words the tax base is much higher in the
case of EET than for advance taxation. For finance ministers, this means
choosing between collecting a small amount immediately (and cutting the
beneficiary’s future pension because lower, taxed contributions will produce
correspondingly lower investment income) or collecting substantially more
(much) later. In view of the continued strained budgetary position in several
EU Member States, there will be a strong temptation to opt for the first system,
despite the economic disadvantages, and this in turn means that EU-wide EET
harmonisation is vital to prevent any such moves.
Prudential supervision will cover154 licensing, reporting requirements, “fit
and proper” criteria155 and rules on liabilities and investments (quantitative
investment rules will be supplemented156 by the prudent man rule).157
The BVI, the German investment companies association, is calling for “AS-
Fonds”158 (special German retirement pension investment funds) to be
incorporated within the scope of the directive.159 The European Commission
thinks that pension funds are important not just for retirement provision, but
also play a key role in improving the flow of funds towards private sector
investments because pension funds are increasingly investing in equities.160 It
also anticipates a cut in non-wage labour costs by relieving the state pension
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THE SCENARIO TODAY
system and thereby creating new jobs.161 The Commission is forecasting growth
in pension fund assets from around €2,000 billion in 1999 to €3,000 billion by the
end of 2005.162
In addition, EU-wide harmonisation will enhance worker mobility and help
the pension fund management companies achieve economies of scale163 that
can be passed on (in part) to the fund members in the form of lower
contributions or higher benefits.
Year-end Asset volume (€bn) Actual harmonisation of financial

1997 1,627.35 services has progressed much faster in the
2000 2,107.47 wholesale EU markets than in the retail
markets. Nevertheless, the Commission is
2005 3,242.60
still not happy with the state of the EU’s
2010 4,989.14
wholesale markets, in particular because it
2015 7,676.41
is convinced that the euro alone is no
2020 11,811.10
guarantee that a single wholesale market
will function properly. The Financial
Table 10: Forecast growth in EU-
Action Plan therefore proposes the
wide pension fund assets
until 2020 164 elimination of numerous legislative,
administrative and fiscal barriers.165 To
harmonise the retail financial markets, the Commission thinks that the priority
is to ensure a clear and generally accepted distinction between professional and
non-professional investors. It also has plans to catalogue the current national
differences in those rules for which the Member States are responsible, and to
ensure convergence of national practice towards a high level of consumer
protection.166
The harmonisation efforts also envisage a greater level of coherence in the
rules governing pension funds, life insurance and UCITS, which the
Commission classifies as “largely interchangeable products”. At present, these
products are subject to diverse regulatory requirements, as well as differing tax
treatments. The objectives of these measures are to promote a level playing
field and to ensure greater transparency for consumers,167 although the
introduction of the single currency is itself a major step in this direction.168
The euro will enable more efficient portfolio management by eliminating the
exchange risk, cutting transaction costs and stimulating competition between
market players. The capital markets will grow both horizontally and vertically,
and the Commission believes that the growth potential in the EU’s poorly
developed retail equity and bond markets is huge, especially in the corporate
bond segment.169 With the volume of new government debt issues set to
decline as public finances are restructured, these will gain in importance and
could become a significant source of income for pension fund portfolios.
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2.1.4 No traditional equity culture in German-speaking

countries
Although the volume of mutual funds in Germany doubled between 1997 and
1999, it is still trailing the trend in other comparable countries by a wide
margin: per capita invested assets are higher even in Spain and Italy. The USA
leads the world with $50,000 per person, and the average German – with per
capita invested assets of €4,775170 at the end of 1999 – owns only around one
third of the asset volume of his French neighbour. Austria and Switzerland, the
two other German-speaking countries, are also well ahead of Germany with
per capita invested assets of €9,919 and €12,140 respectively (see Figure 7).171
C zech R ep. 142

H u n g a ry 163
S o u th A fr ic a 443
D e n m a rk 1268
A u s tr a lia 1983
Per capita invested assets at end-1999 (€)
F in l a n d 2009
P o r tu g a l 2433
G re e ce 3180
N o rw a y 3415
Japan 3970
G e rm a n y 4775
S p a in 5222
N e th e r l a n d s 5407
B e lg i u m 5495
UK 6916
Ita ly 8251
C anada 8841
Sweden 9394
A u s tr ia 9919
F ra n ce 11186
S w itz e r l a n d 12140
USA 25522
0 5000 10000 15000 20000 25000 30000
Figure 7: Per capita invested assets at end-1999 (€)172
Nonetheless, Germany is now experiencing a trend away from traditional

savings deposits and towards savings vehicles with higher returns, including
investments in mutual funds. Evidence for this shift is provided by the
development of private financial assets between 1990 and 1998 (see Table 11
and Figure 8). Whereas “safe” investment forms recorded mostly modest
growth – or even fell – during this period (long-term savings deposits -2%,
building society deposits +42%, bonds +69% and insurance policies +91%),
the amount of money invested in equities grew by 177%, and the volume
invested in mutual funds soared by as much as 326%.
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1990 1995 1996 1997 1998

Long-term bank deposits 229.5 256.7 245.0 234.6 224.6
Insurance 289.6 435.1 472.3 511.9 552.7
Building society deposits 64.3 79.3 84.2 88.9 91.3
Fixed-income instruments 230.6 370.8 379.6 396.1 390.0
Mutual funds 68.0 181.1 201.2 239.9 289.5
Equities 90.6 133.7 161.3 226.5 251.4
Table 11: Private financial assets in billions of euros in Germany 1990–1998173
Long-term bank deposits

450
Insurance
Building society deposits
400
Fixed-income instruments
Mutual funds
Indexed growth (1990 = 100)
350
Equities
300
250
200
150
100
1990 1995 1996 1997 1998
Figure 8: Private financial assets in Germany, indexed presentation with 1990 = 100
A trend reversal for retail investments in mutual funds has also emerged
since mid-1999, with bond funds giving up their lead to equity funds, which
accounted for 61% of new investments in mid-2000.174 In 1999, new cash flow to
mutual funds reached a record €110 billion,175 distributed across the various
fund types as shown in Table 12: at €33 billion, equity funds recorded the
largest new cash flow, while bond funds actually suffered an outflow of €3.8
billion, producing a volume of equity funds (€176 billion) that was almost 57%
larger than that of bond funds (€112,3 billion). In 1998, this difference was still
69% in favour of bond funds.
In 2001, the assets managed by German investment companies176 for retail
investors grew to €404 billion, with equity funds accounting for around 50% of
the total.177
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Fund type New cash New cash Volume 1999 Volume 1998
flow 1999 flow 1998
Equity funds 33.2178 176.0175 87.1175
178 175 175
Bond funds –3.8 112.3 122.3
180 180
Hybrid funds 3.3 1.5 14.8 8.1
Money market funds 4.3180 4.8180 33.3180
AS-Fonds179 0.9180 1.6180
Open-end real estate 7.5181 50.4175 43.2175
funds
182
Total publicly offered 46.0 22.7182 391.6183 288.4183
funds
Special Funds184 64.6181 68.0181 474.0183 369.2183
Total 110.6182 90.7182 865.6183 657.5183
Table 12: Growth in new cash flow and volumes of various fund types in billions
of € in Germany between 1998 and 1999
Investment patterns in the USA are dominated by a model that is

substantially different to Germany, with around half of all households owning
mutual fund shares in June 2000.185
60 mn 60%
Households (mn)
50 mn Households (%) 50%
40 mn 40%
30 mn 30%
20 mn 20%
10 mn 10%
0 mn 0%
1980 1984 1988 1992 1994 1996 1998 1999 2000
Figure 9: Growth in number and percentage share of US households owning

mutual funds between 1980 and 2000186
29
THE SCENARIO TODAY
In 1990, 74% of the entire mutual fund assets in the USA were held
privately,187 and this share had risen to 81% by 1999.188 The number of
individual investors owning mutual funds rose from 77.3 million in 1998 to 82.8
million in 1999189 and to 87.9 million in 2000.
Most investors who buy mutual funds are seasoned equity investors, as
shown by the figures relating to direct or indirect equity ownership at
31 December 1999: the year of first direct/indirect equity purchase was prior to
1990 for 54%, between 1990 and 1995 for 28%, and after 1995 for only 18%.190
Investment saving therefore has a tradition in the USA, and is not a fad
triggered by the booming equity markets in the 1990s.
There is an evident trend in the USA away from direct equity holdings and
towards mutual funds, as US households have sold more direct equity holdings
than they bought indirectly through mutual funds every year since 1994. The
mutual fund industry is clearly benefiting from this trend, which is being driven
in particular by tax privileges for certain mutual fund-based retirement plans .191
Since the early 1990s, equity funds have overtaken bond funds in terms of
annual net new cash flows, and widened the gap appreciably in 2000, when
equity funds recorded a net cash flow of $309.6 billion, but bond funds suffered an
outflow of $48.6 billion. In terms of annual net new cash flows, equities are the clear
leader overall, followed by money market funds, with bond and hybrid funds well
beaten into last place (see Figure 10). Net new cash flows represent the difference
between (1) fund shares sold, including shares transferred with the same fund
family, but excluding reinvested distributions, and (2) repurchased shares,
including those transferred within the same fund family, with the total net
amount of shares transferred within fund families being zero.192
500
Equities
Bonds
400 Hybrid
Net new cash flows ($bn)
Money market
300 Total
200
100
0
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
-100
Year
Figure 10: Net new cash flows to mutual funds in the USA between 1984 and
2000193
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8000
Equity funds
7000 Hybrid funds
Bond funds
6000
Money market funds
5000 Total
$bn
4000
3000
2000
1000
0
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Year
Figure 11: Volume of US mutual funds by fund type 1984 to 2000194
In terms of total investment volume, the ranking is the same as for annual
net cash flows. The volume of equity funds in 2000 was $3,962.3 billion, and
thus more than double that of money market funds ($1,845.3 billion), the
second-largest group. At $808 billion, bond funds were only about 20% of the
size of the equity funds. However, the sharp increase in the volume of equity
funds from the mid-1990s came to an abrupt stop in 2000 when the markets
started sliding in March of that year (see Figure 11).
Although the figures presented above show clearly that equities dominate
the mutual funds market, equity fund assets only accounted for 14%195 of total
corporate equities (17% in 1999196), although there are still the largest
institutional investor.
Typical US mutual fund investors are in their mid-40s and saving for
retirement. They have moderate financial means and invest one third of their
assets in funds, most of which they have bought through employer-sponsored
retirement plans. Seven out of eight households include equity funds in their
fund investments.197
Mutual funds accounted for just under 20% or $2.5 trillion of all US
retirement assets ($12.7 trillion) in 1999 (Figure 12 presents the growth in the
volume of US retirement assets between 1990 and 1999; Figure 13 shows the
growth in the mutual fund share of US retirement assets between 1990 and
1999) and thus represent more than a third of all US funds in their entirety (see
Table 15: the total volume of US funds in 1999 was $6.85 trillion). This means
that the share of retirement assets in mutual funds rose from 19% in 1990 to
35% in 1999.198
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THE SCENARIO TODAY
Employer-sponsored pension plans

IRAs
10.2
$bn
8.9
7.8
6.6
5.7
4.9
4.6
4.2
3.8
3.4
2.5
1.7 2
1.3 1.5
0.8 0.9 1 1.1
0.6
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Figure 12: US retirement assets between 1990 and 1999199
20
19
17
16
15 15
13
11
Percent
10 10
8
7
5 5
0
19 90 199 1 199 2 199 3 1 994 1 995 19 96 19 97 19 98 1999
Figure 13: Mutual fund share of US retirement assets between 1990 and 1999199
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THE SCENARIO TODAY
The remaining 80% of US retirement assets ($10.2 trillion) is managed by

pension funds, insurers, banks and brokers.200 This $2.5 trillion comes mostly
from two sources – employer-sponsored pension plans or individual retirement
accounts in around equal proportions (see Table 13).
Year Total Employer-sponsored IRAs (Individual Retirement
201
pension plans Accounts)
1991 350 161 189
1992 442 203 239
1993 601 277 324
1994 681 329 352
1995 934 455 479
1996 1199 597 602
1997 1542 778 764
1998 1920 975 944
1999 2472 1250 1222
Table 13: Retirement planning investment in mutual funds in billions of USD202
Of the $2.5 trillion in mutual fund retirement assets in 1999, 76% per cent was
invested in equity funds (67% US equities, 9% foreign equities). By contrast, the
equity fund share of overall mutual fund assets, i.e. including non-retirement
mutual funds, was only 59% in 1999.203
The first retail mutual fund was offered in the USA in 1924.204 Since that date,
the number of fund companies has risen sharply. A review of the years 1979 to
1999 produces the following picture for all fund companies that are members of
the Investment Company Institute, accounting for 95% of US mutual fund
assets205 (see Table 14).
Year Number of fund Year Number of fund

206
complexes complexes
1979 119 1990 361
1980 123 1991 361
1981 134 1992 364
1982 150 1993 375
1983 164 1994 398
1984 189 1995 401
1985 217 1996 417
1986 261 1997 424
1987 314 1998 419
1988 349 1999 433
1989 357
Table 14: Growth in the number of fund companies that are members of the
Investment Company Institute between 1979 and 1999207
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Paul Royce, Director of the Division of Investment Management at the SEC,

attributes this success of the investment management industry among other
things to the existence of a regulatory framework that helped ensure the
integrity of the industry. In the 1920s and 30s, the early days of the US
investment industry, there was widespread abuse before the Investment
Company Act of 1940 came into force. There were still no comprehensive
disclosure rules, so investors were kept in the dark about how their money was
actually being invested, or about self-dealing.208 The Investment Company Act
of 1940 is credited with establishing the ground-rules that allowed investor
confidence to be regained. This increased confidence was illustrated by the
tripling of US mutual fund assets between 1941 to 1945 despite the Second
World War.209
2.2 THE NEED FOR ASSET MANAGEMENT STANDARDS

IN THE EURO ZONE
2.2.1 Avoiding capital misallocation

The European Commission too emphasises that efficient and transparent
financial markets help optimise the allocation of capital, and that the EU’s
financial services sector is lagging behind its counterparts in other
industrialised countries.210 The Commission’s Financial Action Plan aims to
remedy this situation.211
A factor that should be taken into account during the drafting process for the
Pension Fund Directive212 is that quantitative investment restrictions213
discourage the efficient allocation of capital and thus not only jeopardise
pension provision, but also adversely affect growth and employment214 because
pension contributions have to be kept unnecessarily high. This increases non-
wage labour costs, which in turn encourages the exodus of labour-intensive
industries and the substitution of labour by capital.
2.2.2 The US asset management industry as the prime

competitor
Europe faces a major challenge because of the huge volume of assets managed
by the US mutual funds and the well-established tradition of regulating these
funds to protect investors.
The crucial significance of the US fund industry is also demonstrated by the
fact that the US investment company share of global open-end funds is almost
double that of the rest of the world together (see Table 15).
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Country/Region 1994 1995 1996 1997 1998 1999

Austria 23,492 33,452 39,543 44,930 63,772 74,557
Germany (excl.
Special Funds) 112,697 134,543 137,860 146,888 195,701 209,949
Japan 435,603 469,980 420,103 311,335 376,533 472,233
United Kingdom 133,092 154,452 201,304 235,683 283,683 326,571
Total non-US 2,315,443 2,574,445 2,815,890 2,769,143 3,143,045 3,524,230
USA 2,155,396 2,811,484 3,526,270 4,468,201 5,525,209 6,846,339
Table 15: Worldwide assets of open-end investment companies in millions of USD

between 1994 and 1999215
On top of this, the US fund industry is now showing signs of wanting to

expand outside the USA. This could threaten the European fund industry if it
does not respond quickly and build on its existing strengths by establishing
competitive standards so as not to leave the entire field open to the Americans.
For example, the ICI is actively lobbying both inside and outside the USA for
the removal of barriers to market entry for US funds in Europe (and Asia). At
the same time, the ICI is trying to eliminate legal (fiscal) barriers to investments
in US funds by foreigners,216 noting that only 1% of overall US mutual fund
assets are held by non-US investors.217
On the other side of the Atlantic, the European fund industry is in turn
calling for equality with US funds on the US market: existing regulations make
it impossible to sell European funds in the USA, while certain EU Member
States, including Germany and Austria, permit the public sale of US mutual
funds.
The BVI and FEFSI, the European investment fund industry organisation, are
consequently calling on the European Commission (and the German finance
ministry) to put the issue of US market access on the agenda for the scheduled
WTO round on the global liberalisation of trade and services (GATS 2000).218
The implementation of strong European standards would make it extremely
difficult for the USA to continue ring-fencing its fund industry against the
European competition.
2.2.3 The risk of impracticable legislation and opaque case

law
Transferring the extremely opaque legal situation in the USA, based as it is on
case law, to the EU without substantial modification would be neither possible
nor desirable. As an example, legal counsel to JP Morgan had to take account of
the following laws, among others, during a partial acquisition of competitor
American Century:219 Investment Company Act, Investment Adviser Act, Bank
Holding Company Act, Savings and Loan Holding Company Act, Securities
Exchange Act and Regulation M, Public Utility Holding Company Act,
Commodities Exchange Act, New York Stock Exchange rules, state gaming,
anti-takeover and insurance laws, and foreign securities laws. What is
remarkable about this wealth of legislative material is that the transaction itself
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did not involve any change in control, because JP Morgan was buying
significantly less than 25% of American Century’s voting stock.220
The litigious nature of the US legal system, a feature regarded by many
Europeans as excessive, is a further significant weakness of the US regulatory
framework for the mutual fund industry, and should be avoided at all costs
when developing European standards. A common practice at US funds, for
example, is for independent directors to seek legal advice about whether they
are exposed to any personal liability hazard before implementing many of their
decisions.221 Lawyers frequently attend board meetings and are asked for legal
opinions on the spot. This involves (substantial) costs, and can delay or even
prevent decisions being taken if the consequences are regarded as legally too
risky, even if they would be in the best interests of the investors.
Another US practice that is surely not worth emulating is the SEC’s habit of
burdening fund boards with “overwhelming stacks of paper”, often leaving
little time for important strategic decisions. Even the SEC222 is examining the
issue of whether fund boards are being troubled with too many trivial
matters.223
The SEC itself224 thinks that financial industry associations and self-
regulation225 are more appropriate means than legislators for regulating asset
managers in the wider sense.
Legislators should do no more than stipulate a fiduciary relationship226
between the client and the advisor, with the industry taking charge of defining
concrete codes of conduct and fundamental qualification requirements. The
industry itself is increasingly voicing its frustration about overlapping,
inconsistent, overly burdensome and outdated regulations under ERISA227 and
other federal securities laws.228
The European Commission too has recognised the danger of over-regulating
pension fund investments and emphasises that – quite apart from the principle
of free movement of capital – there are no specific EU harmonisation rules so
far229 governing pension funds’ investment activities. Recommendations for a
future EU Pension Fund Directive also clearly reject any form of over-
regulation. They call attention to the EU principle of subsidiarity and paint a
picture of a prudential regime that does not mete out draconian punishments,
but rather provides an enabling infrastructure.230
The European Commission thinks that a lean, modern prudential framework
would be the best solution231 for the rapidly changing and increasingly complex
financial services market.232 To achieve the objective of ensuring state-of-the-art
prudential rules, rapid response times in the lawmaking process are at least just
as important as capping the number of regulations – to reduce complexity –
and ensuring that they are of high quality.
To do this will mean overcoming the inertia of the normal legislative process,
because “by the time directives are proposed, debated and adopted, they can
amount merely to detailed solutions to yesterday’s problems”.233 Delays in
modernising the EU’s prudential framework for financial services to bring it in
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line with international developments have “already proved costly in terms of

competitiveness”,234 as well as handicapping efforts by regulators and
supervisors to maintain the stability of the financial system. Establishing
voluntary standards would go a long way to meeting these calls for a regime
incorporating the greatest possible degree of flexibility, and would certainly
make a significant contribution to enhancing the status of self-regulation, as
opposed to government supervision.
The Commission is well aware that the current (EU) regulations are
unnecessarily detailed, but points the finger at the frequent and extensive
amendments put forward to the Commission’s original proposals.235 The
Commission’s own advisers have urged it not to over-regulate pension funds
because this would have adverse effects on pension fund offerings, and thus on
future pension provision. The concern expressed in this respect that the
imposition of (excessively) comprehensive reporting requirements on the funds
to the supervisory authority could be seen (by the general public) as some sort
of unofficial government guarantee does seem to be somewhat far-fetched,
though, in particular because it assumes that investors are easily confused.236
2.3 THE BASIS FOR ASSET MANAGEMENT STANDARDS

IN THE EURO ZONE
2.3.1 Existing and planned legislation in the EU and

Germany
The EU UCITS Directive
UCITS are “Undertakings for Collective Investment in Transferable Securities”.
The European UCITS Directive of 1985237 lays down the legal framework for
publicly traded mutual funds.238 The substantial differences that formerly
existed in the national regulatory regimes governing funds, especially in terms
of the duties imposed on funds and the supervision measures applied to them,
distorted competition and ran counter to the objective of a single European
capital market, as well as offering no effective, uniform investor protection. To
alleviate or eliminate this distortion, the UCITS Directive establishes “common
basic rules for the authorisation, supervision, structure and activities” of
common (mutual) funds “and the information they must publish”.239 Another
objective is to facilitate the cross-border sale of mutual funds within the EU.
This saw the introduction of the principle of mutual recognition,240 a
breakthrough for the financial services sector. This means that a UCITS
domiciled in one Member State can market its funds in other Member States
without the need for further authorisation by the host Member State..
Unfortunately, things have turned out rather differently in practice, because
national law often establishes barriers, and – like all European directives – the
UCITS Directive is not directly applicable and thus enforceable law.
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The UCITS Directive adopts a completely different approach than the later
second-generation financial services directives,241 which are focused on the
service providers. By contrast, the UCITS Directive primarily regulates the
authorised product,242 but contains few regulations relating to the management
company.243
Among other things, the proposals to implement the Financial Action Plan“244
envisage a reform of the UCITS Directive245 and the development of a Pension
Fund Directive.246 As far back as 1993, the Commission presented a proposal to
amend the UCITS Directive with the main goal of extending its scope to other
forms of UCITS. However, this proposal did not find political backing,247 so the
Commission elaborated new solutions that resulted in the draft directive
outlined below.
The UCITS reform consists of a proposal by the Commission for two
directives that will amend and supplement the UCITS Directive: the first draft
directive248 governs the “products” (the types of mutual funds): in concrete
terms (the introduction of ) funds of funds, derivatives funds and their
investment opportunities, index funds, money market and bank deposit funds,
and securities lending. The second draft directive249 principally concerns itself
with the “service providers” (the management companies). Among other
things, investment companies will now be able to provide individual as well as
collective portfolio management services250 and two specific non-core activities
linked to their core activity:251 investment advice and the safekeeping of units
of collective investment undertakings. The draft also regulates UCITS
prospectuses. Individual portfolio management falls under the Investment
Services Directive,252 so management companies are specifically (and
exclusively253) governed by this directive when conducting this activity.
AS-Fonds – German retirement pension investment funds

The Drittes Finanzmarktförderungsgesetz (German Third Financial Markets
Promotion Act) established AS-Fonds (German special retirement pension
investment funds) as special-purpose254 growth funds255 for private and
occupational pension provision in Germany. The first of these funds was
launched in October 1998 .256
The general provisions of the KAGG – the German Investment Companies
Act – for investment funds also apply to AS-Fonds,257 but AS-Fonds are also
subject to quantitative investment restrictions that ensure that real assets are
overweighted. AS-Fonds can invest in assets permitted for investment funds,258
but they can also invest in property, property companies and special property
funds,259 as well as silent partnerships in companies whose management is
located in Germany.260, 261
The following quantitative limits apply:
1. direct and indirect property holdings may not exceed 30% of fund
assets,262
2. silent partnerships may not exceed 10% of fund assets,263
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3. equity and silent partnerships together may not exceed 75% of fund
assets,264
4. the combined share of equities and (directly and indirectly held) property
must amount to at least 51% of fund assets,265
5. derivatives may only be used for hedging purposes,266
6. unhedged foreign currency risks may not exceed 30% of fund assets.267
The consequence of points (1) and (4) is that equities must account for at least
21% of fund assets.
Any pension savings scheme offered by the management company to
investors must satisfy the following criteria:
1. regular payments for at least 18 years or until the investor reaches the age
of 60,268
2. no later than three quarters through the agreed term of the savings
scheme, the investor must be entitled to switch to any other AS-Fonds
offered by the management company at no cost,269
3. the investor must be offered an opportunity to annuitise the plan assets
instead of a lump-sum payout when the plan matures.270
There are no tax advantages at present for AS-Fonds. The BVI points out that
similar forms of retirement provision are normally tax-deductible in many other
countries in the EU and elsewhere,271 and the association is consequently
calling for AS-Fonds to be put on an equal tax footing with conventional
occupational retirement provision instruments and private life insurance
policies.272
The pensions reform adopted in May 2001 could see an improvement in the
status of AS-Fonds or derivative products,273 as the investment industry is
expected to develop AS-Fonds-based pension funds now that these have been
created by the pensions reform. There are plans to market them under the
name “AS-Investmentrente” . They differ from conventional AS-Fonds because of
the requirements of the Altersvermögensgesetz (German Old-Age Provision Act)
that retirement provision products can only be eligible for various concessions
if they offer a capital and a longevity guarantee,274 among other things.275
The need to meet longevity requirements can be helped by allowing dynamic
switching. In other words, investors should be able to do more than reallocate
their portfolio just once, but also rebalance it successively depending on market
developments and by exploiting the cost averaging effect.
A simple form of dynamic reallocation strategy could be to start with (for
example) 100% high-risk securities in the portfolio and gradually replace them
until it contains 100% risk-free securities at retirement. This could be achieved
in the form of annual adjustment transactions. A tailored reallocation profile
should be established for each beneficiary, but it should be flexible enough to
allow modification at any stage. Figure 14 illustrates four such reallocation
profiles.
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Figure 14: Examples of dynamic reallocation profiles276
Special Funds – a significant occupational pension instrument in

Germany
Special Funds are available only to legal entities such as banks, insurance
companies and other corporations and can have a maximum of 10
shareholders.277 The expected risk and return can be tailored to the preference
of the investor(s), usually by defining the investment strategy in the
management agreement between the investment company and the investor(s).
In contrast to public open-end funds, there is normally continuous close contact
between the investor(s) and the investment company.278
In terms of the four traditional types of occupational retirement provision in
Germany – direct commitments, “Unterstützungskassen” (benefit funds), direct
insurance and “Pensionskassen” (staff pension schemes) – Special Funds already
play a major role today and can be regarded as the forerunners of dedicated
pension funds in Germany: at the end of 1998, there were 4,245 Special Funds
with total fund assets of € 372.3 billion, with funds managed for retirement
provision accounting for around € 112.5 billion. Around 40% of the € 272 billion
(1997) assets held in the four different types of occupational pension scheme
are managed in the form of Special Funds.279
The division of functions between a Pensionskasse and the Special Fund it has
engaged is roughly as follows: the Pensionskasse is responsible for strategic asset
allocation,280 selecting the fund managers, monitoring, performance
measurement and reporting. Once strategic asset allocation has been fixed,
individual Special Funds are then engaged (there may be different Special
Funds for different asset classes), their managers are selected and the relevant
performance benchmarks are defined. The Special Fund and its managers are
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in turn responsible for tactical asset allocation and for managing the investment
process.281
Apart from the traditional four occupational pension types mentioned above,
it is also conceivable that as a new type of second pillar retirement provision,
pension funds will be able to invest the available funds, i.e. the contributions by
employees and possibly employers as well, via Special Funds on the capital
markets.282
The “Rebuilding Pensions” study

The “Rebuilding Pensions” study283 is a report commissioned by the European
Commission to elaborate recommendations for a European Code of Best
Practice for second pillar (occupational retirement provision) pension funds.284
It is based on an EU-wide survey of institutions in all sub-sectors of the
pensions industry. The report aims to provide recommendations and support
to the Commission during the drafting process for the proposed Pension Fund
Directive.285
The most important objective of the report is to define the best ways to
ensure the security of pension funds and the protection of their members and
beneficiaries. The report does not cover taxation, mobility or level playing field
issues.
The steadily growing importance of pension funds demands greater
efficiency and transparency in the pension fund industry,286 a concept that has
been dubbed “pension fund governance” and is similar to the development of
corporate governance for listed companies. In turn, implementation of this
concept depends on the existence and enforcement of a “code of best practice” ,
which should ideally be harmonised throughout the EU as part of the planned
Directive.287
The proposed Code of Best Practice is based on the principles of firstly
security, followed by responsibility, accountability, transparency, efficiency,
affordability and adequate supervision.288
The intention behind the report is not to restrict in any way pension funds in
Member States that already have high standards, but rather to act as a catalyst
for all other funds to reach this high level sooner or later. The differing
regulatory and fiscal regimes in each country need to be taken into account.
2.3.2 Existing US standards

Investment Company Act and Investment Adviser Act
The Investment Company Act is based on collective efforts by the SEC and the
fund industry between 1935 and 1940.289 The remarkably good spirit of
cooperation in the fund industry has been repeatedly praised by government
leaders.290, 291
In 1935, the United States Congress directed the SEC to undertake a study of
the fund industry. Lasting six years, it culminated in the Investment Company
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Act of 1940. This legislation is the fundamental nationwide law that regulates
mutual funds and their directors. It lays down the structure and activities of
funds, including in particular rules for protecting investors. It also imposes
certain duties on fund directors that have been extended by the numerous
rules and regulations292 promulgated by the SEC over the passage of time.293
Together with the Securities Act of 1933 and the Securities Exchange Act of
1934, the Investment Company Act of 1940 is one of the core sources of law
regulating the supervision of the securities market by the SEC.294
The Investment Company Act contains the following four core pillars of
protection for mutual fund investors:295
x Investors’ funds are managed in accordance with the fund’s investment
objectives296
x Fund assets are kept safe297
x When investors redeem, they receive a pro rata share of the fund’s assets298
x The fund is managed for the benefit of its shareholders, and not the fund’s
adviser or its affiliates.299, 300
Shareholders
Board of directors
Investment Distributor or Principal

adviser/Management underwriter
company
Independent
Custodian Transfer agent
public accountants
Figure 15: Structure of a mutual fund under US law301
Figure 15 shows the structure of a US mutual fund. Because mutual funds

normally do not have any employees of their own, all the operations are
conducted by companies hired by the fund302 (which can also terminate these
contracts).
These companies include the investment adviser (management company),
the distributor, the transfer agent, the custodian and the accountants. The
rights and obligations of the investment adviser,303 the custodian and the
accountants are dealt with at a later point in this study, so only the functions of
the transfer agent and the distributor are outlined below.
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Distribution, i.e. the direct or indirect sale of mutual funds to investors, is

normally handled by a separate company, the distributor, because Rule 12b-1304
under the Investment Company Act generally prohibits investment advisers
from selling the funds they have issued.305
The transfer agent maintains records of shareholder accounts, calculates and
pays dividends, and prepares income tax information and other notices to
shareholders.306
Among other things, the Investment Adviser Act of 1940 regulates the
following three core areas:307
x Full and fair disclosure to clients, especially as regards conflicts of interest.
x Fiduciary duty308 of the investment advisers to their clients.
x Anti-fraud regulations giving the SEC far-reaching powers.
Concrete rules resulting from these principles cover such issues as advertising
rules, custody requirements and the imposition of disclosure of financial and
disciplinary information on the advisers.
At presents, there are efforts – supported by the SEC – to reform the
Investment Adviser Act so that it is better equipped to deal with today’s
(market) environment. These measures are focused in particular on:
x The possible extension of the scope of this Act to broker-dealers and
financial planners.309 The advocates of such a move are calling for
individuals and companies that are functionally equivalent to investment
advisers to be regulated just as strictly, to prevent any dilution of investor
protection. Their opponents reject the notion of extending regulation to
these groups as a matter of principle and would prefer to see the
establishment of a self-regulatory body by the professional associations
concerned. They think that this would provide greater flexibility and a
more rapid response to market developments than what they see as an
inert legislative process. The critics of this proposal in turn draw attention
to the petty jealousies existing between these professional associations
that will prevent any of them taking the lead in this self-regulatory body,
and also voice fears of the high costs involved. Quite simply, they just
want to maintain the status quo.
x Combating the practice of “pay-to-play”, which involves “buying” public
fund business with campaign contributions, i.e. a sort of bribery. “Pay-to-
play” means selecting investment advisers to manage public funds not
just on the basis of their qualification, but also of the type and amount of
their political contributions. The Treasurer of the City of Chicago was
indicted in early 1999, for instance, for allegedly demanding political
payments from firms interested in managing the city’s assets. There are
calls to split the functions in this area by requiring independent audit
committees to safeguard the public interest.310
x Clarification of the circumstances in which “principal transactions”311 are
allowed.
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x Revising the advertising rules with the objective of greater flexibility and
enhanced investor protection.
x Possible introduction of a code of ethics covering personal investing by
employees of investment advisers.312
x Assessment of the effectiveness of the de facto reinforcement of fiduciary
duty by the Investment Adviser Competency Exam that has been
compulsory for investment advisers since 1 January 2000, and that (at long
last) now represents at least a minimum barrier to entry because there are
practically no other criteria defining who is “fit and proper”.313
ERISA and 401(k)

The objective of the Employee Retirement Income Security Act (ERISA), which
came into force in 1974,314 is to protect US occupational pensions against
(negligent or deliberate) mismanagement and misinvestment. It imposes
stringent fiduciary duties on the sponsors and ensures that plan assets are
clearly segregated from corporate assets.315 As a federal law, ERISA takes
precedence over state law and thus represents uniform nationwide rules
throughout the USA.316 Through ERISA, the USA more than a quarter of a
century ago realised a goal that the EU is still trying to achieve with its constant
efforts at harmonisation.
ERISA allows each working American to establish a personal retirement
provision in the form of an Individual Retirement Account (IRA, see Table 13,
p. 33), into which they can pay up to $2,000 untaxed income317 each year. IRAs
invest directly in equities, mutual funds (around 50%) or insurance policies.318
ERISA was enacted at a time when defined benefit (DB)319 pension schemes
predominated, rather than today’s more common defined contribution (DC)320
plans, which reached around $1.8 trillion in 1998.321 In addition, the rapid
growth of new patterns of employment where employees often switch
employer or frequently move between conventional employment relationships
and self-employment (genuine or dependent) is a significant social
development that has not yet been reflected in ERISA.322
The US fund industry believes that its success has been jeopardised in recent
years by new rules and regulations that it thinks are too narrowly focused and
cause unnecessary costs. It has responded by talking publicly about a disastrous
potential future scenario where disappointed pensioners, whose sup-
plementary pensions are much lower than expected because of over-regulation,
are then forced to rely on government programmes that are already financially
overextended.323
Together with other changes in the financial and pension environment since
ERISA was enacted, this scenario has driven the US fund industry, as well as
legislators, to call for a reform of ERISA.324 The fact that DC schemes pass the
risk that the value of plan assets might decline (for example because of equity
market collapses) to the plan member has resulted in demands for more
stringent regulation. Issues under debate include somewhat controversial
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demands, such as more stringent professional qualification standards for those

involved in asset management and advice or greater disclosure duties to plan
members, as well as calls for stricter investment restrictions – which should be
examined critically – or even an insurance programme to safeguard against
excessive losses (“earthquake-proofing”).325
Reservations about the latter proposals are driven firstly by portfolio
optimisation considerations326 and secondly by potential conflicts with the
structure of DC plans, which are by nature schemes in which the member bears
the benefit risk. Pension fund industry representatives oppose these
suggestions and are calling for a reduction in the compulsory premiums paid to
the Pension Benefit Guaranty Corporation.327
In addition to ERISA, funded pension plans have been encouraged by the US
Internal Revenue Code since the 1920s.328 Section 401(k)329 of this Code is the
legal framework that allows US employees to participate in DC pension plans.
Payments to these 401(k) plans can be made either by the employer only, the
employee only, or both employer and employee together, and are tax-deductible
up to the amount of $9,000 per year. 401(k) plans are also portable, i.e. employees
can take the plan with them when they move to a new employer.330
Figure 16 shows how the assets invested in 401(k) plans grew by a factor of
4.5 between 1990 and 1999. Figure 17 shows the rapid growth in the mutual
fund share of total 401(k) plan assets between 1990 and 1999, and again
reinforces the tremendous importance of asset management standards for
mutual fund-based retirement provision.
Fiduciary duty and prudence

The concept of “fiduciary duty” is a core principle of US law that is not just
restricted to mutual funds. However, it is not conclusively and clearly defined.
The principle is applied to asset management in the wider sense, i.e.
including portfolio and fund management, and to the management of personal
matters, for example by lawyers, for third parties. Fiduciaries – for instance
investment advisers, fund managers (or other bodies exercising influence on
the fund) as well as lawyers – are expected to exercise a greater degree of
loyalty, prudence and professional knowledge than normal individuals. In
general terms, a fiduciary is a person or institution that has a relationship of
trust with one or more persons or institutions.
Priority is given to the best interests of the client, which thus take precedence
over the interests of the fiduciary and its affiliates. The need for this construct
arises from the asymmetry of expertise and information between the client and
its fiduciary, and the particularly sensitive nature of investment and legal
matters. This directly impacts the well-being of the client, who is placed in a
dependent position, based on trust, that requires particularly stringent
prudential criteria to protect the client as far as possible against abuse,
incompetence or even merely negligent misconduct.
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1723
1473
1276
1061
$bn
864
675
616
553
440
385
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Figure 16: 401(k) plan assets 1990 to 1999 (USD billions)331
50
45
40 41
37
33
30 31
Per cent
27
23
20
15
10 9 10
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Figure 17: Mutual fund share of total 401(k) plan assets 1990 to 1999331
ERISA defines the fiduciary of a pension plan as a person or group with the
following functions:332
x Exercise of discretionary authority and control relating to the
management or disposition of pension plan assets.
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x Remunerated investment advice relating to money, investments or other

assets of the pension plan.
x Vested discretionary authority or responsibility relating to the
management of the pension plan.
The conduct of a fiduciary is measured in terms of prudence, which in turn
has been defined in greater detail by the US courts over the years:
x The “prudent man rule” , which goes back to a Supreme Court ruling in
the case of Harvard versus Amory in the year 1830, which laid down the
following principle: “All that can be required of a trustee to invest is that
he shall conduct himself faithfully and exercise sound discretion. He is to
observe how men of prudence, discretion, and intelligence manage their
own affairs, not in regard to speculation, but in regard to the permanent
disposition of their funds, considering the probable income, as well as the
probable safety of the capital to be invested.”333 Although this prudent
man rule clashes in part with modern insights into capital market theory,
it is still applied by many courts.
In particular, the prudent man rule prohibits risk/reward optimisation
of the portfolio because it places an obligation on the asset manager to
preserve the principal of the individual securities and not of the overall
portfolio. This rule has therefore been interpreted as requiring the
elimination of risk, and led to highly restrictive rules that normally
allowed only investments in time deposits (e.g. CDs) and government
bonds.
In the mid-1990s, however, the American Law Institute came up with a new
draft “Prudent Investor Law” , that was enacted at the end of 1995, including in
the two states with the largest public pension plans, California and New York.
US courts are now being asked to apply the following, considerably more
flexible criteria in their rules that reflect the insights of modern financial
theory:334
x All investments must be assessed at a portfolio level, not on the basis
of individual securities.
x No investment is itself inherently prudent or imprudent.
x The portfolio should normally be diversified.
x The effects of inflation must be included in investment decisions, i.e.
the real, and not the nominal, return is what matters.
x If the fiduciary has insufficient investment expertise, asset
management must be delegated to a qualified “prudent expert”.
x The “prudent investor rule” . The restrictive nature of the prudent man
rule that was shown to be excessive by Modern Portfolio Theory335 led to a
new understanding by US courts, which now apply the following
standards:336
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x Overall portfolio risk must be appropriate. One of the fiduciary’s core

duties is to master the conflicting goals of risk and reward.
x Appropriate diversification must be ensured. There are no longer any
quantitative investment restrictions, and essentially any investment is
possible as long as it contributes to an optimal portfolio (and satisfies
other prudence rules).
x Application of prudence allows fiduciaries to delegate responsibilities,
something that was generally prohibited by the prudent man rule.
x Investment decisions taken must be cost-conscious, in particular the
return of a certain investment strategy must be weighed against the
resulting transaction costs.
x The prudent expert rule. This rule, which is found in ERISA and thus
applicable to pension funds in particular, requires fiduciaries to exercise
the same level of prudence and professional knowledge as a prudent man
familiar with such matters, i.e. actual experts and not merely average
prudent persons.337 This prudent expert rule is only one of a whole raft of
requirements imposed on pension fund fiduciaries, including the
following fiduciary duties:338
x Fiduciaries must act exclusively in the interests of the fund members,
i.e. participants and their beneficiaries (duty of loyalty).
In case of any conflict of interest between the fiduciary and the
pension plan, the resulting decision may not adversely affect the plan
or the beneficiaries. In addition, the only objectives permitted in the
management of the pension plan are the provision of benefits to
beneficiaries and the minimisation of management costs (cost-
consciousness)339 (“exclusive benefit rule”).340
However, ERISA contains no guidance about solving conflicts
between the beneficiaries, i.e. between contributing participants and
pensioners. A typical example of such conflicts is the case of the New
York Municipal Union pension plans during the New York financial
crisis in the early 1970s. Although these public pension plans do not fall
under ERISA, they are regulated by a very similar state law. These
pension plans bought high-risk municipal bonds to ward off New
York’s impending insolvency. This prompted older municipal
employees to file a suit because they saw the security of their pension
plan in jeopardy and contended that although this investment helped
the city, it did not help them. The courts ruled against them with the
argument that younger municipal employees would benefit from this
investment because it would ensure the long-term solvency of the city.
The exclusive benefit rule was thus interpreted extremely liberally,
revealing the faults of this concept.341
This type of fiduciary duty is also a requirement that appears in relevant EU
law. It applies in principle to UCITS, which have a “general obligation to act
solely in the interest of unit-holders”.342
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THE SCENARIO TODAY
x Avoidance of prohibited transactions that may involve conflicts of

interests. There are general rules,343 as well as detailed regulations, for
example concerning self-dealing344 or kickback transactions.
x Cost-consciousness.
x The duty of diversification. Employee Stock Ownership Plans
(ESOPs),345 stock bonus plans and sometimes also 401(k) plans often
only meet this requirement vaguely if they invest large parts of the
portfolio in securities issued by the plan sponsor (normally the
employer). What is important here is that the securities risk is analysed
in conjunction with the portfolio and not in isolation. This latter is
required by numerous US state laws which lay down that each
individual investment must itself be prudent, which in practice leads to
low diversification and, all other things being equal, to unnecessarily
high risk or unnecessarily low returns.346
x Compliance with the “governing documents” of the pension fund,347
known as the document rule. In practice, this refers in particular to the
investment policies that must be followed as long as they do not conflict
with other ERISA rules. An implied consequence of this requirement is
that a plan sponsor must always have written investment policies.348
x Prohibition on delegation. Trustees cannot escape responsibility and
liability by delegating decisions. They can use the services of
consultants and advisers, but only for the decision-making process that
must result in a decision by the trustees themselves.349
A breach of fiduciary duty entails personal liability to compensate the plan
for any losses to the plan resulting from the breach, and to restore to the plan
any profits unlawfully made by the fiduciary. The court may resolve further
sanctions, such as removal of the fiduciary.350
The interpretation of what is “prudent” has undergone considerable change
in the past. One hundred years after the Harvard v. Amory ruling,351 investing
in equities was still regarded as imprudent because of the high risk associated
with these instruments. Nowadays, exactly the opposite holds true, i.e. most
investors would regard turning a blind eye to equity investments as imprudent,
partly because of the insights provided by Modern Portfolio Theory.352 Even
more recent research suggests that under certain circumstances, ignoring what
the public regards as high-risk derivatives could also be imprudent (and thus a
potential source of claims for damages) if they are used not for speculating, but
for risk hedging or as a low-cost instrument of diversification. The
consequences of this for fiduciaries are that they must keep themselves well
informed about the latest developments in the field of capital market theory,353
for example so that they have sufficient skills nowadays to decide when
derivatives can be used and when they should be avoided.354
The European Commission has plans to establish a concept similar to the
prudent investor/expert rule in Europe. Although its proposals only ever refer
to a prudent man rule, it does not interpret this as restrictively as the US
49
THE SCENARIO TODAY
regulators. This involves an evident (and considerable) discrepancy in the

definition, because the Commission actually argues for the prudent man rule to
be bypassed, while at the same time presenting this as a means of trimming back
restrictive quantitative investment rules. Table 16 presents the key differences
in interpretation.
EU concept Corresponding US concept

Restrictive Prudent man rule
quantitative x No portfolio-based analysis; the principal of individual
investment rules securities must be preserved
x In practice, investment restricted to CDs and government
bonds
Prudent man rule Prudent investor/expert rule
x Portfolio-based analysis: appropriate overall risk
x Duty to diversify
x Governing documents of the pension plan are the
reference point
Table 16: Differing terms for the same concepts in the EU and the USA
In the United Kingdom, the Financial Services Authority (FSA) ) has recently
published Principles for Business to apply to the business activities of
regulated businesses.355 They emphasise prudence and the duty to protect the
interests of customers, requirements that come very close to the concept of
fiduciary duty:
x They require skill care and diligence, both as regards internal procedures
and the firm’s customer relationships.356
x In terms of conflicts of interest between the firm and its customers (or
between customers), the requirements: “A firm must manage conflicts of
interest fairly”357 and “A firm must pay due regard to the interests of its
customers and treat them fairly”358 are weaker than the primacy of client
interest over the interest of the fiduciary as expressed in the US system of
fiduciary duty. The FSA intends to beef up its principles by introducing a
complaints code for dealing with customer complaints.359
The SEC’s role

A consequence of the great stock market crash of 1929, which occurred in an
ineffectively regulated capital market because of the lack of any uniform federal
law, was the Securities Act of 1933 and the Securities Exchange Act of 1934,360
which were enacted to restore investor confidence in the capital markets. One
of the core outcomes of these two laws was government supervision of the
capital markets, and the Securities and Exchange Commission (SEC) was
established in 1934.361
The SEC is headed by five Commissioners appointed by the President for
five-year terms (with one of them designated the Chairman). The
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THE SCENARIO TODAY
Commissioners in turn head up four divisions with a total of 2,900 employees.

These four divisions are the Division of Corporation Finance, the Division of
Market Regulation, the Division of Investment Management and the Division
of Enforcement. The SEC is headquartered in Washington, D.C., and also has
eleven regional and district offices throughout the United States.
The SEC works together with a range of different institutions, such as
Congress, various federal departments and agencies, self-regulatory
organisations,362 state securities regulators and various private sector
organisations. The SEC oversees almost all the key participants in the capital
markets, including listed companies, stock exchanges, broker-dealers,
investment advisers – including mutual fund management companies – mutual
funds and public utilities.
Investor protection lies at the heart of the SEC’s activities, in particular
overseeing compliance with corporate disclosure regulations. The SEC has
overall responsibility for enforcing capital market laws, not just those affecting
disclosure. It is these powers vested in the SEC – the ability to launch
investigations and file cases in federal court – that are crucial to the SEC’s
effectiveness. Each year, the SEC brings 400 to 500 administrative actions for
breaches of securities laws, focusing in particular on insider trading, accounting
fraud and breaches of disclosure requirements. The SEC’s powers are restricted
to civil enforcement actions, but it works together with other government
agencies where there is a need for criminal prosecution.
In its preliminary, private investigations, the SEC gathers evidence by a
variety of means, including informal inquiries and interviews with witnesses,
examining brokerage records and reviewing trading data. If a formal
investigation is then launched, witnesses can be subpoenaed and the SEC can
require all relevant documents to be produced. Following the investigation, the
SEC can decide to file a case in federal court or to bring an administrative
action.363
The SEC emphasises that it regards itself as part of a team. It believes that
educated and careful investors are the best protection against irregularities on
the capital markets and therefore offers a wealth of information to the public.
All public documents are available for inspection at the SEC’s Public Reference
Room in Washington, DC., where copies can be obtained free of charge. All
documents filed since May 1996 are available on the Internet364 or on computer
terminals at the SEC’s offices in New York and Chicago.
However, the SEC does more than merely enforce and interpret existing
regulations. It can also issue its own rules, although major rules are subject to
congressional review and veto.
The Division of Investment Management oversees investment companies
and mutual funds and their advisers, and has the following responsibilities:
x Interpretation of laws and regulations to support investors and to assist
the SEC’s own inspection and enforcement staff.
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THE SCENARIO TODAY
x Handling no-action requests. These are an application to the SEC for a

preliminary decision that a particular activity complies with the law and
will not result in action by the SEC. Applications for exemptive relief, i.e. a
request to be exempted from certain rules or regulations, have a similar
function.
x Review of documents filed with the SEC by investment companies and
advisers.
x Review of enforcement matters.
x Development of new rules.
52
CHAPTER 3
A Description of the
Structural Components of
the Systematic
Classification of the
Synopsis
3.1 INVESTOR RISK
3.1.1 Management risk – Confidence risk

Management risk comprises the risk of loss due to:
x human error, e.g. because of an excessively risky or recklessly defensive
investment strategy,
x or criminal, negligent or incompetent action or omissions.
This is why the risk of fraud, of defective or inefficient processes or of the loss
of key employees, for example, also falls under management risk.365
The board of directors plays a key role in reducing management risk; because
of its fiduciary duties, its prime obligation is to safeguard the interests of the
shareholders and, in the event of conflicts of interest between the shareholders
and other (legal) entities involved in the fund, its first duty is towards the
shareholders.366
Prudence – in the shape of the prudent man rule – is one of the primary
obligations under these fiduciary duties.367
53
STRUCTURAL COMPONENTS OF THE SYSTEMATIC CLASSIFICATION
The proposal in the EU368 is to include in this category law-abiding asset

managers who take into account any existing liabilities and all other necessary
information in their investment (strategy) decisions, and who are independent,
forward-looking, willing to learn from their mistakes and cost-conscious. They
must fulfil the underlying principles of security, profitability, diversification,369
quality and liquidity to be regarded as prudent.370 Quality of asset management
and of assets means supporting security, and is thus the opposite, for example,
of sloppiness, complacency and inappropriate risk policies. The quality of the
assets should not be viewed in isolation, but rather together with the principles
of diversification and profitability. Otherwise, it could be taken to mean that
investments should only be made in government bonds or large caps.
The view in the USA is somewhat more sophisticated, due no doubt to the
longer tradition of fiduciary duties and prudence. In the USA, the prudent man
rule means restrictions on investment, the antithesis of the interpretation in the
EU. ERISA371 and the updating of legal interpretation through court rulings
have led to the establishment of more modern standards – the prudent expert
rule and the prudent investor rule.372
3.1.2 Investment risk – the risk inherent in the investment

Investment risk is the uncertainty resulting from investment decisions and
market changes. It is multi-faceted by nature and thus consists of a variety of
sub-risks, including the risk of poor asset allocation or securities selection,
interest rate risk, bankruptcy risk and reinvestment risk.373
3.2 RULES FOR REDUCING THE INVESTOR’S RISK
3.2.1 Investment rules

Quantitative investment rules aim to control the investment risk and limit asset
allocation by either completely prohibiting investments in certain asset classes
or restricting them to a certain maximum percentage of the funds under
management. Conversely, they may require the asset manager to invest certain
minimum percentages of the fund assets in certain asset classes. In practice,
rules governing pension funds generally seem to involve restrictions or
prohibitions on “risky” asset classes such as equities, and above all derivatives,
while at the same time privileging debt instruments, and especially
government debt instruments.
However, such investment rules seem to be losing their importance,
especially as a consequence of both Modern Portfolio Theory, which has
demonstrated that the risk of fluctuation can be better controlled by
diversification, and of active portfolio management,374 which permits
risk/return management going beyond Modern Portfolio Theory, with the
result that diversification and prudence are now the most important principles
for reducing investment risk.
54
Fund managers are also increasingly relying on qualitative investment rules

that place as few quantitative barriers as possible in the way of portfolio
optimisation, and emphasise the management of the overall risk of the fund
instead of the risks of its individual securities.
The investment rules that control management risk relate in particular to
transactions involving (potential) conflicts of interest between the fund
shareholders and the individuals and entities involved in fund management.
They are elaborated in great detail especially in the USA, where such
investment rules are used to spell out what is actually involved in
implementing the principle of fiduciary duty.
3.2.2 Separation of functions

In contrast to a normal company, a fund normally does not have its own
employees. Those persons working for it are generally employees of the
investment adviser – the management company – of the fund that is a separate
corporate entity from the fund and also remunerates these persons. However,
the management company is not the only service provider, albeit the most
important one: the services it is required to provide and the payment to which
it is entitled – generally a certain percentage of the fund assets – are defined in
the advisory contract. Its most typical service is that of portfolio management,
with the resulting securities orders being passed to broker-dealers.
This special organisational structure (see Figure 15, p. 42) of a fund may lead
to conflicts of interest between the fund (and its shareholders) and the
investment adviser who manages it: on the one hand, both of these parties
have common interests, such as seeking outstanding investment
performance,375 but there are also various areas of conflict resulting from the
fact that the fund manager’s aim is to maximise profits, which may conflict with
its paramount duty of acting solely in the interests of the fund and its
shareholders.376
The separation of functions aims to minimise the potential for abuses
resulting from conflicts of interests by preventing any single institution from
exercising sole overall control of the funds (comparable with the “dual control”
principle).
Curbs are imposed on management by ensuring that safekeeping of the
fund’s assets is normally entrusted to another institution (custodian), that
broker-dealers are required to execute securities transactions and that day-to-
day responsibility for supervision lies with a partly independent board of
directors.
In the EU, the separation of custody from the sponsoring undertaking at
pension funds is regarded as the most important precaution,377 while the
separation of custody from investment management is not viewed as an
“absolute condition”,378 albeit desirable. Such separation is not being proposed
vigorously for cost reasons, because smaller pension funds in particular would
become less competitive. The separation of asset management and the
55
controlling fund board, as the body safeguarding the interests of the

shareholders, is also regarded as paramount.
3.2.3 Disclosure
The aim of disclosure requirements, i.e. the mandatory publication of material
facts and circumstances, is firstly to allow (prospective) investors to make
rational investment decisions by informing them about the risks and rewards of
the investment. They arise from the need to resolve conflicts of interest
between the fund manager aiming to maximise profits for its owners, and the
investors aiming to maximise their own personal investment performance,
through the instrument of transparency.
They are also a control instrument for regulators. Control is thus not
devolved solely to the market or to investors, as it can be assumed that the
average non-institutional investor has only a limited capacity to interpret
qualitative and quantitative information, and because investors who “vote with
their feet” by fleeing from dubious investments may put themselves at a tax
disadvantage because they may face capital gains taxes.379
To avoid over-regulation resulting from an accumulation of disclosure
requirements, however, this instrument of protection and control should only
be used with restraint, as it would otherwise become less effective, and its
inherent costs and expertise requirements could see it slipping into a barrier to
market entry.
Disclosure is one of the guiding principles for best practice and should be an
element of EU-wide harmonisation that is as comprehensive as possible,
certainly in terms of minimum requirements. If there is general agreement that
greater risk demands more comprehensive information, it will be necessary to
link stricter disclosure standards for DC380 than for DB381 pension schemes382 as
part of a future EU Pension Fund Directive.383
Extremely comprehensive disclosure requirements apply to (pension) funds
in the USA. The SEC is certainly not alone in thinking that the success of the US
mutual fund industry in the second half of the 20th century was due to a large
part to the fact that investors knew what they were buying. This is why most of
the regulatory efforts in recent history in the USA have concerned disclosure.384
3.2.4 Control and enforcement of rules

In both the US and the (future) EU regimes, the most important institution for
the continuous control of the fund’s activities is the fund board; another feature
common to both regimes is that the fund board has two types of members,
“interested” and “independent” directors. The first type are normally
employees of the fund’s management company or investment adviser. By
contrast, the independent directors are prohibited from having any significant
business or professional relationship with the management company or the
underwriter, so that they can ideally provide a controlling counterbalance to
the fund’s management.385 This supervisory body aims in particular to resolve
56
conflicts of interest between the fund (and its shareholders) and the
management company, as illustrated by the following two examples:386
x Is it realistic to assume that a management company will decide to close a
fund (temporarily) to new investors and thereby waive additional profit if
it has grown so quickly in the past that it will find it extremely difficult to
invest the new money sensibly?
x Are the interests of the shareholders safeguarded if the management
company transfers the management of additional funds to one of its
portfolio managers, possibly resulting in this manager being overloaded?
The control of these and many other conflicts of interests to safeguard the
fund’s shareholders is the responsibility of the independent directors, and the
SEC terms this supervisory role “critical”.387
Although the concept of an effective board of directors is a new one for
many EU member states, particularly because of the role of independent
members, the notion of a regulatory authority as a control instance has been
established for a long time; there are, however, efforts to delegate
responsibility from the often overworked regulators to the fund board. The
concept is comparable with the principle of subsidiarity – the model on
which the division of responsibilities between the EU and its Member States
is based. The European Commission has more concrete plans to complete
the single market for mutual/pension funds by the introduction of uniform
EU-wide fund registration using a “single European passport”.
57
CHAPTER 4
The Regulation of
Management Risk
4.1 INVESTMENT RULES
4.1.1 Prohibition of transactions in the USA involving

conflicts of interest
Definition
The conflicts of interest to be regulated involve situations in which persons, for
instance employees of the investment adviser, have a private or personal
interest that might influence the objective exercise of their professional duties
that are subject to certain duties (of loyalty) towards clients (or the employer).
This interest does not necessarily have to be of a directly financial nature; it
may also involve pecuniary advantage or patronage.388
This broad definition is set out in more concrete terms in numerous
provisions of US capital market laws; the prohibition contained in the
Investment Company Acts of 1940, by which persons controlling or influencing
the fund may not use this power to their own financial advantage,389 is one of
the more broadly worded rules.
Personal investing by affiliated persons

Investments by portfolio managers or other employees affiliated with the fund
who invest for their own accounts are not rejected out of hand, but they may
easily lead to conflicts of interest with their “own” fund.390 The SEC aims to
prevent this with a rule it has issued governing personal investing by
58
THE REGULATION OF MANAGEMENT RISK
investment company employees.391 This was tightened as follows in 1999:

stronger supervision by the fund board,392 extended reporting requirements for
personal securities holdings, and a requirement for pre-clearance of
investments in IPOs and private placements.
However, an excessively restrictive code of conduct could deter talented
portfolio managers from taking a job at the management company in
question.393 It should be sufficient for personal investing by fiduciaries to satisfy
the following criteria to be classified as ethically acceptable:
x the client is not disadvantaged;
x the fiduciary does not gain any personal benefit from transactions
conducted for the client;
x and no applicable laws or other rules are violated.
These requirements should be seen as the absolute minimum because the
elaboration of such a code of conduct is ultimately very company-specific and is
very difficult to define in more generic terms. However, a code of conduct is
only half of the solution, because without any accompanying compliance394
procedures, it could easily become just another paper tiger.
The minimum content of guidelines for the personal investment practice of
investment company employees could contain the following points:
x Prohibition on investments in initial public offerings.
x Restrictions on investments in private placements.
x Stipulation of blackout periods, i.e. no own account trading in securities
for which the client has an order pending; this aims to counter front
running.395
x Restrictions on short-term own account trading – for example, a minimum
60-day holding period should be observed.
x Accepting directorships in public companies only with the consent of the
employer, and notification of all interested parties.
x Reporting requirements, for instance relating to personal portfolios and
securities held in trust; the broker(s) of the investment company
employees should be obliged to send copies of all transactions and
account/portfolio statements to the compliance department of the fund’s
management company.
x In the event of own trading in breach of the code of conduct, the
transaction must be reversed immediately (by an offsetting transaction)
and any profit must be skimmed off.
x Clients should be able to inspect the code of conduct on request.
Affiliated transactions and self-dealing

The SEC allows a certain level of flexibility in the case of transactions between
the fund and its management company or with affiliates of the fund (“affiliated
transactions” or, in the nomenclature of the Investment Adviser Act of 1940,
59
“principal transactions”). These primarily relate to the purchase or sale of

securities for the fund involving the management company or other affiliates as
counterparties dealing for their own account. Potential conflicts of interest that
may arise are illustrated by the following practice:396
x Dumping poor-quality securities.
x Incorrect selling/buying price. This is often assumed to be the case if the
corresponding market price is used, because the effects of market impact
are ignored, i.e. the impact of the trade in question on the price of the
trade caused by the law of supply and demand.
There are proposals to counter such abuses through volume restrictions,
permitting only orders with a negligible market impact to be traded.
However, such a rule would itself run into problems because it is
impossible to devise a generic formula for calculating market impact, a
factor that is contingent upon numerous parameters – some of which
simply cannot be captured – that are mostly also specific to the individual
security.
Pushing certain securities in the manager’s own portfolio, which may be
questionable even in the case of high-quality securities and a correct price,
simply because potentially better alternatives are ignored, and the
management company is primarily pursuing its own interest in selling
these securities, rather than the interest of the fund, which in turn runs
counter to its fiduciary duties.397
The SEC relies in particular on oversight by the fund board and above all its
independent directors. In view of the global consolidation of the investment
industry, this role of independent directors will become even more important
because the SEC expects that this will give the industry far-reaching flexibility
during the necessary adaptation processes.398
The Investment Company Act sets out a general prohibition on affiliated
transactions, i.e. persons affiliated with the fund may not, as a rule, sell any
securities or other assets to the fund or buy them from it, nor may they borrow
money from the fund.399 The SEC issues rules granting numerous exemptions
to this principle to enable common transactions in which conflicts of interest
can be largely precluded:400 the fund board must review and approve the
procedures to be applied to such transactions in advance, as well as
determining at least quarterly that transactions covered by this code of conduct
during the preceding quarter complied with the code of conduct401 – an
example of the compliance duties of the fund board.
Such transactions requiring approval include, for example, the purchase or
sale of securities by funds in the same fund complex, or the purchase of
securities from an underwriting syndicate that includes the fund management
company. The SEC can also grant individual exemptions on application if
certain conditions are met.402
ERISA too offers a number of specific solutions to these problems:
60
x An ERISA fiduciary may not deal for own interest or account with the
fund’s assets (prohibition on self-dealing403).404
x As a rule,405 transactions by the fund in favour of (legal) entities whose
interests run counter to the interests of the fund406 or who can exercise an
influence on the fund (a party in interest) represent a breach of fiduciary
duties.407 This general rule is put into more concrete form by a list of
prohibited direct or indirect transactions between the fund and parties in
interest:408
x the sale, exchange or lease of any assets;
x loan transactions;
x the manufacture of goods or provision of services;
x the transfer of fund assets or their use to benefit a party in interest;
x the acquisition of securities or real property of the fiduciary’s employer
unless certain rules are complied with.
Joint transactions
The Investment Company Act prohibits persons directly or indirectly affiliated
with the fund to effect any transactions involving a joint company or another
joint arrangement or a profit sharing scheme in which the fund is also a
participant, unless the SEC has approved such an undertaking on
application.409
Allocation of securities
Where demand for certain securities exceeds supply, which is often the case
especially with initial public offerings (IPOs), the question arises of how
securities received by the management company or by the individual portfolio
managers managing several funds should be allocated overall to the individual
funds.
The desirable solution – albeit one which is not (yet) obligatory – would be a
written, published allocation policy. However, the fiduciary duties imposed by
the Investment Adviser Act410 can be interpreted in such a way that the
management company is obliged to prepare such a policy statement, at least in
the long term.
If there is general acceptance of the need for such guidelines, the question
then arises of how this will be formulated, because the fiduciary duties do not
allow any scope for arbitrary or inequitable mechanisms. The least disputed
solution is pro rata allocation, but rotating random allocation also appears to be
suitable. This latter illustrates clearly that allocation procedures do not
necessarily have to satisfy the aforementioned requirements in terms of each
individual allocation, albeit certainly over a longer period. There are also
controversial suggestions that smaller (or more poorly performing) funds
should be preferred,411 as mini-allocations do not hold out any significant
improvement in the performance of very large funds in any case. An
61
exaggerated instance of the preferential treatment of certain funds, which has

already been prohibited by the SEC as fraudulent, is the preferential treatment
of an extremely popular fund – this is a clear breach of the primacy of investors’
interests over those of the management company under the terms of its
fiduciary duties.412
If a code of conduct has been issued, the oversight problem then arises. This
can be solved, for example, by the establishment of a committee (“Equity
Steering Committee” or “Brokerage Control Committee”), although paramount
responsibility still rests, of course, with the fund board. As an illustration, an
analysis of the comparative performance of funds employing the same
investment strategy may identify (unlawful) differences in the allocation of
outperforming securities as the underlying cause.413
Soft dollars
Soft dollars is the term used to denote a practice by which asset managers or
fund management companies use the brokerage commissions generated by
their clients’ transactions to obtain research on securities, issuers, markets and
related topics from the broker-dealers without having to pay for it in “hard”
dollars.414
This practice traces its origins back to the unreasonably high minimum
broker-dealer fees commonly charged until 1975,415 far exceeding the actual cost
of executing the orders. At the time, this meant that competition between
broker-dealers was not price-driven, resulting in compensatory soft-dollar
arrangements.
However, this practice may represent a breach of the asset manager’s
fiduciary duty,416 because a fiduciary may not use the assets entrusted to him
for his own advantage or for the benefit of clients other than the principal, even
if this does not cause additional costs for or otherwise disadvantage the client,
unless the client concerned has given his consent on the base of complete and
fair disclosure.417
The possibly unlawful advantage to the asset manager is that he does not
have to prepare or pay for the research etc. himself. A common exacerbation of
this conflict of interest – the asset manager wants (cheap) research and his
clients want low fees and optimum order execution – is where orders are no
longer executed at best, counter to the duty to ensure best execution.418 Neither
is the scale of this problem negligible, as estimates put the volume of soft
dollars at over $1 billion in 1998, and an SEC study419 reckons that almost all
asset managers make use of this practice.
Subject to certain conditions – defined in greater detail420 in the “safe harbor”
contained in Section 28(e) of the Securities Exchange Act of 1934,421 asset
managers may pay more than the lowest possible order execution fee if
internally generated or otherwise not generally available422 research and other
services423 are received as an additional consideration.
62
The most important condition for admissibility is disclosure of the details424 of

the soft dollar arrangements to the clients. In broad terms, Section 28(e) of the
Securities Exchange Act of 1934 stipulates that payment of a commission for
effecting a securities transaction that is greater than the minimum fee
receivable is not a breach of fiduciary duty if the fiduciary believes in good faith
that the amount of commission is reasonable in relation to the value of the
brokerage service, including research, etc. The reasoning behind this is that
issuing an order solely on the basis of the (lowest achievable) commission does
not necessarily have to be in the best interests of the investor to be protected,
because he certainly stands to gain from participation in the broker-dealer’s
analysis activities, and because selection of the broker-dealer is a matter for the
fiduciary’s reasonable business judgement.
In practice, breaches relating to soft dollars425 fall into two categories, namely
research and other services
x that are essentially permitted under the terms of the safe harbor, but for
which compliance with the disclosure requirements is either inadequate
or non-existent, as well as those
x that are most certainly unlawful and that cannot be remedied by
disclosure. Asset managers frequently claim safe harbor protection
without meeting the safe harbor requirements.
The fact that both of these types of breach of relevant rules occur frequently in
practice is due largely to the fact that only very few broker-dealers and asset
managers have adequate internal controls and documentation426 relating to soft
dollars. This is thus a compliance issue.427
The SEC recommends the establishment of internal central administration
and control systems for soft dollar arrangements so as to counteract the
widespread shortcoming of uncoordinated soft dollar decisions at various
management and function levels resulting in inadequate documentation.428 For
example, if an asset manager cannot provide a complete list of soft dollar
services received during the course of an SEC inspection, it can be assume that
any established compliance system is not effective.
However, the fund board, whose duties also include control of soft dollar
arrangements,429 sits between the regulator and the compliance department.
The complexity of the soft dollar issue can be countered by an unambiguous
code of conduct, although this can never represent a complete list of
procedures, which is why the principles of the primacy of client interest and
fair disclosure must always be applied in situations not explicitly covered by
such a code.
Prohibition on kickbacks
ERISA sets out that accepting any pecuniary advantage to one’s own benefit
from any natural person or legal entity during the course of fund transactions
with this person is a breach of fiduciary duty.430, 431
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4.1.2 Prohibition on transactions involving conflicts of

interest in the EU and Germany
Conflicts of interest also affect EU funds, of course, but there are no comparable
extensive rules and regulations there. Although the inclusion of provisions on
this sort of personal investing was recommended432 for the proposed Pension
Fund Directive,433 the recommendation was not implemented in the
corresponding proposal for the Directive dated October 2000.434
In Germany, there are rules of conduct governing conflicts of interest in the
form of the DVFA’s Standards of Professional Conduct that apply to all
professionals in securities trading enterprises within the meaning of the
German Securities Trading Act, i.e. financial analysts, portfolio managers and
investment advisers:435
x Compliance with the provisions of the German Securities Trading Act to
avoid conflicts of interest436 is a professional obligation.
x Own account dealing is generally permitted, but using inside information
is prohibited to professionals in securities trading organisations (and not
only for own account dealing) and their families.
x Front-running is prohibited,
x as is the publication of investment recommendations serving the
professional’s own interests.
4.1.3 The essence of future standard-setting

When devising investment rules to control management risks, a distinction can
be made between two fundamental approaches, although in practice a middle
way between these “pure” forms appears to be desirable: they can either be
highly restrictive and based on case law, or they can be extremely liberal in
terms of legislation if reliance is placed instead on some sort of written
commitment (code of conduct, code of ethics) including its effective supervision
by the fund board, although it must then be possible to place reasonable trust
in this body.
In the USA, there is no harmonious synthesis of these two approaches under
the auspices of the SEC, but rather a situation of co-existence, a solution that
appears to be less than optimal, particularly in terms of cost. If fund boards in
the EU are organised such that there can be no doubt about their structural
integrity and effectiveness, the liberal approach appears to be more
advantageous in that it enables greater flexibility in the face of structural
market change – as well as non-EU competitors – and is probably also more
cost-effective.
As a part of the standards relating to these issues, a code of ethics should
cover the following potential conflicts of interest; the fund board or its
independent members should essentially have an arbitration role, and there
should be adequate documentation (and its safekeeping) of the processes.
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Personal investing: a blanket ban on personal investing would fail the test of
legal and factual barriers. Neither is it necessary if there are clear rules of
behaviour combined with professional obligations, supervised by an effective
compliance department.
Guidelines that govern transactions between the funds on the one hand, and
its management company or other service providers and their affiliates on the
other, should at the least enshrine the principle that such transactions must be
avoided in cases of doubt; otherwise, there would certainly be a need for highly
detailed rules and regulations, although experience shows that these too would
never in themselves be enough to cover every conceivable situation.
The problem of allocation of securities for which demand is heavy, but
supply is tight, to individual funds or portfolio managers can be solved by
defining a written, fair allocation policy, combined in turn with supervision by
the compliance department, the fund board or a special board committee.
The limits of efforts to tackle soft dollar abuses though detailed guidelines are
shown by the unsatisfactory situation in the US, where the “safe harbor” rule is
often insufficient to prevent breaches because of inadequate compliance. There
is certainly a need for more extensive research into the extent of soft dollars
throughout the EU in order to establish whether a general prohibition on soft
dollars is feasible and desirable.
4.2 SEPARATION OF FUNCTIONS
4.2.1 Institutional separation of the management company,

the fund, the board of directors and the custodian in
the EU and the USA
The situation in the USA
Among other things, the US Glass-Steagall Act bans senior bank executives
from serving as members of the board of a fund affiliated with the bank. Banks
that issue funds do not have to be registered with the SEC as investment
advisers, but this does not mean, of course, that they are not subject to
legislation, and their fund activities are subject to stricter control by the banking
regulator than would otherwise be the case for regulation by the SEC.437
The supervisory perspectives of the two US regulators responsible for bank-
related funds – the banking regulators and the SEC – are very different: the
prime directive for banking regulators is to protect the bank as an institution
and the depositors, and they have an ambivalent relationship toward
disclosure, especially in the case of information that could unsettle depositors.
The top priority for the securities regulator, on the other hand, is investor
protection, and it pushes for the greatest possible disclosure.438 The ICI439 is
pressing for the present practice to be replaced by an oversight regime in which
each subsidiary of a holding company is subject to functional supervision, i.e.
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banks would be supervised by the banking regulator, and mutual funds –

including bank-related funds – by the SEC. It rejects the notion that certain
funds should be regulated by the Federal Reserve Board.440
In the case of bank-related funds, the question that arises most in practice is
that of affiliated transactions:441 in some cases, banks may act as custodians,
securities lenders or lenders for “their” funds. However, such services may also
be regarded by the directors as restricted affiliated transactions that are then
reviewed to establish whether they are really in the fund’s best interests, or are
geared more to serving the bank’s interests.442
The separation between the management company and the custodian is
based on Section 17(f) of the Investment Company Act and the related rules
and regulations issued by the SEC:443 the fundamental principles here include
the safekeeping of fund securities in a separate physical location to third-party
securities (dematerialised safekeeping through record-keeping procedures is
also possible); no authorisation of the custodian to encumber, pledge or claim a
right of retention on the securities; frequent inspection of the securities
holdings by independent public accountants and the right of the SEC to inspect
at any time; the dual-control principle governing disposition of securities;
compulsory fidelity insurance for all persons enjoying access to the securities in
an amount pegged to the fund volume.
Certain banks (including foreign banks), members of a national securities
exchange, (foreign) securities depositories or clearing houses are eligible to act
as the custodian, and – under certain circumstances – even the investment
company itself.
The situation in the EU

The European Commission regards the control function of the custodian or
depositary444 as “crucial”, and emphasises the resulting need for effective
independence between the management company and the custodian.445 A
similar separation was also scheduled for the planned proposal for a Pension
Fund Directive.446, 447 As announced at the time of the preliminary work on the
proposed Directive,448 Article 8 of the proposed Directive that was eventually
published449 requires the legal separation of the sponsoring undertaking and the
“institution for occupational retirement provision”, i.e. the pension fund.
In the case of UCITS, measures to assure independence and avoid conflicts of
interest must be undertaken in the following situations for this purpose:450
x the management company and the custodian belong to the same group;
x the management company has a qualifying holding in the custodian or
vice versa;
x the management company otherwise exercises significant influence on the
custodian or vice versa;
x the management company is permitted to enter into transactions with the
custodian.
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The UCITS Directive expressly requires the separation of the management

company and the custodian,451 and emphasises that these two institutions must
act independently of one another and solely in the interests of the
shareholders.452
The management company may not undertake activities other than the
management of mutual funds or investment companies,453 although it is
unclear whether this means that downstream activities, such as sales, are also
prohibited.454 Together with investor protection by avoiding conflicts of
interest, the purpose of this exclusivity principle is to enable the greatest
possible specialisation. In particular the ban on management companies
conducting own name investment business aims to prevent both conflicts of
interest and stability problems. However, the proposed Directive455 to amend
the UCITS intends removing this exclusivity principle, and allowing the
management company to hold mutual fund shares for safekeeping.456
The principle that still applies, however, is that “a unit trust’s assets must be
entrusted to a depositary for safe-keeping”.457 In turn, the depositary
(custodian) can only be an institution that is subject to public supervision,458
although it is up to the EU Member States themselves to decide which
institutions are eligible.459 However, only institutions with adequate financial
resources and an adequate organisational structure, and which are subject to
prudential supervision, are eligible.460
In addition, the recommendation to the Commission is that it includes in its
proposed Directive a requirement for actuaries, who are necessary only for DB
schemes,461 to be independent of the sponsoring undertaking. Moreover, the
separation between asset management and the fund board and the supervisory
board should be mandatory.462 As it turned out, these proposals were not
implemented in the proposed Directive dated October 2000.455
The basic principles governing the business activities of financial services
companies regulated by the UK’s Financial Services Authority (FSA) require
reasonable protection of the investors’ assets by the company responsible,463
whereby the separation of the custodian from the management company
should most likely been seen as part of this “reasonable protection”.
4.2.2 Assuring the effective separation of the board of

directors from the management company by means of
independent directors
Independence criteria
A crucial question is whether formally independent directors can in fact ever be
effectively independent, as they must necessarily collaborate with the
management company in the best interests of the fund, while at the same time
supervising the same management company. In turn, the primary source of
information for conducting this oversight function is the management
company. For the directors, this poses the question of how they can judge the
67
reliability and adequacy of this information. How can the directors

simultaneously maintain a good working relationship – experience shows that
effective relations between the management company and the fund board do
not necessarily have to be permanently confrontational – at the same time as
they supervise it?464
Independent directors with multiple appointments, i.e. directors who are
members of 30 or 40 fund boards,465 may also experience restrictions on their
independence, normally because of inadequate knowledge about the
circumstances of each individual fund and the limited time available to them.
Membership of several boards in a family of funds also entails a risk that
directors will weigh up – and possibly offset – the interests of one particular
fund against the others: it may happen, for instance, that a handful of funds in
a family of funds with otherwise excellent performance have performed very
badly, and the fund board may decide that the poor performance of individual
funds is not sufficient to question renewal of the investment advisory
contract.466 This would subordinate the interests of the shareholders of the
underperforming funds to the interests of the shareholders of the
outperforming funds, something that is prohibited in the USA.467
On the basis of the Investment Company Act of 1940, the SEC can issue an
order finding that a person is an “interested person” due to a material business
or professional relationship with a fund or certain persons or entities. The
period for such relationships starts at the beginning of the two preceding fiscal
years (two-year period) of the fund. The relationships that the SEC believes are
material are of practical importance here:468 Such a relationship is material if it
might jeopardise the independence of the (potential) director, although this is
not the case if the benefits from such a relationship flow from the (potential)
director to the other party, rather than vice versa. In particular, the holding of
certain positions or involvement in certain transactions with certain natural
persons or legal entities is considered by the SEC to impair independence:
x When evaluating professional positions at certain entities (this would
normally be the investment adviser) during the two-year period, the level
of responsibility and compensation linked to the position are the decisive
factors. On this basis, for instance, the position of a fund’s portfolio
manager is regarded as a material relationship. The same applies in most
instances to directors or employees of the fund’s investment adviser (or of
its holding company), although simultaneously holding an additional
directorship of a fund managed by the same fund manager is not classed
as grounds for exclusion.
x When evaluating transactions (which could merely involve a single
transaction) during the two-year period (and in the future for proposed
transactions), the following examples of incompatible situations are cited:
x The investment adviser manages an advisory or brokerage account for the
director and favours it (or creates the impression that it will favour it) over
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comparable accounts of other clients, e.g. in terms of fees or securities

allocations.
x The director is the CEO of a company for which the CEO of the
investment adviser is also a director. Because the investment adviser’s
CEO has a say in the director CEO’s compensation, the latter’s
independence as a fund director is impaired.
x The director has a controlling interest in a company that conducts material
business with the investment adviser.
The SEC is itself currently examining whether the definition of an interested
person is too restrictive. Tom Smith, a well-established US lawyer who for 15
years was co-chair of the subcommittee on investment companies and
investment advisers for the Securities Subcommittee of the American Bar
Association, warns in this context of what he calls the “Judge Ito syndrome”:469
during the O.J. Simpson trial, Judge Ito ruled that nobody who read the daily
papers could serve on the jury.
Definition of a minimum number of independent directors in the

EU and the USA
In the USA, investment companies are managed by a board of directors; at least
40% of the board members may not be interested persons,470 i.e. at least 40% of
the board must comprise independent directors.471
In practice, most of the large US fund companies now have fund boards with
a majority of independent directors,472 above all because of the legal
requirement that funds whose underwriter and investment adviser are
affiliated must have a majority of independent directors.473
The SEC (working together with the Investment Company Institute ICI474
and others) wants to amend the Investment Company Act so that in the future,
fund boards will have to have a majority of independent directors.475 Together
with the proposals outlined below, this measure is just one of several proposed
as part of a major SEC initiative to improve mutual fund governance:476
x Nomination of new independent directors by the independent directors
themselves477
x External advisers to the fund board should be independent of the
management company478
x The provision of more detailed information to the shareholders so that
they can assess the independence of “their” directors479
The notion of a majority of independent directors is not a new one, but is
debated in the USA every couple of years; it even appeared in the draft of the
bill that emerged as the Investment Company Act of 1940, although it has yet to
be actually implemented.480
The SEC regards a majority as at least 51%, while the ICI would prefer a two-
thirds majority. The purpose of such a majority would be to strengthen
69
independent oversight of the investment adviser, which would be crucial in

particular in conflicts of interest between the fund and its investment adviser.
Individual state law would allow – among other things – a (simple) majority of
independent directors to appoint officers of the fund, to convene meetings and
to take other actions affecting the fund’s business operations without
consulting the investment adviser.481 In the EU too, there are efforts to ensure at
least one or two independent directors.482
Nomination of new independent directors and setting

compensation by the independent directors themselves in the USA
The level of effective independence of directors depends on who can appoint
and dismiss them. If this responsibility lies with the investment adviser, then
they are unlikely to be independent.483
For US funds with a 12b-1 plan,484 the independent directors themselves seek
out and nominate their successors.485
A desirable move would be the election of independent directors by those
persons whose interests they represent, i.e. the shareholders, similar to the
election of the supervisory board by the shareholders of a public company in
Germany and Austria.
However, it would be unrealistic to assume that individual investors can
organise themselves (or allow themselves to be organised) to exercise even the
slightest influence on the appointment process. In reality, average investors
only hear from the independent directors of their fund when there is a major
problem and the directors want the shareholders’ support.486
Both the SEC and ICI want independent directors to nominate their
replacements in the future: in addition to the usual personal conflicts
analysis,487 independent directors should screen new candidates for factors
such as the number of other boards the candidate serves on, and relevant
professional and legal experience. However, the management company should
not be completely excluded from the nomination process, but should have the
right to propose candidates, although the independent directors will retain the
final say.488
If the compensation of the independent directors is set by the management
company, as is usually the case in the USA, this does, of course, restrict their
independence: the SEC is increasingly investigating cases where the main issue
centres around the high level of compensation paid to certain independent
directors and the consequent question of the extent to which these highly paid
directors avoid disputes with the management company that would serve
investors’ best interests, for fear of being dismissed or suffering a drop in
income. On the other hand, in all five cases of excessive compensation
adjudicated in the 1980s, the judge ruled that the independent directors
concerned were indeed independent. Ultimately, the shareholders themselves
can reach a judgement because the level of compensation must be published.489
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Restricting the period of office of independent directors would be desirable

to avoid management and independent directors becoming too “intimate” over
time.490
Independent legal counsel to the board in the USA

The view that a legal adviser can simultaneously represent the management
company and the fund or its independent directors is increasingly viewed as
obsolete in the USA.491 The widespread practice at the present is that either the
management company’s counsel also advises the board, or the fund’s counsel
also advises management. Previously, legislators and the fund industry
believed that the disclosure of potential conflicts of interest and the consent of
the client to such multiple appointments was sufficient. However, it has also
happened on many occasions that in the event of extremely blatant conflicts of
interest with the management company, the directors have brought in their
own counsel, although there is no obligation to do so.492
The question now facing those in the USA who accept the need for
independent legal counsel is that of how to design the organisational structure
for independent legal counsel:493
x Separate legal counsel for the independent directors, for the fund and for
the management company, i.e. a total of three different independent legal
advisers.
x Joint legal counsel for the fund and the management company, and
another one for the independent directors.
x Joint legal counsel for the fund and the independent directors, and
another one for the management company.
Although the first proposal would implement the ideal scenario for avoiding
conflicts of interest, the third proposal appears to be more efficient, and at the
same time offers an almost equally strong safeguard for investors’ interests,
because the interests of the fund and the independent directors should
coincide, at least in theory.494
In the same way that the fund’s independent public accountants are chosen
solely by the independent directors,495 selection of legal counsel and the
definition of counsel’s responsibilities should lie solely with the independent
directors.496
In its broad-based initiative to improve “fund governance”,497 the SEC is
calling for anybody who acts as an adviser to the fund board to be independent
of the management company. The SEC believes that this is necessary, firstly
because funds are subject to a complex regulatory scheme, and secondly
because they are exposed to conflicts of interest with their management
company.498 The first factor is what makes legal counsel necessary in the first
place, and the second makes their independence from the management
company desirable.
71
Discussion of this issue in the EU is still at a much earlier stage of

development. For example, the essential requirement that directors should be
able to receive support both from internal (management company) and
external advisers has only recently been put on the table. An illustrative list of
eligible professionals in this context includes actuaries, money managers,
custodians, auditors and investment consultants.499
Extended disclosure requirements concerning directors in the USA

The SEC wants to tighten up the rules so that shareholders receive more
detailed information allowing them to assess the independence of “their”
directors. The facts to be disclosed should include the following:500
x Whether directors own shares in the funds they oversee. At present, funds
are only required to disclose the fund holdings of all directors and officers
as a whole. If this amount is less than one per cent of the fund, only this
fact need be disclosed.
x The existence of an earlier or a current relationship with the investment
adviser.
x The number of portfolios under a director’s supervision and the length of
the directorship concerned. Currently, funds only disclose the number of
investment companies from which a director receives compensation..
Legal liability insurance for directors in the USA

The SEC’s proposals for enhancing “fund governance” 501 include the
elimination from joint fund D&O/E&O (directors’ and officers’/errors and
omissions) insurance policies of “insured vs. insured” exclusions, where no
insurance cover is available for lawsuits between insured parties, specifically
between the investment adviser (insured together with the board) and the
independent directors.502
4.2.3 Chinese walls and firewalls at the management

company
Chinese walls and firewalls denote the functional and organisational separation
(in particular by the physical separation of the staff concerned) of the
independent departments of a securities firm, with the aim of restricting access
to non-published, material information to individuals who necessarily need this
information (“need-to-know” principle), thereby preventing the unlawful use
of inside information. For example, data from the research or investment
banking department of a securities firm should not be passed on to the dealing
department because the latter’s staff might draw inadmissible advantages from
the use of inside information. The dealing room is the primary goal of this
screening process, because it contains the people who could most easily misuse
inside information.
72
A range of internal controls, including structural measures, and in particular

the separation of front office and back office functions and regular controls,
were put on the table503 for the proposed Pension Fund Directive,504 although
these did not appear in the proposal for the Directive dated October 2000.505
The UK’s regulator, the Financial Services Authority (FSA) sees the
responsible and effective organisation and control of the business and affairs of
regulated firms as a core principle for the conduct of their business. Although
adequate risk management is expressly mentioned in this context, the concept
of effective organisation surely also includes firewalls, because these are an
effective organisational instrument for preventing insider abuses.506 Directors
and senior managers are primarily responsible for ensuring compliance with
this core principle.507
4.2.4 Proxy voting

In the past, US investors attached little importance to issues of corporate
governance that they were in a position to influence by exercising the voting
rights vested in their common stock. Investors with a short-term horizon, and
minority shareholders in particular, steered well clear of firms they perceived as
being badly managed (with bad management equating to a price discount),
instead of trying to influence management by increasing their position and the
associated voting rights.
Retail investors voted with their feet by simply selling the stock in question,
and even institutional investors rarely exercised their voting rights, interacting
with management only in times of crisis. Such a strategy soon reaches its limits
in thin markets, however, especially with small and mid-caps where large block
trades can have a seriously negative market impact.508 One consequence of this
is that the trade-off with such investments is low liquidity (or that suboptimal
management must be accepted as the price for investing in certain markets or
stocks), so the only feasible investment targets would then be blue chips. In
turn, this would push up the price of blue chips disproportionately (with a risk
of overpricing), and above all, any opportunities to be gained away from large
caps would disappear from sight.
In view of this unsatisfactory situation, a greater emphasis on proxy voting
would be most welcome. If there is acceptance for this need, the next question
to be faced centres around voting practice and the associated responsibility of
the proxy. The reason for this is that in the USA, proxy voting is a fiduciary
duty: because exercise of a voting right has an economic value, votes must be
cast in the interests of the shareholders or pension plan members, which in
turn means that the fiduciary must gather and analyse all the necessary
information about the matters being voted on.
A written voting policy statement is desirable, with the fund board its most
suitable author. Here too, the general principle applies that the fiduciary cannot
discharge his responsibility by delegation (to specialised firms).509 If relevant
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advisers are, however, engaged, their supervision must be assured to the extent
that they do not breach principles of prudence and suitability criteria.
The ERISA rule is that either the management company can have sole
authority to decide voting procedures, or the sponsor reserves the right to
determine them and can issue instructions to the management company,
which can only refuse to implement them if they would breach the prudence
principles or other ERISA regulations. The voting policy statement must be
reviewed regularly (which in turn requires precise rules of conduct for the
preparation and storage of corresponding documentation); this may result in it
being revised, which in practice is normally the consequence of votes on
controversial issues.
The matter again at issue in this area of fiduciary duty is the avoidance of
conflicts of interest by setting down requirements and prohibitions, as well as
disclosure rules. Potential conflicts include, for example, situations where
individuals who can influence voting behaviour:
x also have (senior) positions at the companies on which the vote is being
taken;
x are shareholders of these companies;
x or are personally dependent on them, e.g. as a business partner or
borrower;
x or have been pressured or even bribed by the management of these
companies.
The contents of policy statements on proxy voting are illustrated below by an
extract from the policies adopted by TIAA-CREF (Teachers Insurance and
Annuity Association-College Retirement Equities Fund):510
x The board of directors (meaning the board of the corporation concerned,
not a fund board) should adhere to the principle that each share of
common stock has one vote and that votes should be resolved by a simple
majority of votes cast. Multiple classes of common stock with disparate
voting rights as well as super-majority voting requirements should
therefore be avoided, except if necessary to protect the interests of
minority shareholders.
x The board should adopt the principle of equal financial treatment for all
shareholders to limit the corporation's ability to buy back shares from
particular shareholders at higher-than-market prices.
x Regarding defensive measures to prevent hostile takeovers, TIAA-CREF
believes that the market provides appropriate mechanisms for disciplining
management, and that takeover defences should not make a board
impregnable. TIAA-CREF specifically opposes defensive measures
containing provisions that seek to limit the discretion of a future board to
modify such measures.
Many states have adopted statutes that protect companies from
unfriendly takeovers, in some cases through laws that dilute directors'
74
fiduciary obligations to shareholders. Proposals to change the

corporation's domicile to another state should therefore be opposed if
their purpose is to take advantage of protective statutes. Where possible,
the board should opt out of coverage under state laws mandating anti-
takeover protection.
x The board should not combine disparate issues and present them for a
single vote. An entire proxy issue proposal should be rejected if any of the
constituent parts are opposed.
x A proposal to increase the authorised number of common shares should
be accepted only if they are intended for a valid corporate purpose and
are not to be used in a manner inconsistent with shareholder interests, for
instance an excessively generous stock option plan. An increase in the
authorised number of preferred shares should be opposed if they can be
used without further shareholder approval as part of an anti-takeover
program, for example for a “poison pill”.

In terms of the separation of functions, the EU Pension Fund Directive
currently under development, combined with the “Rebuilding Pensions”
study, has very few shortcomings, as it expressly stipulates the following
separations:
x Institutional separation of the fund and its sponsoring undertaking, the
employer of the pension plan members;
x Independence of actuaries from the sponsoring undertaking and the
management company;
x Independence of the custodian;
x The use of chinese walls to separate the management company’s securities
dealing department in particular from other departments;
x Separation of asset management (i.e. the management company) and the
fund board.
The latter point, however, urgently needs more detailed regulation, especially
as regards the proposed fund board independent directors:
x There appears to be no adequate definition in sight as to the proportion of
independent directors on the fund board; all there is at present is a brief
proposal that there should be one or two independent directors per board.
If would surely make more sense to define a minimum percentage, as in
the USA, that could even be a majority.
x There is still uncertainty about the standards to be applied to individuals
so that they can be eligible to serve as independent directors. A look at the
USA on this topic reveals generally broadly drafted incompatibility rules
that have been narrowed down over the years by SEC interpretations.
These have thus led to the emergence of what some people see as an
excessively restrictive approval regime which – in combination with the
75
high level of personal responsibility that can result in expensive lawsuits –

is a contributory factor in ensuring that many candidates with
outstanding professional credentials and valuable experience cannot or
will not serve as independent directors.
x The nominating body and the body with the final say also need to be
regulated, with the same applying to the setting of compensation. If the
management company decides on the nomination and compensation of
independent directors, their independence is likely to be compromised.
The other extreme view that independent directors should nominate their
own replacements and have sole decision-making powers about their own
compensation in turn involves a risk that the directors will feel obligated
mainly to each other because of the lack of non-legal sanctions. This
would not necessarily be remedied by comprehensive disclosure duties in
this respect, because investors often perceive such disclosures as nothing
more than “noise” that goes under in the general flood of information.
Great importance is attached to the independence of the fund board’s legal
counsel in the USA, while its overall importance for EU boards is certainly far
less pronounced because the EU legal system is a completely different one –
based to a far lesser extent on case law – and boards do not need external legal
advice on many issues.
Another issue to be regulated relates to the exercise of the voting rights
vested in the fund’s securities: here too, the aim is to resolve conflicts of interest
with the goal of ensuring that investor interests receive the best possible
protection. Standards in this area must ensure that voting rights are exercised
on the basis of shareholder value aspects, and not in the pursuance of personal
– the acceptance of gifts or other benefits from companies that are the matter to
be voted on – or professional interests – for instance if the company in question
is a (potential) customer.
4.3 DISCLOSURE
4.3.1 Disclosure of all material facts in the USA, in particular

in conflict of interest cases
Investment advisers are obliged to disclose fully and fairly all material facts as
part of their primary duty to safeguard the interests of clients under their
fiduciary duties.511, 512, 513
This disclosure is made above all by way of the prospectus514 and the
standardised registration form for investment advisers, Form ADV.515 The SEC
wants to update the contents of this form so that in future, investors will
receive even more information about financial conflicts of interest that may
arise between the (staff of) the investment adviser and its clients.516
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4.3.2 Valuation of fund assets

The rule for UCITS is that the custodian is obliged to ensure the proper
valuation of the fund assets,517 although there is no explicit obligation to use
market prices.
In addition, the issue and redemption price of the fund units must be
published at least twice a month (or even only once a month in approved
exceptional cases).518
The recommendation to the Commission is to require fund assets519 to be
marked to market in its proposed Directive regulating pension funds520 and to
harmonise valuation rules across the EU.521
The proposal for valuing derivatives makes a distinction between futures, for
which the underlying value522 should be used, and options and warrants,
which should be valued on the basis of their market value. The significance of
this valuation problem is qualified by the fact the derivatives are only used
occasionally by pension funds, and that they are generally only used for
defensive purposes, e.g. for hedging or cost reduction.523
In the USA, funds are required by law to determine the price (net asset value)
of their shares at least once a day. This price is the value of the fund’s assets less
any liabilities, divided by the number of shares outstanding.524
US law requires listed securities to be valued at market prices,525 with a fair
value determined for all others in good faith by the fund board (with the
assistance of the independent and “interested” directors).526 Even if market
quotations are available, the fair value method can be used as long as the
resulting value does not exceed the market value.527
The fair value method is of particular importance in the case of foreign or
illiquid securities, or large positions in small caps.
The following aspects of the fair value method deserve a more detailed
explanation:528
x Good faith valuation: valuation does not necessarily have to be accurate to
the nth degree, but the process used must be understood by the fund
board and determined to be consistent (see below). The fund board
cannot waive its duty of prudence by outsourcing, e.g. by engaging
specialist pricing services.
x Determination by the fund board: this does not mean that the directors
have to discharge a management duty on a daily basis by determining the
actual fair value of each security concerned – this would also run counter
to their statutory independence, because if the directors essentially
become part of management, they can no longer be independent of it.
Rather, the responsibility of the directors is to ensure that prices are
correct in that they have to understand the pricing process and the
methodologies used, and to determine that these are consistent. They are
ideally – but not necessarily – assisted here by external advisers or by the
establishment of a board valuation committee, which may also consist
solely of “interested” directors. It would be impossible in reality to involve
77
the entire board in each individual valuation because the board does not
meet in continuous session. Not even any valuation committee is normally
permanently available (unless it consists solely of “interested” directors),
which is why daily valuations are made by the investment adviser, and
specifically by the portfolio managers, who use valuation methodologies
that have been reviewed and approved by the fund board. However,
because of their inherent bias, excessive reliance on portfolio managers is
not desirable (they are, after all, responsible for the decision to buy), and
may represent a breach of fiduciary duties by the fund board.
The valuation committee or the entire fund board is only convened when the
established methodologies are insufficient in specific instances. If even then no
satisfactory solution can be found, it is best not to include the security
concerned in the fund portfolio in the first place.
The US Internal Revenue Service (IRS) defines fair value as the price at which
an asset would be exchanged between a willing purchaser and a willing seller if
the seller is under no pressure to sell and the buyer is under no pressure to buy,
and both parties are reasonably informed about all relevant facts.529

In the USA – the EU has not adopted any Union-wide rules here – conflicts of
interest between the management company (and its affiliates) and the fund are
regulated in a number of ways:
x by (generally case law) prohibitions on certain transactions with an
inherent conflict of interest potential,530
x by disclosure requirements covering (potential) conflicts of interest, and
x by the fund board’s oversight obligations under its fiduciary duties.
Relying too heavily on disclosure could be risky because the ability of the
average investor to process information is limited. Rather, reliance should be
placed above all on the fund board and its independent directors, although
here too, it is vital to structure the fund board such that there can be no doubt
about its integrity and effectiveness. This would also have the advantage of
eliminating strict prohibitions, which in turn would help increase the flexibility
of the management company and, one would hope, thus enhance performance
(and cut costs) for the investors.
78
CHAPTER 5
The Regulation of
Investment Risk
5.1 INVESTMENT RULES
5.1.1 Prudence, not extensive quantitative restrictions, in the

EU and the USA
The changing regulatory situation in the EU
The UCITS Directive currently imposes extensive investment restrictions on
mutual funds:
x Investments normally531 only in listed securities or securities traded on an
adequately regulated market.532
x General prohibition on borrowing with only a few exceptions.533
x Prohibition on short selling.534
x Prohibition on securities lending.
However, the European Commission is aware that pension funds “… make
investments in order to meet future obligations”.535 The Commission
understands that even very slight improvements in the risk/return equation
can produce considerable gains for future pensioners,536 at the same time
reducing the ever growing cost537 of pension provision.538 The Commission
therefore wants to curb investment restrictions without simultaneously
reducing the quality of prudential supervision.
The Commission has plans to replace the existing investment restrictions by
“sensible”539 prudential rules that allow pension funds to optimise their
portfolio structures through risk diversification,540 specifically by investing in
79
THE REGULATION OF INVESTMENT RISK
“pan-European equity, international equity, real estate and fixed income

assets”.541 Pension funds should be able to select assets that better match the
long-term nature of their liabilities and thus reduce risk.542 In addition to
diversification and appropriate supervision, transparency for the members of
pension funds is seen as a requirement for such a regime.543 The proposal for an
EU Pension Fund Directive consequently envisages employees and pensioners
being entitled to receive the annual accounts and annual report on request544 as
well as an explanation of the investment policy.545
Shortly before the single European currency was launched, the types of
investment permitted by the individual Member States varied considerably:546
the proportion of equities permitted in the UK – and to a lesser extent in
Ireland – was high (80% and 55% respectively), but most other Member States
required a greater weighting towards fixed-income securities, and in particular
government bonds, because only these were available in the volumes sufficient
to satisfy demand. These differences also affected the funds’ ability to invest in
foreign securities:547 30% of fund assets could be invested in foreign securities in
the UK and 25% in the Netherlands, but most other Member States limited this
to a maximum of 10%.548
In view of the changing circumstances since these figures were recorded –
with a single currency in place – these restrictions must now be revised, at least
by the euro-zone countries, as investments in the euro zone should be treated
as domestic investments because of the elimination of the currency risk; if this
is not the case, the country concerned would rightly be accused of subjective
(and unlawful) discrimination.
The European Commission believes that as a rule, the regulatory regime for
financial services should be pegged more to qualitative than to quantitative
criteria. The Commission itself wants to set a good example here by exercising a
degree of self-restraint to avoid over-complex legislation, but emphasises that
this must be reciprocated by the institutional partners.549
Voluntary standards could fill any vacuum that arises here, supplementing
qualitative core principles by quantitative criteria.
The proposal to amend the UCITS Directive extends the range of eligible
investments by the following instruments::
x Liquid money market instruments whose value is determined regularly550
as well as such instruments that are not traded on a regulated market, as
long as certain conditions are met.551
x Shares of other UCITS,552 normally553 up to a maximum of 10% of the
fund’s assets in shares of a single UCITS,554 as long as this is not a fund of
funds.555 Shares of the same or of an affiliated fund complex may be
acquired subject to certain conditions, in particular the waiver of fees and
costs, following approval by the regulator.556
x Bank deposits,557 where these are not excessively concentrated in a single
credit institution558 and this credit institution is not the depositary
(custodian).559
80
x “Ancillary” liquid assets (e.g. sight deposits) and cash.

x Standardised options (in particular currency and interest rate options)560
and futures contracts561 traded on certain markets,562 as long as the
associated risks are fully covered by ensuring that appropriate amounts of
corresponding assets are held.563
x OTC derivatives, if the counterparties are suitable institutions.564
x Under certain circumstances.565 involvement in securities lending,
including as the lender.566
The draft Pension Fund Directive planned for publication by the European
Commission for the summer of 2000567 was eventually published in the autumn
of that year.568 The aim was to improve supplementary pensions,569 and in
particular to subject pension funds to a minimum level of regulation at EU
level,570
As part of its work in this area, the European Commission published a
communication entitled “Towards a single market for supplementary
pensions”571 in May 1999, outlining the core aspects of a corresponding
directive. These included a proposal to remove the quantitative criteria
applying to pension funds’ investment rules and replace them by the
application of the “prudent man”572 rule.573
In this communication, the Commission states that: “Investment rules should
not unnecessarily restrict the investment strategy of pension funds”.574 In its
pensions green paper, the Commission notes similarly that it is not proposing
any special investment rules for pension funds, adding: “It is the role of the
fund managers to determine the best investment strategy for the ultimate
benefit of pensioners, subject only to appropriate prudential supervision.”575
Such statements can be interpreted as an invitation to develop voluntary
standards to add substance to the room for manoeuvre promised by the
Commission.
The Commission is thus proposing standards comparable with the US
prudent expert/investor rule, and explicitly notes the importance of
diversification;576 applied properly, it can both cut risk and increase return. It
also emphasises that even government bonds do not always offer the level of
security often associated with them by the average investor, because they
respond to changes in the interest rate environment and to inflation
(sometimes quite sharply, as shown by bond market trends in 1994 and 1999).577
The European Commission even goes as far as terming equities a safer
investment than bonds in the long run, citing the results of a US study of the
risk/return characteristics of equities and bonds classified by investment
horizon (see Figure 18). This suggests that above an observation period of ten
years, and provided that there is no difference in volatility, equities are “just as
safe” as bonds, but offer a significantly higher return of 7%, compared with the
just over 3% for bonds. For longer periods, not only is the return generated by
equities still far higher than that of bonds, their volatility is also lower, i.e. they
are safer. Because retirement provision in particular is characterised by a long
81
investment horizon, this study contradicts the argument put forward by

various groups that equity investments are too risky for pension provision.
Figure 18: Risk/return for various investment horizons (1802–1995)578
A look at a more Europe-centric environment produces similar results: an

analysis of DM/euro bond trends (represented by the REX) and international
equities over a twenty-year period from 1 January 1978 to 1 January 1999
indicates that an equity portfolio has superior risk/return characteristics over a
ten-year period than a 100% bond portfolio, because although its risk is higher
– expressed by the standard deviation (3.88 instead of 0.39 for 100% bonds) – its
average return is also significantly higher (11.77% rather than 7.58%) (see
Figure 19).
The advantages of equities over bonds for long-term investment horizons are
due to what is known as “time diversification”:579 As the investment period
increases, the expected cumulative return rises linearly (see Equation 2), while
the cumulative standard deviation only rises degressively (see Equation 3).
Value-at-risk (VaR), as the cumulative return less the cumulative standard
deviation, initially falls, but then starts rising again from a certain point (i.e. a
certain investment horizon), indicating that the cumulative return more than
offsets the cumulative risk starting at a certain investment horizon.
This is illustrated in more concrete terms by the following example of the
greater gains from an investment in equities versus an investment in bonds
over a long-term period. An expected return of 10% p.a. and a volatility of 18%
is assumed for equities, and a 5.5% annual return and 4.5% volatility for bonds.
82
Adopting a sceptical position on equities that expects the worst case

development for equities, marked by long-term underperforming the expected
return by one standard deviation (see Figure 20), and the best case for bonds –
outperformance of one standard deviation (see Figure 21) – produces the
minimum investment horizon needed to ensure that equities nonetheless
outperform bonds in the long run. It is evident that this requires an investment
horizon of at least twenty-five years (see Figure 22), i.e. the sort of requirement
that would, in most cases, be more than satisfied by individuals saving for their
pensions.
return
16% 100% international stocks
14% 100% stocks
100% stocks 30% EUR bonds/70% int. stocks

12%
30/70
30/70
50% EUR bonds/50% int. stocks
50/50 50/50
10%
75/25
75/25 75% EUR bonds/25% int. stocks
8%
100% Bonds 100% EUR bonds
6%
4%
1 year 3 years 5 years 10 years
2%
standard deviation
0%
0 2 4 6 8 10 12 14 16 18 20
Figure 19: Risk/return of five differently structured portfolios580 for 1, 3, 5 and 10-
year holding periods581
Cumulative return = µ · n where: µ Expected annual return

n Investment horizon in years
Equation 2: Cumulative return
Cumulative standard deviation = O V n

where: O Confidence parameter (number of standard deviations)
V Volatility
n Investment horizon in years
Equation 3: Cumulative standard deviation
83
360% Expected return

340% Cumulative expected return: equities
320%
300%
280%
260% Cumulative worst
case return: equities
240%
(VaR)
220%
200%
180%
160%
140%
120%
100%
80% Cumulative standard
60% deviation: equities
40%
20% Years
0%
-20% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
Figure 20: Worst case equities scenario over 35 years: expected return 10% p.a.
with 18% volatility, worst case is one standard deviation below the
expected return

340%
320%
300%
280%
260%
240%
220%
200%
180%
160%
Cumulative best
140% Cumulative
case return: bonds
120% expected return:
bonds
100%
80%
60%
40%
Cumulative standard deviation: bonds
20%
Years
0%
-20% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
Figure 21: Best case bonds scenario over 35 years: expected return 5.5% p.a. with
4.5% volatility, best case is one standard deviation above the expected
return
84

340%
320%
300%
280%
260% Cumulative worst case
return: equities(VaR)
240%
220%
200%
180%
160%
140% Cumulative best Investment horizon
case return: bonds minimum 25 years
120%
100%
80%
60%
40%
20%
Years
0%
-20% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
Figure 22: Worst case equities versus best case bonds, 25-year horizon
The Commission also cites a prominent economist in its list of reasons for
abandoning its previous practice of investment rules: “Restrictions imposing
arbitrary limits on asset holdings by type of asset, country or currency
distribution run contrary to the prudential principle because they severely limit
risk diversification. This constraint forces pension funds to assume more risks,
while sacrificing return, and to conduct investment policies that are detrimental
to their members in the long run.”582
The “Rebuilding Pensions” study also vigorously advocates the view that
traditional investment rules should be rejected in favour of freedom of
investment, because – together with the need to invest in equity instruments –
this is a fundamental requirement for funding future retirement provision.583
Quantitative investment restrictions give the wrong signals, because they (a)
distort competition by largely preventing asset managers from using their
professional knowledge, (b) encourage complacency by preventing the
emergence of a developed pensions management industry, and – above all – (c)
prevent both increased returns and reduced risk.584 To still be able to guarantee
the security of pension funds in a regime without quantitative investment
restrictions, Asset/Liability Management585 – a superior risk management
instrument586 – could be used, as well as a fund board with extended powers
and responsibilities.587
Active portfolio management588 should also be properly included in the field
of investment rules in any discussion of standards because it represents a
structured, quantitative investment approach with risk management as an
integral component.
85
The Commission itself says that: “Experience has shown that over-restrictive
investment rules have considerably harmed the yields of pension funds
without any gains in security”.589 It is even clearer when it notes that stringent
limits on the proportion of equities that pension funds can have in their
portfolio could not only reduce the rate of return, but could actually even
represent “a threat to security. Such restrictions might prevent investors from
benefiting from the euro zone in order to diversify their risks”.590 This is
emphasised by reference to studies that demonstrate both a better return and a
lower volatility, and hence the lower risk, of equity investments in comparison
with government bond investments over the period of a pension
commitment.591 The consequence of such rigid regimes is reduced benefits
and/or higher contributions. The latter would further increase the already high
burden of non-wage costs and thus negatively impact employment, one of the
EU’s most sensitive problem areas. At the same time, restrictions targeting
equity investments in particular limit the private sector’s ability to raise
finance.592
In fact, almost all Member States have such quantitative restrictions.593 A
feature of such restrictive regimes is that a high proportion of the assets they
regulate has to be invested in government bonds. The European Commission
doubts, however, that easing or abolishing these restrictions would change
actual investment patterns very much because in many cases, the limits of the
investment restrictions have not even been reached.594
The European Commission’s proposal for a Pension Fund Directive is indeed
based on “a qualitative approach to investment rules”:595 it states that
investment portfolio management should be based on the principles of
security, quality, liquidity, return and diversification, rather than on
quantitative investment rules. Nevertheless, the proposed Pension Fund
Directive does not completely reject quantitative investment restrictions, but
rather proposes that restrictions by individual EU Member States should be
allowed (solely) for supervisory reasons, i.e. if the “supervisory methods used
…. are closely linked to the application of quantitative rules”595. However, they
may be used neither to discriminate against non-domestic securities, nor as
disguised restrictions for non-prudential reasons.596 However, even where
restrictions do exist, pension funds must still be able597
x to invest at least 70% of their technical reserves or their portfolio598 in
equities, securities treated as equities and corporate bonds;
x to invest more than 70% of their technical reserves in non-matching
currencies,
x and to invest in risk capital markets.599
In practice, such restrictions will only be permitted if there is no proliferation of
such quantitative rules, if they do not excessively restrict freedom of
investment,600 if they do not prevent601 effective Asset/Liability Management
and do not oblige funds to invest in certain asset classes. At any rate, domestic
86
assets may not be preferred over comparable assets from other Member States
for prudential reasons.602 In addition, actuaries – who are only required for DB
systems – may be entitled to restrict the investment strategy as part of their
oversight powers.
The European Commission believes that the present situation, where
pension funds are widespread in those countries where they are not subject to
quantitative restrictions, and where higher returns (see Table 17) are evident in
particular because the proportion of equities in the portfolios is higher than in
countries with quantitative restrictions, demonstrates the soundness of its
desire to adopt the prudent man rule.
Country Real average return 1984–1998 (%)

Belgium603 10.33
Denmark 6.14
Germany 6.72
Ireland603 12.54
603
Netherlands 9.64
Switzerland 4.90
603
UK 10.35
USA603 10.49
Prudent man rule countries ex-USA 10.71
Prudent man rule countries incl. USA 10.67
Countries with substantial quantitative
investment restrictions 5.92
Table 17: Real average rates of return (in local currencies) of the pension fund
portfolios of selected countries between 1984 and 1998604
The need to relax restrictions on EU pension funds on what they can invest
in equities is also further demonstrated by a historical analysis of the higher
returns offered by equities compared with bonds (see Table 18 and Table 19).
The Gesamtverband der Deutschen Versicherungswirtschaft e.V. (GDV – the
German Insurance Association) is not entirely happy with the system for
regulating pension funds proposed by the European Commission,605 arguing
that the focus of the green paper606 is wrong because it is too fixated on the
capital markets and pays insufficient attention to security. The GDV is of the
opinion – a belief that would find few backers in the USA – that retirement
provision systems should be geared purely to provide pensions (and possibly
to cover biometric risk607), and that any (side-)effects on the capital markets –
even positive ones – should be ignored.
The life insurers trace the historical success608 of their products to the fact that
they meet their customers’ criteria for security and contrast them starkly with
the investment rules for pension funds; these are regarded as too insecure, in
particular the reliance on the prudence principle (prudent man rule) and the
abandonment of quantitative investment rules.609
87
’97 31.8 3.7 Equities

’96 29.2 7.6 Bonds
’95 8.0 16.7 Bond return outperforms equity return
’94 –6.3 –2.5
’93 48.7 14.7 20.7 7.8
’92 –0.7 13.4 14.1 9.8
’91 14.5 11.2 11.3 10.5
’90 –20.9 1.4 4.6 7.4
’89 36.6 1.6 12.8 8.3
’88 35.0 5.0 10.6 6.4 15.6 7.1
’87 –36.9 6.8 1.1 5.1 7.4 7.4
’86 5.8 8.6 –0.5 4.6 5.2 7.5
’85
First year of analysis period
87.6 10.3 18.2 6.4 11.2 6.9

’84 15.6 13.2 14.3 8.7 13.6 8.5
’83 45.4 4.9 16.1 8.7 13.3 7.6 15.7 7.6
’82 20.2 18.6 32.0 11.0 15.5 8.0 15.0 8.6
’81 5.3 5.1 31.9 10.3 14.5 7.4 13.5 8.4
’80 4.3 3.1 17.3 8.8 17.8 7.6 13.2 7.5
’79 –6.9 0.5 12.3 6.3 13.3 7.5 13.2 7.8
’78 9.1 3.7 6.0 6.0 10.9 7.4 10.8 7.0 13.2 7.2
1 year 5 years 10 years 15 years 20 years
Length of investment period
Table 18: Comparative returns of German equities and bonds610
1970–1998 German
1984–1998 pensions
(29 years) expert Bert Rürup too
(15 years)
Netherlands 5.92% 7.18% focuses on the security
France 4.97% 3.12% aspect, rather than
UK 3.95% 3.67% returns, when he
Germany 1.48% 4.36%
emphasises the impor-
tance of investment
USA 4.79% 5.29%
security as one of the
Japan 1.92% –3.32%
two fundamental con-
Table 19: Returns above corresponding bond market ditions for structuring
returns achieved in selected equity markets pension products,612
(in local currencies)611 and ignores what fin-
ancial theory has learned about efficient portfolio construction (see Capital
Asset Pricing Model (CAPM), p. 90).613
The GDV does not want to abandon quantitative investment rules and
argues that these are in any case only operational rules that put the prudent
man rule into a concrete form; in any case, they contend, the EU Member States
88
should be able to continue insisting on their application. The insurance

industry is also trying – evidently with some success at the moment614 – to
persuade the German government that the system for regulating private
retirement provision currently under debate should include a mandatory
guarantee for, at the very least, the paid-in capital. This would benefit the
insurers because in contrast to fund-based pension products, redistribution
between the individual policyholders is a core feature of the insurance
business.615
However, what has been discussed previously in this chapter shows clearly
that such quantitative investment rules would hinder the implementation of
the prudent man rule, and by forcing pension plan investors to accept a lower
return, often without a corresponding reduction in risk (bond prices can also
fluctuate sharply), would deny them a substantially better pension.
Both passive portfolio management616 – implementing Modern Portfolio
Theory – and active portfolio management617 – which casts doubt on this theory
– are impaired by restrictive quantitative investment rules to the extent that
these investment techniques may be rendered impossible. On the other hand,
there can be no objections to quantitative rules that supplement qualitative
investment rules as long as they are objectively justified, and thus have only
very limited potential for obstructing advanced portfolio management
techniques.
What the GDV itself terms its most serious criticism is aimed at the European
Commission’s intention not to classify the coverage of biometric risk and the
annuitisation of payouts as mandatory criteria.618 The Party of European
Socialists (PES) has also spelled out that it will certainly not vote for a draft
Pension Fund Directive in the European Parliament if the safeguarding of
biometric risk is not included.619
In contrast to the pension funds, the mainstays of the second pillar of
retirement provision, the EU has already issued620 harmonisation rules for life
insurance companies,621 the most important representatives of pillar three
pensions. The following principles are of importance for investment policy:622
x Investment must be based on the prudent man principle;
x Member States may not require insurance companies to invest in
particular asset classes;
x Member States may not require insurance companies to invest more than
80% of assets in the currency matching their liabilities. This matching
currency rule has been dropped in the euro zone in the course of the
introduction of the euro.623

In the USA, quantitative investment rules are not as prominent as in Europe,624
due of course to the long-established prudent investor/expert rule.625
89
At the end of 1999, almost 75% of 401(k)626 occupational pension plan

balances were invested in equity securities. Sensibly, however, the proportion
of fixed-income securities rises as the plan member grows older; only 20% of
the plan assets of people between 20 and 30 is invested in fixed-income
securities, but this proportion grows to just over 40% for plan members over
the age of 60.627
5.1.2 Modern Portfolio Theory

Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing
Model (CAPM) builds on the
theory of portfolio selection
developed by Markowitz in
the early 1950s which states
that securities can be
described by the expected
value and variance of relative
price changes. In efficient
portfolios, the securities
available on the capital
markets are weighted such
that the variance of portfolio
return is minimised for a
Figure 23: P-V2 curve of efficient portfolios specified expected portfolio
return. Figure 23 shows the
2
resulting P-V curve of efficient portfolios: the risk that can be eliminated in
portfolio construction is eliminated in portfolios lying on the AA´ curve
through diversification. All that remains is non-diversifiable risk (systematic or
market risk) in the form of the variance V2 linked to a certain return P:
Equation 4 shows the calculation of the variance of such a portfolio composed
of M securities. This illustrates the high information requirements of this model,
as there is a large number of parameters to be estimated (see Equation 5).
However, this and other numerical problems that emerge when trying to
optimise portfolios are now largely manageable.628
M M
V2 ¦¦ n n i j cov ij
i 1 j 1
Equation 4: Variance of a risk-efficient portfolio (after Markowitz)
90
Covariance
s
Variances
`
m2 m m2 m
Estimates : m
2 2
Equation 5: Number of variances and covariances to be estimated to establish portfolio
variance (after Markowitz)
The CAPM traces its roots

back to Sharpe, who
developed a model for
valuing capital assets in
equilibrium. However, the
process leading to this
equilibrium is not part of the
model.
Capital market theory (see
Figure 24) is normally based
not on variance (as in
Figure 23), but rather on
standard deviation, and also
describes return as a
Figure 24: The efficient frontier and the capital dependent, rather than an
market line629 independent, variable (as in
Figure 23). The well
diversified market portfolio M with an expected return PM and its standard
deviation of VM lies on the AA´ efficient frontier (the curve of efficient
portfolios). Although curve BB´ also contains the market portfolio M, but other
contains inefficient portfolios with a risk that can be reduced through
diversification. A tangent set in M and the curve AA´ bisects the ordinates at P0,
the risk-free rate of return.
Differently weighted combinations of the two sub-portfolios (1) riskless asset
and (2) market portfolio lie on this tangent of P0 and M: starting at P0 towards
M, the proportion of the risk-free asset in the overall portfolio decreases
continuously until it reaches 0% at M. To the right of M, the riskless asset is sold
(i.e. money is borrowed at the risk-free rate of interest630) to finance further
investments. This tangent is termed the set of dominant portfolios or the capital
market line.
91
In contrast to the
capital market line,
the security market
line (see Figure 25)
describes the expect-
ed returns Pi from the
individual securities
in the portfolio (see
Equation 6); it makes
use of the variable E
(see Equation 7),
which is extremely
important in both the
theory and practice of
Figure 25: The security market line portfolio manage-
ment. E describes the
covariance of return of the security concerned in relation to the market
portfolio return, normalised to the variance of the market portfolio return. The
second term in Equation 6 describes the risk premium of the security
concerned, i.e. the difference between the expected rate of return of the market
portfolio and the risk-free rate of return, multiplied by the market risk E.
µi = µ0 + (µM – µ0)E i where: µ0 Return of the risk-free asset
µM Market rate of return
Ei Beta of security i
631
Equation 6: Security market line
covri , rM U iM V iV M Vi cov(ri, rm) Covariance of return of

Ei U iM
V M2 V M2 VM
security i in relation to the
where
return of the market portfolio
:
Vi Standard deviation of return
of security i
VM Standard deviation of market
rate of return
UiM Correlation between return of
security i and market rate of
return
Equation 7: Beta
Theoretically, this market portfolio consists of all assets traded on the market,
but in practice, a benchmark – normally an index – is used as an approximation,
so that the rate of return of a security in Equation 8 is determined by a single
index, in conformity with Equation 6. For the random variable Hi, the expected
92
value is normally zero, the variance is 1 and the correlation between random
variables is zero.
µi = Di + EiJ µJ + Hi where: Di Return component independent
of EiJ
µJ Expected rate of return of the
index asset
EiJ Beta of security i in relation to
index asset
Hi Random variable
Equation 8: Expected rate of return in the single index model
Passive portfolio management and prudence

Together with the Efficient Market Hypothesis632 (EMH), the Capital Asset
Pricing Model (CAPM) proposes the superiority of passive investing that tracks
a market index. This superiority rests on the efficiency and diversification of
this approach.633
The basis of the efficiency is that a portfolio that complies with the CAPM
and the EMH (a differently weighted combination, depending on risk/reward
preference, of the market portfolio and the riskless asset, which is normally
represented by government bonds) represents an optimum solution in terms of
its return or its risk to the extent that – all other things being equal – no higher
return is obtainable for the same risk, or that – again all other things being
equal – at least an equally high return cannot be obtained for a lower risk.
In other words, if the market – in the form of the aforementioned
combination of market portfolio and riskless asset – cannot be outperformed,
why bother investing in active asset managers who try to identify underpriced
and overpriced securities (which the EMH tells us do not exist)? This is why the
opinion is often voiced that passive portfolio management is also the most cost-
efficient form of investment (lower research and analysis cost of passive
portfolio management).
However, doubts are increasingly being cast about EMH; empirical data is
put forward to argue that purely passive investment may leading to the
investor holding extremely risky individual securities that may even go
bankrupt. There is a widespread belief, however, that insolvency can be
predicted by using screening methods, so purely passive portfolio management
is not prudent because prudence requires the application of just such screening
procedures, which would result in a portfolio that differs in reality from the
market portfolio.634
In addition to this problem, there are other reasons why pension fund
fiduciaries must provide justification for any decision to opt for passive
portfolio management, or at the least they must have ready answers for the
following questions:635
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1. What percentage – if any – of the pension fund will be invested in index

funds?
The advantage of index funds is their lower cost; the downside is the
inefficiency that exists in certain markets; for example, the market for
small caps may be less efficient than the market for large caps, so the small
cap market will tend to require active portfolio management. The question
of which markets the fund actually invests in will depend on the
overarching investment strategy and goals.
2. If index funds are used, which funds will be selected, and what is the
relevant market portfolio?
Depending on the pension fund’s target risk/return, a variety of
markets, and thus of index funds, will be considered. The efficiency of the
selected index fund(s) must then be established, i.e. its/their tracking
error636 must be estimated.
3. Should the pension fund portfolio manager examine the composition of
the index fund to establish that it really does track the specified index? If
so, how often?
These review costs may be so great that they substantially reduce the
cost advantage of passive portfolio management.
4. Does the use of index funds limit the liability of the pension fund portfolio
manager for the investments?
This would certainly not be the case for an ERISA fiduciary, who is
generally prohibited from delegating decisions;637 this would be
incompatible with investing in index funds, because the decision to invest
in individual securities is necessarily delegated to the index fund manager.
A point in favour, on the other hand, is that US courts are increasingly
ruling is that the portfolio must be treated as a whole, rather than at the
level of the individual securities,638 which increases the legal certainty of
passive management.
5. Does the use of index funds affect the extent to which pension fund
portfolio managers should be involved in the management of the
companies whose stocks they hold so that they can encourage them to
improve share price performance?
Asset managers do not agree on this issue, but intervention is supported
by the fact that the exit costs for large-volume stocks in the portfolio may
be very high (because of the market impact639). Additionally, it may be
very difficult to maintain a 100% equity proportion in certain markets if
the manager avoids investing in all corporations not deemed to be
optimally managed. Moreover, intervention is an EMH-compliant method
of improving investment performance.
94
5.1.3 Active portfolio management as an example of a

structured portfolio management approach to
implementing qualitative investment rules
Outline of the approach
Active portfolio management is a structured, quantitative investment
management approach for all asset classes, such as equity instruments, bonds
or currencies,640 that centres around the notion that an active manager can
implement superior information or (temporary) inefficiencies641 as portfolio
decisions.642 The composition of actively managed portfolios does not therefore
correspond to that of the market portfolio (or of a combination of the market
portfolio and the riskless asset) or the benchmark, because the aim is to
generate excess returns (or active returns) compared with these yardsticks.643
This is achieved largely by overweighting (underweighting) those securities
which the active portfolio manager expects to generate higher (lower) returns
than the market (selection).
The investment decision process consists of the efficient implementation of
“raw” superior information, which may be both quantitative and qualitative, as
an active investment strategy, comprising at least the following components:644
x primary information gathering, followed by its filtering and processing;
x the analysis model evaluates this information for its effects on the
fundamental value of the relevant investment opportunities (a certain
strategic asset allocation is assumed, depending on the benchmark
chosen;
x the risk model analyses this information for its impact on the risk
(volatility) and interaction (correlation) of the relevant investment
opportunities;
x systematic, consistent and efficient implementation of the output of the
analysis and risk model as an active investment strategy;
x ex post performance attribution and risk analysis.645
Active portfolio management is seen as the counterweight to the trend
towards the predominance of passive management646 since the 1980s – and its
belief in efficient markets – and also contradicts Modern Portfolio Theory,
whose equilibrium model is also based on the notion that the sort of market-
outperforming risk/return combinations offered by active portfolio
management are not possible. This is because recent studies question the
CAPM and the EMH647 and argue in favour of at least partly active portfolio
management because this can achieve superior risk/return combinations.
“Partly” means that if it is assumed that the market largely follows the EMH,
but that there are indeed inefficiencies in smaller areas, the manager can
structure the core portfolio passively and manage the rest actively, which has a
cost advantage over a 100% actively managed portfolio in that the active
95
management costs are only incurred for a substantially smaller volume, and the
cost of passive management is lower than the cost of active management.648
The variables of total risk and return649 are central to passive portfolio
management and Modern Portfolio Theory,650 while active portfolio
management is based on active risk and active return, i.e. it does not want to
track benchmarks, but to outperform them.651
A core variable in active portfolio management is the portfolio manager’s
information ratio.649 The larger it is, the greater – all other things being equal –
the manager’s forecasting ability, and thus the greater his opportunities for
active portfolio management.652 If a portfolio manager does not have any
information (that is superior to the market), and thus no exceptional forecasting
ability, i.e. his information ratio is zero, he should invest passively rather than
actively.653
The fundamental law of active portfolio management649 enables the
calculation of ex ante information ratios and thus helps identify those portfolio
managers with desirable high information ratios.654
In terms of the regulatory environment for active portfolio management, it
should be considered that active selection of individual securities may expose
ERISA asset managers to an increased liability risk in the event of poor
performance, if selection is deemed ex post by the courts to be imprudent. On
the other hand, active portfolio management is growing in importance as a
feasible alternative for managing pension fund assets because of the
aforementioned criticism of the efficient market hypothesis.655
Aggregated supply and demand for active portfolio management

An analysis of the market for active portfolio management with pension funds
as buyers/consumers of asset management services on the one hand, and
investment managers as sellers/vendors of such services on the other, produces
the sort of picture shown in Figure 26:656
x The supply curve S is relatively flat or elastic because the costs to the
vendors of active management are relatively independent of the quantity
(of active management) produced, i.e. fixed costs predominate. The costs
may even fall as the quantity rises (from a certain point), which would
lead to a supply curve with an at least partially negative slope.
x The alpha curve with the points 0 and A in the lower half of the figure
describes the excess return produced as an absolute monetary amount,
and initially rises together with the increase in the volume of active
management supplied. However, because the transaction costs also rise,
and alpha is analysed here after transaction costs, the slope of the alpha
curve to the right of point A is negative.
x Ideally, consumers would want to be at the peak of the alpha curve, i.e. at
A, and those at the corresponding point Q1 on the supply curve.
96
x However, a surplus supply situation may arise at Q2, pushing consumers

back into the negative region of the alpha curve at point A1, where a
negative return that is lower than the benchmark return of passive
portfolio management will be generated.
Such a situation may arise because uninformed consumers overestimate
the actual shape of the alpha curve and therefore saturate the market for
active management. In addition, numerous studies conclude that the
average vendor of active portfolio management services is not in a
position to produce positive alphas, resulting in over-supply.
Figure 26: The market for active portfolio Figure 27: Curve shifts on the market for
management657 active portfolio
management658
However, the alpha curve may be subject to change. If there are

improvements in the business practice or environmental conditions in the
pension fund industry, the alpha curve may grow, corresponding to a shift
towards the top right, as shown in Figure 27. This in turn causes a shift in the
optimum demand curve from D1 to D3, producing a new equilibrium at Q3.
Such improvements may result because pension funds can obtain tax breaks,
or if they bring their investment policies more in line with prudent investor
standards.659
Implementation in practice
Selecting portfolio managers

Portfolio managers should be selected solely on the basis of their information
ratio (IR),660 rather than classifying them into risk-seeking versus conservative
investment styles. This means that a risk-averse investor should not prefer a
conservative portfolio manager with a low IR over a more aggressive manager
with a higher IR, but should rather engage the latter; however, he will only
entrust part of the total portfolio to this portfolio manager, investing the rest
97
e.g. in index funds. This division into two subportfolios is also a characteristic of
the CAPM, whose efficient portfolios comprise a combination of the market
portfolio with the riskless asset.661
Criteria for portfolio managers
If the right portfolio manager has been found, his (or her) room for manoeuvre
must be specified by defining the following parameters; this is a matter for the
SIP,662 the fund board or of the sponsoring undertaking in the case of pension
funds:
1. Desired risk preference: this is incorporated into the model in the form of
residual risk aversion.
2. Selection of a benchmark: this determines strategic asset allocation,663 and the
asset manager can use his expertise to select specific securities.664 Risk-
adjusted outperformance of this benchmark is the indicator for the quality of
active management.665
3. Constraints, such as a bar on short selling or large cash positions, the
exclusion of certain assets for liquidity reasons or because of self-dealing,666
constraints on the volume of investments in individual securities (to promote
diversification667), etc.668
All constraints limit the scope, and thus possibly also the efficiency, of
active portfolio management, but there is a variety of approaches for
optimising portfolio management subject to such constraints. A bar on short
selling, for example, not only means that information that will depress
prices669 cannot be used in full, but also limits the manager’s ability to react to
price-increasing information, because long positions cannot then be financed
by short positions.670 Moreover, it will result in small caps being overweight
to large caps (negative size bias).671
4. Supervision of transaction costs:672 the greatest possible accuracy in
estimating transaction costs673 plays just as important a role in
implementation as estimates of the (active) return and the (active) risk. In
particular, there will be competing goals between return and transaction
costs when portfolios are rebalanced, where the time horizon – as the
amortisation period – will be highly significant.674 In simple terms: high
alphas, low (active) risk and low transaction costs, i.e. essentially a high
value added675 after transaction costs, will result in portfolio rebalancing, for
which a number of techniques such as screens, stratification, and linear or
quadratic programming are available in practice.676
The constraints mentioned in point 3 above should be kept to an absolute
minimum so as to minimise the inefficiencies in the investment process that
result in any case from prudential supervision.
The more varied the permitted investment opportunities, the easier it is for a
portfolio manager to exploit even temporary inefficiencies677 in certain markets
to realise active returns. In reality, however, this advantage is frequently offset
by the practice of hiring a separate manager for each market or sector, and it is
98
thus purely a matter of chance whether managers can “benefit” from

inefficiencies in their markets/sectors and are thus given an opportunity to
generate higher active returns.
In the language of active portfolio management, this means that a single
manager with a wide-ranging remit (or a management team led by a generalist
whose formal task is to ensure that the ratios of expected marginal return to
expected marginal risk are the same for all positions in the active portfolio678)
will almost necessarily have a higher information ratio679 than a portfolio
manager restricted to an individual market, firstly because inefficiencies help
realise superior skill,680 and secondly because they also enhance breadth681 – the
number of opportunities to place “bets” on excess returns is much larger.682
A SIP should therefore not contain investment policies that specify
required/prohibited asset classes or percentage position limits, but should
rather stipulate a certain maximum ex ante tracking risk.683 The objective of
investment constraints is, after all, to ensure that the portfolio does not deviate
too much from the selected benchmark. “Deviation” in turn means that the
tracking risk should not be too large compared with the selected benchmark.684
If this recommendation is applied, however, the investment policies are by
no means fully exhausted, because the tracking risk formulation described
above only controls normal market risk; for instance, it does not regulate
operational risks or counterparty credit risks. There is also a need to lay down
how the ex ante tracking risk will be estimated, and who will do this: although
portfolio managers are, as a rule, technically in a position to do so, they should
not – as the persons to be controlled – be able to influence the controls imposed
upon them. It would be inefficient for the plan sponsor to do it because of the
high cost, so this task therefore appears to be an ideal field for consultants.685
The core terminology of active portfolio management

Alpha: Expected residual return (ĺ Expected total return, ĺ Residual return).).
Active return: The difference between the portfolio return actually achieved
and the return of the selected benchmark. If ĺ Benchmark Timing is avoided
and selection is the only technique applied, the active return corresponds to the
ĺ Residual return.686 In contrast to the CAPM, the manager thus no longer
operates relative to the market (this applies to the theory as well), but relative
only to one of its subsets in the form of the selected benchmark.687
Active risk (Tracking Risk, Tracking error): Tracking error is a measure of the
quality of benchmark tracking. It measures the risk of deviation of the portfolio
return actually realised from the benchmark return.688 In mathematical terms, it
is the volatility (i.e. the annualised standard deviation) of the ĺ Active
return.689
Benchmark timing:690 Together with ĺ Selection, this technique is used to
create ĺ Value added and describes the choice of a certain (active) beta by the
portfolio manager; if he expects above-average market performance in the near
99
future, he will lift his portfolio’s beta above 1, and conversely, he will choose a
beta of less than 1 if he expects adverse market development. In theory, such
positions should be implemented using equities, but in practice, futures and
forwards are used because this avoids both residual risk (where equities with a
high/low beta are overweight), the risk of beta prediction errors (relating to the
overweight equities) and high transaction costs caused by trading many
individual positions.
In practice, however, benchmark timing is most uncommon because the
ĺ Fundamental Law of Active Portfolio Management requires a very high
ĺ Information Coefficient for benchmark timing to as to achieve a reasonably
high ĺ Information Ratio;691 i.e. it is extremely difficult to increase ĺ Value
added using benchmark timing.692
In other words: timing decisions are extremely risky compared with selection
decisions (ĺ Selection) because the diversification principle does not work with
timing decisions, which involve optimal timing for moving into an overall
market, rather than choosing individual securities as in the case of selection,
where isolated wrong decisions can be compensating by other selection
decisions with a certain level of probability.693
Breadth (of information694): the frequency of independent forecasts695 (bets) of
excess returns per year.696
Expected total return: The expected return can be broken down into four sub-
returns:697
1. The liquidity premium (or time premium) is the compensation for
relinquishing the liquidity corresponding to the investment for a year and
is expressed by the risk-free rate.
2. The risk premium is the expected excess return of the benchmark over the
riskless asset on the basis of long-term observations.
3. The extraordinary benchmark return is the expected short- to medium-term
deviation from the long-term risk premium (point 2).
4. ĺ Alpha.
Fundamental Law of Active Portfolio Management:: According to this law, the
(ex ante) ĺ Information Ratio is the product of the ĺ Information Coefficient
(IC) and the square root of ĺ Breadth (see Equation 9).
IRex ante IC u Breadth

Equation 9: Ex ante information ratio
A portfolio manager can thus e.g. double his information ratio either by
quadrupling the frequency of his forecasts (bets) or by doubling his forecasting
quality.
(G)ARCH: (Generalised) Autoregressive Conditional Heteroscedasticity. The
(G)ARCH models, of which there are many variants, work with time-variable
100
volatilities, i.e. the volatilities at different times are mutually dependent. They
are based on the empirical observation that fluctuations in securities prices
display characteristic time patterns: for example, it is possible to identify phases
of low variance, as well as phases of high variance. This phenomenon is termed
volatility clustering.698
The actual characteristics of returns that display a leptokurtic rather than a
normal distribution (see Figure 36, p. 121) tend to be incorporated using
(G)ARCH.699
Information coefficient (IC, information quality700): This is a measure of skill,
and describes the forecasting quality of the expected ĺ Residual returns
resulting from the correlation of the forecasted and the actual returns. For
simplicity’s sake, the IC is assumed to be constant for all forecasts (bets).701 In
practice, the following can be established for the order of magnitude of the
IC:702 a portfolio manager with a good forecasting (betting) skill has an IC =
0.05; an excellent one has an IC = 0.1; and a world class manager has an IC =
0.15. Portfolio managers claiming a higher value or an IC greater than 0.2 are
either seriously mistaken or will soon be the defendants in a forthcoming
insider trading trial.
Information ratio: As an ex post variable, it is the ratio of the expected
ĺ Residual return to its annual volatility (see Equation 10). Ex post IR is
relevant because it helps forecast future IRs.703
D
IRex post
Z
Equation 10: Ex post information ratio
As an ex ante variable, it is a measure of the opportunities of a particular

portfolio manager to implement active portfolio management on the basis of
his skills (ĺ Fundamental Law of Active Portfolio Management).
Omega: The volatility of the forecasted ĺ Residual return.
Residual return: This is the part of the ĺ Expected total return that is not
correlated with the benchmark. CAPM assumes its expected value to be zero,
because it represents the notion that residual risk can be diversified away and
cannot therefore be rewarded by an expected residual return,704 so active
portfolio management, which actually aims to systematically realise excess
returns, is therefore impossible, and it would be better to use passive portfolio
management.705
Residual risk aversion: In contrast to passive portfolio management, individual
risk preference affects the composition of the portfolio held in active portfolio
management.706 This individual risk preference is expressed in the residual risk
aversion. The higher this variable is (it can be specified to the portfolio manager
101
by the client, for instance a mutual fund), the less any given information ratio
can be exploited because it reduces the realisable ĺ Value added.707
Score: Raw forecast of return standardised to normal distribution.708 Various
return forecasting models are used to calculate the score, such as time series
analysis,709 ĺ (G)ARCH, chaos theory, neuronal networks or genetic
algorithms.710
Selection: A technique that overweights (underweights) securities for which
the active portfolio manager expects returns in excess (falling short) of the
market.711
Tracking Error ĺ Active risk
Tracking Risk ĺ Active risk
Transaction costs: These can be systematised into four components:712
1. Fees and expenses: These are the lowest and most easily measured
component.
2. Bid/offer spread: Like fees, this spread is also transparent and therefore
unproblematic.
3. Market impact: Each trade changes the market; its impact is stronger the
larger and more urgent the order. Market impact describes those additional
costs that are incurred if an entire block is traded, rather than a single share.
Because it is impossible to trade a single share and a block under exactly the
same environmental conditions, it is very difficult to measure market
impact.713
4. Opportunity costs: As with market impact, this is a cost component that is
not capable of direct observation.
Value added: This is a preference model that aggregates the two residual
variables of ĺ Residual return and its volatility to a single variable (see
Equation 11): value added (or Risk-Adjusted Expected Return), such that the
residual variance ĺ Omega (multiplied by the residual risk aversion Ȝ) is
subtracted from the residual return ĺ Alpha.
Value Added D Z uO
714
Equation 11: Value added
There is indifference as to the which (residual) risk/return combinations

produce the same value added.715 In the case of optimum residual risk, the
maximum value added results from Z* (see Equation 12).
IR
Z*
2uO
Equation 12: Optimum residual risk716
102
Value added can be realised by using two techniques: selection and

ĺ Benchmark timing, i.e. the selection of a certain (active) beta by the portfolio
manager.717
5.1.4 Style management

Key features
Style management adds an additional step to the structure of a classic
investment process (see Figure 28):718
1. Classically, a distinction is made for the first stage between active719 and
passive720 portfolio management styles.
2. The second stage distinguishes between the type of information processing:
while the “traditional/fundamental” approach is based on subjective,
qualitative criteria, the quantitative/structured approach uses objective,
statistically provable correlations.
3. The relatively new721 stage of style management consists of defining the
market segment: either securities are selected722 within a certain market
segment, or the manager switches between different market segments using
timing723 (style rotation).
Common market segments are “large cap” versus “small cap”, and “value”
versus “growth”, as well as increasingly sectors or topics.
Figure 28: Classification of the structure of an investment process724
A market segment is characterised by equities with similar fundamental

attributes that tend to perform as a group across several macro-economic and
capital market cycles. Segmentation of the capital markets was established as
early as the 1970s, and the phenomenon that certain segments achieve risk-
adjusted outperformance (in defiance of the Efficient Market Hypothesis) was
described as a “market anomaly”. Style management aims to exploit just such
market anomalies, such as the “small firm effect” or the “price/book effect”, to
realise active returns.
103
Style benchmarks are now long established on the US market to support the
implementation of style strategies, so that today there are even
multidimensional benchmark indices, such as “large value” or “small growth”.
By contrast, the availability of style benchmarks in Europe is nowhere near as
diverse.
Value/Growth and Small/Large

Portfolio managers who pursue a value strategy operate in that segment of
equities with a high “intrinsic value”. Such “cheap” or undervalued stocks are
identified using ratios: these are normally stocks with a low price/book ratio, a
high dividend yield or a low P/E, i.e. stocks that are currently avoided by most
other market participants, which is why the value strategy is also known as the
“contrarian” (anti-cyclical) strategy. This model suggests that active returns will
be realised when these other market participants eventually wake up to this
undervaluation, buy the stocks and thus trigger a revaluation, i.e. an
appreciable price rise. This is based on the notion that markets tend towards
temporary exaggerations, i.e. mispricing, which is expressed in the case of value
stocks by the fact that their market price is temporarily below their
fundamental value.
By contrast, the aim of a growth strategy is to invest in those stocks for which
high future gains are expected, and which therefore appear to be expensive in
terms of the value approach. This is a pro-cyclical strategy because it focuses on
the current market favourites (“glamour stocks”).
In recent years, market segmentation by value/growth criteria was atypically
rather static and attracted the buzzwords “Old Economy” (value) versus “New
Economy” (growth).
The small versus large strategy divides the market by size, based on the
market capitalisation of the individual corporations: studies of the US market
concluded that smaller companies achieved risk-adjusted outperformance in
the past. In Europe on the other hand, exactly the opposite was identified:
analysis of the price trends of the STOXX Europe index family between 31
December 1986 and 20 January 2002 (see Figure 29) shows that the larger stocks
substantially outperformed their smaller counterparts. There is a clear
performance hierarchy based on market capitalisation: the small caps are right
down the bottom, followed by the mid caps, then the broad index as the
benchmark; this is then outperformed by the large cap index, which in turn is
outperformed by the still larger blue chips.
104
140
Blue Chip
Large
120
100
Broad
80
60 Mid
40
Small
20
12/31/86
12/31/87
12/31/88
12/31/89
12/31/90
12/31/91
12/31/92
12/31/93
12/31/94
12/31/95
12/31/96
12/31/97
12/31/98
12/31/99
12/31/00
12/31/01
Figure 29: Relative development of the STOXX Europe index from 31 Dec. 1986 to
20 January 2002, using the STOXX Broad Europe index as the
benchmark725
5.1.5 The use of financial derivatives

Financial derivatives (see Figure 30) should be a standard element of modern
portfolio management. In reality, however, the use of derivatives is not as
widespread as it should be, because investors are often inadequately informed
about their potential for improving the return and reducing the risk of a
portfolio. Press reports, which mostly present derivatives in connection with
speculative deals resulting in spectacular losses, have certainly played a role
here, although derivatives are most commonly used in practice for hedging
purposes.
Financial markets
Spot Forward
Conditional forward Unconditional

transactions forward transactions
Forward Rate
Exchange-
OTC options Futures Agreements
traded options
(FRAs)
Swaps
Figure 30: Overview of financial derivatives726
105
Three primary applications for derivatives in the fund industry are outlined
below:727
1. Hedging: Derivatives put managers in a position where they do not have to
sell risk positions in anticipation of falling markets, a factor that cuts costs
appreciably. Hedging can also be used highly selectively:
x For example, market risk alone can be hedged, or the segment (or even
the specific security) risk can be hedged. Because there is no such thing as
a free lunch, however, hedging costs rise as the level of hedging grows.
x The fluctuation margin of the portfolio can be restricted to a defined
bandwidth for a certain time period, or a certain (minimum) value can be
guaranteed at a particular date.
x Depending on the fund’s risk profile and the fund manager’s assessment
of the market, symmetric or asymmetric hedging may be used. The first of
these strategies, which is normally implemented using futures, has the
same effect on opportunities and risks, while the latter, normally
implemented using put options, accommodates the intuitive
understanding of risk by trying to reduce the downside risk, while at the
same time trying to maintain the upside potential as far as possible.
2. Tactical risk management:
x Anticipatory transactions: especially with pension funds, cash flows occur
at certain, previously known dates, in anticipation of which futures or
calls can be bought so as to exploit a current attractive market level for
investing these cash flows.
x Asset allocation: Futures allow the fund manager to quickly and cheaply
build up diversified foreign positions (synthetic exposure). This allows the
market and currency risks in particular to be separated: if the target
currency is the euro, and the fund manager expects to the US equity
market to rise, he can either buy US stocks or US stock index futures. In
the first case, he also has to bear the currency risk in respect of the dollar,
which may erode any gain if stock prices actually do rise. Currency
futures may reduce this risk, but because the amount to be hedged is
uncertain, they are not ideal. By contrast, if he buys index futures, the
funds earmarked for the actual purchase of US stocks remain on the euro
money market, and the only dollar exposure is the (low) margin
payments. If, on the other hand, he expects the dollar to rise against the
euro, he will park the money on the US, rather than the euro, money
market, establishing a position that is equivalent to a direct stock
purchase.
x Isolation and transfer of alphas:728 if the manager expects the overall
market to fall, and at the same time that certain individual securities will
outperform the market, the appropriate strategy is to buy the individual
shares with a perceived upside and to sell index futures; this hedges the
market risk, leaving only the specific security risk, although the portfolio
manager has taken a positive stance on this. A real gain will be realised if
106
the securities concerned outperform the market, irrespective of the

direction in which it travels.
An expectation that sub-markets will record different developments can
also be implemented in an investment strategy, for instance if a Euro
STOXX-oriented portfolio is hedged using Euro STOXX 50 futures,
because the manager expects the mid caps to outperform the large caps
(represented by the Euro STOXX 50).
3. Performance optimisation:
x Cost advantage of derivatives over direct investments: because of its
standardisation and the low number of different contracts, the futures
market in particular offers substantial market depth and transparency, so
the transaction costs729 are very low. Depending on the study consulted
and the derivative analysed, this cost advantage is in the order of 1:2 to
1:25.
x Arbitrage, i.e. exploiting price differences between assets that embody an
identical cash flow.
x Writing option positions, normally in the form of selling covered calls, i.e.
optioning stocks held in the portfolio. The option premium collected on
the one hand is merely offset by the risk of opportunity losses on the
other, if the underlying stock price has risen above the strike price at the
exercise date and the stocks thus have to be transferred to the buyer. If, on
the other hand, the stocks were not held in the portfolio (naked position)
and the option was exercised, the writer would have to cover
(expensively), resulting in actual cash losses.
Concrete selection of the stocks to be optioned and the choice of option
term demand a complex decision-making process, which is characterised
by the following conflicting goals, among others: preference should be
given to optioning those stocks which the manager expects to move
sideways, so that the option will never be exercised. However, such stocks
are mostly characterised by a low implied volatility, which in turn leads to
a low option price and thus lower income. Options with longer terms
would have the advantage that they normally command a higher option
premium because their implied volatility is higher. On the other hand,
short-dated options have the advantage – from the seller’s perspective –
that their time value falls faster shortly before expiration, generally
allowing the option to be bought back at a profit after only a short term.
Even if this decision-making process has been successfully completed,
the manager must still examine whether another strategy would be
intrinsically better, i.e. whether for example some security with a high
value added730 can be identified that promises higher risk-adjusted returns
than writing a covered call.
x Trading strategies:731 depending on the market assessment – bearish or
bullish, sideways, high volatility – a variety of combinations of options
and/or equities may be considered.
107
5.1.6 Quantitative restrictions

Fixed maximum percentage of fund assets in securities of a single
issuer
Funds regulated by the UCITS Directive may not invest more than 10% of their
assets in securities of a single issuer,732 except where these relate to state-
guaranteed or equally secure733 debt instruments, for which the ceilings are
then 35% and 25% respectively.734 In the case of the new index funds allowed
by the amendment to the UCITS Directive,735 equities of a single issuer can be
bought up to a maximum of 35% of the fund assets.736 Such funds may also buy
equities of a single issuer in an amount that would allow them to exercise a
significant737 influence on its management.738
A general rule to be observed by UCITS, however, is that the voting rights
vested in their assets should not allow them to become controlling
shareholders. US laws have exactly the opposite intention, because US mutual
funds are explicitly expected to play the role of active institutional investors
that should exercise a (positive) influence on the management of their
investments.739
Prior to the publication of the proposal for an EU Pension Fund Directive in
October 2000,740 a study commissioned by the European Commission
recommended stipulating a 4% ceiling per issuer in the same way as the UCITS
Directive, with this restriction also applying to investments in the securities of –
and loans to – the pension plan sponsor(s) (self-investment).741
However, the proposal itself contains more liberal provisions: a 5% ceiling for
investments in the sponsor, and no concrete upper percentage limit for general
investments, but rather a requirement that “assets shall be properly diversified
in such a way as to avoid accumulations of risk in the portfolio as a whole”.742
The US ERISA imposes restrictions on self-investment; an aggregate
maximum 10% may be invested in certain securities or real estate of the
sponsor or its affiliates. In addition, the fund may only hold a maximum of 25%
of the total volume of a certain securities class of the sponsor, and at least 50%
of this total volume must be held by persons who are independent of the
sponsor.743 Exemptions from these rules (and from other prohibited
transactions744) may only be granted by the US Department of Labor if they are
in the interests of the plan participants and beneficiaries and do not infringe
their vested rights.745
Diversification
The fundamental concept of diversification

The core concept behind diversification is to reduce the portfolio risk and/or
increase the portfolio return. Risk is analysed not on the basis of the individual
investment, but as consolidated risk for the fund as a whole. This means that
assets may be included in the fund portfolio that, taken in isolation, may
108
appear to be of lower quality, if their low correlation with the other fund assets
leads to fund-wide risk reduction with an equivalent or higher total return.746
Diversification in the EU
The UCITS Directive defines “UCITS” as, among other things, funds whose
objective is the “investment … of capital raised from the public and which
operate on the principle of risk-spreading”.747
A duty of diversification was included in the proposal for an EU Pension
Fund Directive,748 as recommended.749
Diversification in the USA in general, and for Employee Stock Ownership
Plans (ESOPs) in particular
In the USA, diversification may be a consequence of fiduciary duties750 and is
also expressly required by ERISA.751
Employee Stock Ownership Plans (ESOPs) are special DC752 occupational
pension plans; at least 51% of their portfolio must be invested in stocks753 of the
employer.754 To do this, they may borrow money (normally from commercial
banks) or even issue bonds755 (“leveraged ESOPs”). The benefits must normally
be paid to pensioned employees in the form of the plan’s employer shares,756
but in certain circumstances it can also be paid exclusively in cash.757 The
pension can be paid in a lump sum or as a annuity over a limited period of
time; portfolios up to $735,000 must be paid out over a maximum of five years.
This period rises by one year for each additional $145,000 up to a maximum of
ten years.758
If the benefit obligation is satisfied by employer shares, the beneficiary is
entitled to a mandatory put option on these shares in respect of the employer
in the case of unlisted companies, i.e. the employer is required to pay the fair
market value on surrender of the shares. The ESOP itself can buy the shares
rather than the company, but it can never be forced to do so. The ESOP
trustee’s fiduciary duties759 require it to always weigh up purchases of
employer shares against other investments.
However, the sole objective of ESOPs expressly stipulated by law is not their
retirement provision function, but rather to broaden the distribution of wealth.
Given that in 1999, employees held, through ESOPs, an estimated $150 billion
of the corporate assets amounting to $4,000 billion at the time, this objective has
also been achieved.760
The introduction of ESOPs can be traced back to 1974 and ERISA,761 but the
legislation has been amended on numerous occasions since then.762 ESOPs also
have to comply with other laws, such as the Internal Revenue Code (IRC), the
regulations issued by the Department of Labor (DOL), the Securities Act of
1933763 and various state securities laws.764
There were around 11,000 ESOPs in 1999 with nine million employee
participants and a total equity volume of more than $400 billion. 10% of ESOPs
are listed corporations.765
109
ESOPs have the following advantages over traditional pension plans for
employers:766
x The employees covered by the ESOP are motivated to increase
productivity because they are co-owners. Although this argument is often
advanced as the prime reason for establishing an ESOP, it certainly has no
conclusive scientific backing.
However, a study in the 1980s did confirm the motivational effect: the
employees surveyed tended to feel more strongly that they were part of
their company the greater their equity investment in their employer; they
had greater job satisfaction and staff turnover tended to be lower. These
positive findings do not necessarily indicate a general trend, though,
because they related above all to those companies that took employee
participation seriously and were not merely interested in the tax breaks
linked to ESOPs: the more the employees were integrated into corporate
decisions and were provided with information, the more striking their
positive response to ESOPs.767
x As employee shareholders, employees covered by ESOPs are generally
allies when it comes to defending the company against hostile takeovers768
if they are entitled to exercise the voting rights vested in their shares.
Employees covered by ESOPs may (and must in the case of listed
companies and, under certain circumstances,769 of unlisted companies) be
entitled to exercise the voting rights vested in the shares held by the ESOP
in the form of “pass-through voting”.770 Where pass-through voting
procedures are in place, there is a tendency for employees to vote with
management in the case of takeover attempts because they tend to trust
existing management to protect their jobs rather than external managers.
As a rule though, voting is a matter for the trustee under its fiduciary
duties (who is often the plan sponsor, i.e. the employer). The ESOP
bylaws define whether the trustee is independent or has to vote as
directed by a plan committee (directed voting). Even in the latter case,
however, responsibility to vote in the best interests of the ESOP members
rests with the trustee.771 ESOP plan committees are generally composed of
directors, senior executives and/or employees of the company concerned.
The members of this committee are self-evidently exposed to conflicts of
interests; neither are they necessarily familiar with matters of finance and
fiduciary duties, which is why this responsibility of the trustee may be
significant. There is a view,772 for example, that the trustee should only
follow the instructions of the plan committee in the case of important or
extraordinary voting matters if, after due consideration, he himself
believes that this would not produce a result that would be imprudent or
not in the best interests of the ESOP members; otherwise, the “trustee
override” must be invoked. Such a case is, of course, contentious and
should be well thought through by the trustee to eliminate any remaining
doubts and avoid the possibility of exposure to claims for damages.773
110
In the case of pass-through voting”, the trustee can only ignore the
employees’ instructions if it is blatantly obvious that these are in breach of
ERISA.774
The trustee is only released from his obligation for exercising voting
rights if an investment manager has been engaged to vote. In this case, the
trustee is only required not to implement the investment manager’s
decisions if he is aware – or should be aware – that fraud is involved.775
What often happens in practice is that ESOPs are used in anticipation of
– or in response to – a takeover battle. There is even a view in some
quarters that this is often the most attractive feature of ESOPs for
companies, and that the aforementioned motivation argument is
overrated; these observers also believe that the tax break argument
discussed below is also exaggerated because the same effect can be
achieved with other instruments, and existing ESOPs mostly do not make
full use of the tax advantages available to them.
Another argument advanced in support of this view is that ESOPs
frequently end up disadvantaging shareholders – and thus also the ESOP
beneficiaries – because they are good at sheltering inefficient
management. In addition, management is tempted to influence the ESOP
members to follow its line in votes on other matters, although this does
not necessarily coincide with the interests of the ESOP beneficiaries.
ESOPs thus encourage conflicts of interest that cannot in practice
always be resolved by management in line with its fiduciary duties as plan
sponsor. ERISA certainly imposes the obligations of prudence and
observance of fiduciary duties for ESOPs. For example, an ESOP
fiduciary776 must act solely in the interests of the plan members,777
although this does not mean that it cannot derive other benefits from an
ESOP, but that conflicts of interest must be resolve in favour of the
beneficiaries.778 Moreover, the ESOP trustee must make clear to all
involved that when they vote, the employees cannot be subjected to any
overt or covert coercion (by management). The trustee must also inspect
all information material and presentations to judge whether such coercion
exists or not, and his presence at employee meetings to discuss the matter
to be voted on is advisable. Finally, he must ensure that individual
employees can cast their votes in a secret ballot.779
x Tax-deductible employer pension contributions780 and dividends on own
shares held by the ESOP.
The drawback of ESOPs is that they violate the principle of diversification
because much of the plan assets are concentrated in a single investment – the
employer. Instead of being allowed to invest a maximum of 10% of plan assets
in the securities of a single company (as would be the case under ERISA781), an
ESOP must invest at least 51% in the stock of the plan sponsor, which is why
ESOPs are excluded from the ERISA duties of diversification and prudence
where the purchase and holding of employer shares are concerned.782
111
To remedy this diversification defect, the (supplementary) occupational

pension should never rely solely on an ESOP. In fact, most of the listed
companies offering ESOPs also offer additional pension plans.783 If these are
also qualified plans, complicated rules must be observed that affect the
maximum amount of accumulated contributions and benefits and their tax-
deductibility. Combinations of a DB or a 401(k) plan784 with an ESOP (KSOP785)
are very common.786 It is clear that US lawmakers were in any case fully aware
of this lack of diversification in the case of ESOPs because the Internal Revenue
Code (IRC) stipulates that ESOP members who have been members for at least
ten years and are at least 55 years old must have an opportunity to diversify
25% of their portfolio within five years. In the sixth year, they then have a one-
time opportunity to diversify up to 50% of their portfolio.787
Foreign currency assets
Restrictions on foreign currency assets in the EU

The rules in many EU Member States imposing ceilings on investments in
assets denominated in a particular currency788 have now become significantly
less important with the introduction of the single currency, at least in the
countries participating in EMU. Pension funds should always have sufficiently
liquid assets in the currencies in which their liabilities are denominated (if the
liabilities are in an EMU currency, then all other EMU currencies are, of course,
equally suitable for matching) so that due pension payments can be made.789
The EU prohibits Member States from issuing regulations that require life
insurers to invest more than 80% of their assets in a matching currency (i.e. a
currency in which the liabilities are denominated),790 but the currency matching
rules were abolished for both occupational pensions and life insurers when the
euro was introduced on 1 January 1999.791
During the preparatory phase for the draft Pension Fund Directive,792 the
Commission provided no clear answer as to whether currency matching rules
would be needed, preferring instead to await the findings of further studies.793
During the consultations held at the time, some Member States voiced the
opinion that both pension funds and life insurers should have to invest 80% of
their assets on a matched basis, while others countered by arguing that the
long-term nature of pension fund investments mean that exchange rate
fluctuations are relatively insignificant, and the investments in non-EU
countries with a sustained need for capital and a high working proportion
could represent a significant source of income in the coming decades, and that
there is therefore no need for such a (far-reaching) matching currency
requirement.794
The justification put forward in the “Rebuilding Pensions” pensions for
rejecting currency matching rules was that they disrupt capital market
efficiency, increase risk instead of reducing it, while at the same time
preventing opportunities from being seized, and that a board of directors is a
112
much more suitable vehicle for ensuring security. In concrete terms, there
should be no such constraints for the EMU currencies and for non-EU
convertible currencies, and it should be up to the board of directors to allow
modest investments in non-convertible currencies or prohibit them completely.
The factors driving such a decision should be firstly fund-specific aspects,795 and
secondly the correlation with the fund’s other asset classes. If the correlation
with the other asset classes is low or even contrary, such assets may well be
ideally suited for reducing the risk of the portfolio as a whole.796, 797
The proposal for the Pension Fund Directive that was then published in
October 2000 stipulates that at least 30% of the fund assets may be held in non-
matching currencies.798
Growing importance of investment in foreign currency assets in the USA
The usual reason given for investing in non-US securities is that this
strengthens diversification799 and that the non-US markets, which are seen as
less information-efficient, offer opportunities for high active returns. In
practice, growing financial market integration and globalisation make such
investments increasingly easy.
The rising share of international securities in US portfolios is also certainly
due to the fact that the relative share of the US capital markets in the global
capital markets has shrunk in recent decades, especially as regards equity
instruments,800 so pension funds are more or less forced to “switch” part of their
assets into non-US securities so that they can invest the continuous flow of
incoming pension contributions.
Before deciding to invest in foreign securities, however, the fiduciary has to
clarify or resolve a number of issues:801
x Will the fund invest in industrialised economies or emerging markets?
This means either investing in relatively moderate but stable, or strong but
highly volatile, economic growth802 with corresponding price movements.
x Are the markets driven primarily by supply and demand, or more by state
regulation/control?
x The performance of foreign markets varies because their risk/reward
profile differs from that of the domestic market; this is further accentuated
significantly by the foreign currency factor. As mentioned earlier in this
chapter, this foreign currency risk increases the opportunity to realise
significant active returns because of the assumed informational
inefficiency of non-US markets.
x The diversification effect, i.e. reducing risk and/or increasing return by
adding international equities, is not unambiguous: certain studies show a
low correlation between foreign and US securities, which would support
the diversification effect. However, they also established that phases of
high volatility are accompanied by rising correlation, meaning that the
diversification effect tails of significantly particularly when it is most
needed.803
113
In addition, the apparent good performance of certain foreign indices

on a dollar basis is due in part solely to the foreign currency factor; on a
local currency basis, a lower return compared with the US market is
accompanied by a higher risk (expressed by the volatility).
x Higher cost of trading foreign securities: increasing globalisation,
improved institutional efficiency – especially in the form of transactional
efficiency804 – and greater trading productivity by the use of modern
information technology may reduce the cost drawback and also improve
the supply of information, but there is still a cost difference.
x Tax treatment: if withholding taxes are deducted abroad, there may be
double taxation treaties in force which enable tax exemption or at least a
partial refund.
x Differing accounting standards may complicate matters for analysts.
x Foreigners face securities trading restrictions on various non-US markets.
For example, SET, the Thai stock exchange, restricts stocks that can be
traded by foreigners to the “Alien Board”, with the result that only some
listed companies can actually be traded. There is a special class of shares
tradable by foreigners for these selected companies, and the prices quoted
for them normally differ from the corresponding “domestic” class.
x Recruiting suitable asset managers: even if the fund only invests passively,
it still needs expertise in trading practice and market characteristics to
ensure that the cost edge offered by passive portfolio management can
actually be exploited.
x To avoid squandering resources, the importance of investing in emerging
markets for the performance of a pension fund should not be overrated:
emerging markets only account for 1% to 2% of global market
capitalisation, and will therefore only make up a similarly low proportion
of the pension fund’s portfolio. This means that only around 2% of the
fund manager’s time and resources should be devoted to this 2% share of
the portfolio, because even if such a small component of the portfolio
generates an exceptionally high return, its effect on total portfolio return
will still be very small; the reverse is also true, of course, as shown by the
catastrophic performance of the emerging markets since the late 1990s.
5.1.7 Special criteria for defined benefit plans

Dynamic Minimum Funding
Defined benefit pension plans are faced with the problem of “funding
adequacy”, i.e. the percentage of the plan’s assets needed to cover its liabilities.
If the market value of the plan’s assets is lower than the present value of the
plan’s liabilities less future contributions, the plan is underfunded; if the
reverse is true, it is funded or overfunded.805 Funding is influenced by two
factors: pension contributions and investment policy.806
114
Certain assumptions have to be made in order to be able to calculate a

pension plan’s liabilities:807
x The wage/salary growth rate of each member of the pension plan.
x How long will each employee remain part of the workforce from today?
x What is the remaining life expectancy of each employee from the date of
retirement?
x What discount rate should be applied from today to the expected benefit
payments?
A proposal has been made to the European Commission to include a flexible
(Dynamic) Minimum Funding Requirement (DMFR808) for DB plans in its
proposal for a Pension Fund Directive:809 this means that benefits would not
have to be fully funded at all times because of the long-term nature of pension
funds. A DMFR is governed by the asset structure/risk profile and the liability
structure of the pension fund concerned, and allows both overfunding of the
total technical reserves (in the form of a liquidity reserve) as well as slight
underfunding.810 The level of over- or underfunding is expressed as a
percentage of the benefit liability which need not be symmetric.
Technical reserves
0% 90% 100 120%
%
Maximum underfunding Max.

liquidity
reserve
Figure 31: Example of a flexible Minimum Funding Requirement with max. 10%
underfunding and max. 20% overfunding
On the asset side, the proportion of equities in total fund assets811 plays a
particularly significant role, and on the liability side, the average age of the
participants and the ratio of contributors to beneficiaries,812 i.e. the maturity of
the pension fund, are the key factors.
The advantages of such a DMFR are that it can be tailored to individual
funds and that short-term fluctuations in contributions can be avoided;
meaning that there is no need to adjust the contribution level every time the
fund’s assets fall slightly short of the technical reserves, but rather that
contributions are only reduced if the maximum liquidity reserve is exceeded813
or increased if underfunding exceeds the permitted limit.814
The proposal includes a recommendation that the technical reserves must be
measured by an actuary who is independent of the plan sponsor.815
As a rule,816 an additional compulsory solvency margin817 does not appear to
make much sense, because the standard practice of specifying a small
115
percentage of assets does not offer sufficient protection, but only the
appearance of protection, and would merely push up the cost of pension
provision.
In conjunction with a critical assessment of the prudent man rule,818 the
European Commission draws attention to the existence of modern risk
management systems,819 and more explicitly Asset/Liability Management
(ALM): this method invests portfolio assets to reflect the nature and duration of
the corresponding liabilities and concentrates portfolios on the highest
corresponding realisable returns,820 with the increased risk thereby incurred
offset by diversifying the investments into assets that are imperfectly
correlated.821, 822
Freedom of investment should not go so far as to allow assets that do not
match the nature and duration of the liabilities823 incurred.824 At any rate, there
will be rules covering the liabilities of DB pension funds and for the
relationship of their assets to their liabilities.
A central requirement here is that the liabilities must be measured by an
independent actuary using accepted actuarial principles.825 As a model, ALM
should be used to capture financial market volatility risks and their impact on
fund assets and liabilities826 and enable a balanced investment (asset) and
funding (liabilities) policy that will harmonise the sometimes conflicting goals
of contribution minimisation, contribution stability and avoidance of
underfunding (as far as possible).827
The recommendation put forward to the European Commission is to
incorporate828 ALM in a code of good practice,829 but it also includes a
cautionary note that ALM is sensitive to the assumptions made and that the
risk of potential manipulation is therefore high; in addition, various
representatives of supervisory authorities are against the notion of mandatory
ALM.830
Asset Allocation on the basis of an asset/liability analysis
Downside risk
The symmetric risk concept of volatility or standard deviation is not ideal for
DB pension funds because the members, the board of directors and the
regulators are more concerned with ensuring that there is no shortfall against a
defined minimum investment target. Asymmetric risk measures also tend to
correspond more closely in practice to investors’ risk preferences,831 for example
in the form of downside risk, i.e. the distribution of returns below a certain
minimum return. A feature of “safety-first” investors is that they want to
maximise their expected return subject to the constraint of a controlled
downside risk.832 The concrete risk measures are as follows:
116
x Shortfall risk denotes the probability of a shortfall against a certain

minimum return for a given portfolio structure and investment horizon
(see Equation 13).833
§ r P · where: rMin Minimum return

PAF P^Return rMin ` I ¨ Min ¸
© V ¹ I . Value of standard
normal distribution at
the given point
µ, V Expected value and
standard deviation of
the return distribution
of an investment
Equation 13: Shortfall risk834
x The expected shortfall magnitude then describes the extent of such a shortfall.
x Semivariance (see Equation 14) differs from variance in that it only
incorporates the negative deviations from the expected value.835
n~
1 where: ri¯ Return that is less than the mean return
¦ r
2 2
V SV i r n
n i 1 1
r r
n ¦r
t 1
t Mean return over all n periods
n~ Number of returns that are less than the

mean return
Equation 14: Semivariance836
US rating agency Morningstar in turn bases its mutual fund ranking on the
relative expected shortfall, i.e. the mean shortfall against the risk-free rate837
(LPM1, for lower partial moment of the first order, see Equation 15). The
explanatory value can be increased by introducing LPM2, the shortfall variance.
1 T
n where: Rf Risk-free rate
LPM n >
¦ maxR f RPt ;0
T t 1
@
RPt Discrete portfolio return RP at
time t
Equation 15: Lower partial moment of the nth order838
Downside risk as a constraint in the Markowitz model

The requirement for a minimum return can be incorporated into Markowitz’s839
expected value/variance concept as a constraint: for example, if the actuary
concludes in his report that (all other things being equal) a minimum return of
1.5% is necessary to maintain the desired funding level, the Markowitz efficient
frontier can, for a given confidence interval (e.g. 90%), be divided into two
parts using a “shortfall line”: all portfolios on the efficient frontier to the left of
117
the point of intersection with the shortfall lines satisfy the minimum return
constraint, all those to the right do not.
This extension of the Markowitz model can be seen as the starting point for a
rudimentary asset/liability analysis, i.e. there is an integrated analysis of the
assets and liabilities, rather than treating the risk definition of asset allocation
isolated from the liabilities, something that is, unfortunately, frequently
encountered in practice. Moreover, an asset/liability analysis is a dynamic
process, meaning that a regular adjustment (every three to five years) should
be undertaken because of the continuously shifting environmental
conditions.840
Figure 32 shows shortfall lines with various parameters; the one mentioned
above (1.5% minimum return for a 90% confidence interval) is indicated by the
lowest dotted line. It is evident that only the first four efficient sets are feasible.
A change in the required minimum return corresponds to a parallel shift of the
shortfall line by the corresponding percentage rate on the ordinate. A change in
the confidence interval, on the other hand, results in a corresponding change in
the slope of the shortfall lines. It is clear that if the confidence interval and/or
the minimum return is increased, the number of feasible efficient sets declines,
until finally none of them matches the criteria; this is already the case for a
relatively low minimum return.
14
P
12
10
6
Markowitz efficient sets
4 90% confidence interval, 1.5% minimum return
95% confidence interval, 1.5% minimum return
2 90% confidence interval, 2.5% minimum return
95% confidence interval, 2.5% minimum return
V
0
0 1 2 3 4 5 6 7 8 9 10 11 12
Figure 32: Markowitz efficient sets with incorporation of a minimum return as a

constraint
If the pension fund is overfunded, portfolios on the efficient frontier with a

higher risk/return characteristic can also be achieved in practice using this
model:841 For example, if the fund is 108% funded, the model can be used on a
minimum return of –8% without (all other things being equal, and
corresponding to the selected confidence interval) having to be wary of
underfunding (see Figure 33).
118
12 P
Markowitz efficient sets
11
90% confidence interval, -8% minimum return
10
1
V
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Figure 33: Markowitz and shortfall line for overfunding
However, this Markowitz model extended by shortfall lines is not satisfactory

in practice in this simple form because it is both too static and too deterministic:
x By contrast, a dynamic approach would have to ensure that adequate
funding is continuous and not merely given at a certain time; this would
illustrate that action may be needed because although there is currently
(over-)funding (where a static model would give a green light), there may
be underfunding in the foreseeable future: Figure 34 shows the case of a
pension fund that is currently (1999) overfunded by €34 million, but
where the overfunding will be eroded by 2012, and the fund will then
move to steadily growing underfunding.
x Because both the development of assets and the development of liabilities
are stochastic variables, simulations would be needed for their
management. A simplified process would be to define and analyse only a
few scenarios as representative, and then to make conservative
assumptions as a safety margin, for instance higher than expected
longevity (liability) or a below-average long-term capital return (assets).
Finally, a dynamic stochastic model could produce the situation shown in
Figure 35 that is optimised compared with Figure 34.
119
Figure 34: Development of assets and liabilities in case of underfunding842
Figure 35: Development of assets and liabilities after optimisation843
Downside risk beyond the assumption of normally distributed returns

As the most important measure of downside risk, the shortfall risk844 is reliable
only if normally distributed returns can be assumed, which is not the case in
practice. However, the actual distribution function of returns is not known with
absolute accuracy, although it has been repeatedly observed that it is a fat-
tailed curve whose shape – in contrast to the bell curve of normal distribution –
displays a higher concentration of returns around the mean and at the tails of
120
distribution, i.e. the curvature (kurtosis)845 is higher. Such distributions are also
termed leptokurtic distributions (see Figure 36).846, 847 The classic estimators for
shortfall risk are therefore subject to relatively large estimation errors because
they are based on the unrealistic normal distribution.848
Figure 36: Comparison of the curtosis of various distributions849
One way of avoiding the problem of inadequate accuracy of estimation using

the Chebyshev approximation is to capture the tails of distribution using a
semi-parametric method (in contrast to the fully parametric normal
distribution850 or to the non-parametric capture of the entire distribution851).
The restriction to the tails is logical because it allows the situations removed
several standard deviations from the mean to be described, i.e. those
exceptional situations that represent worst case (or, of course, best case)
scenarios. The advantage of merely describing the tails without saying
anything about the centre is that the properties of the tails can be better
described.
Another approach draws attention to the importance of (non-)correlation of
the maturity of the performance measures used for the calculation with those
of the investor’s planning horizon: if the maturities do not coincide, a strategy
may be mistakenly taken to be more risky or less risky than another one. This is
the case especially where the returns have a shorter maturity than the
investment horizon. For example, if intrayear returns (e.g. monthly returns) are
used to select an investment strategy aimed at capital preservation over a
period of a year, it is possible to overestimate the risk of loss.852
5.1.8 The fiduciary’s responsibility in defined contribution

plans
In the case of define contribution (DC)853 plans as well, which are by definition
always fully funded and do not oblige the plan sponsor to pay any guaranteed
minimum benefit, the fiduciary is not released from his responsibility to the
121
members, even if (as happens frequently) they themselves select the

investments made by their pension plan (“self-directed” plans). As the
fiduciary, the plan sponsor is required to ensure that:854
x the beneficiaries are able to invest in suitable asset classes.
x the asset managers offered to the beneficiaries must be prudently selected
by the fiduciary.
x there is a certain degree of continuous oversight and evaluation of
investment performance, as a result of which the asset manager may be
changed.
x the costs are reasonable and are controlled.

The European Commission, many economists and sections of the fund industry
utterly reject quantitative investment restrictions (especially on pension funds)
that set apparently arbitrary upper limits on investments in certain asset
classes, countries or currencies. In practice, such restrictions result in assets
being concentrated in government bonds; in future, this could also lead to
problems if budgetary discipline reduces the volume of issues, but demand
surges when the second and third pension pillars – with pension funds as the
primary instrument – record substantial growth. Moreover, the market for
corporate bonds in continental Europe was extremely underdeveloped until
recently,855 especially the market for non-investment-grade corporate bonds.856
Consequently, this should see – all other things being equal – a reduction in
government bond yields, which in turn would equate to a reduction in at least
the nominal level of pension provision.
The frequently encountered constraints on strategic asset allocation through
restrictions on investment in international assets obstruct the search for cross-
border opportunities to improve returns and the ability to reduce (total) risk
through better diversification. Decisions in this area have a substantial impact
on the risk/return profile: it is evident that international asset allocation is the
most significant reason for the variation in performance of internationally
oriented portfolios.857
More serious, however, is the fact quantitative investment restrictions
hamper or prevent the implementation of both passive portfolio management
(Modern Portfolio Theory) and active portfolio management, forcing funds to
relinquish returns and simultaneously accept unnecessary risks. This problem
cannot simply be ignored, but given the long-term investment horizon that
typifies pension funds, even marginal improvements in return result in an
appreciable increase in the future value.
Concerns about security and investor protection in a regime dominated by
qualitative investment constraints (the prudent man rule as interpreted by the
US “prudent investor rule”) can be countered by appropriate prudential
arrangements,858 including effective powers (and obligations) for the fund
board,859 risk management techniques860 and structured investment
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management approaches, such as active portfolio management, as well as

disclosure requirements.861 Especially in the case of active portfolio
management, the risk management of the investment process is highly
significant. Standards should therefore focus on this technique, and possibly
also integrate it as a recommendation.
Certain largely unobjectionable quantitative restrictions, such as limiting
investments in the securities of a single issuer (and especially in the sponsor’s
securities in the case of pension funds), or restrictions on investments in non-
convertible currencies, can also be imposed. Voluntary standards could also
include further objectively justified quantitative criteria if required.
5.2 DISCLOSURE
5.2.1 SIP – Statement of Investment Principles/Policy

Definition
Statement of Investment Principles, Statement of Investment Policy or
Investment Policy Statement (SIP/IPS) are all terms that describe investment
policies. In both the USA and (in future) in the EU,862 preparation of the SIP
is/will be one of the fund board’s fiduciary duties that cannot be delegated.863
The reasoning behind this division of responsibilities is to avoid conflicts of
interest that could arise if the SIP is drawn up by asset managers or investment
advisers, because they could be tempted to tailor the SIP to the features of their
own products instead of the needs of the shareholders.864
Among other things, the reasoning behind a SIP is to generate the following
benefits:865
x An investment policy formulated in a SIP can be supervised and assessed.
Distortions in valuation due to selecting the wrong benchmark (meaning
that the characteristics of the portfolio and the benchmark do not match)
should not arise. Risk/return criteria that are stipulated in advance and
easy to audit substantially restrict the scope for excuses in the event of
prolonged underperformance.
x The provision of arguments or evidence in the event of accusations – or
even lawsuits – relating to inadequate asset management.
x Continuity of investment policy does not depend on who the portfolio
manager or investment adviser actually is.
x A SIP can serve as an “anchor” for portfolio managers in times of crisis and
help avoid panic-driven decisions because there is an investment policy
that has been prepared with the consent or knowledge of the investor,
rather than merely arbitrary investment decisions.
x Even when there are no extreme situations on the capital markets, a SIP
enables a logical and systematic investment policy, rather than sometimes
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emotionally driven buy or sell surges when the market booms or

collapses.
SIPs have not yet established themselves in the EU, although they have been
standard practice for pension funds in the USA since 1974. The pioneer in
Europe has been Switzerland, which has had a positive experience with SIPs
since they were introduced in April 1997.866
A quick look at strategic asset allocation

The concept of asset allocation will now be explained briefly because it involves
the single most important decision in the management of any pension plan.867
The purpose of asset allocation is to enhance efficiency through
diversification.868 Asset allocation in the broader sense has many levels, while
asset allocation in the narrower sense only involves diversification at the asset
class level.869
Figure 37 presents asset allocation in the broader sense with five levels, with
the first three of these – the selection of asset classes, countries and currencies –
together termed strategic asset allocation. The term “strategic” in this sense
denotes the far-reaching time- and content-related significance because the
time horizon is relatively long and a decision is made at a relatively abstract
level to invest in entire markets rather than individual securities. By contrast,
the impact of the remaining two levels – tactical asset allocation – on portfolio
performance is less important.870
Asset allocation in the narrower sense is analysed below; this distinguishes
between the following primary asset classes:871, 872
1. Equity instruments (domestic and foreign listed shares of issuers in
industrialised countries)
2. Bonds
3. Cash (money-market securities)
4. Unlisted equity investments: private equity, venture capital and real estate
5. Less common investments such as common shares of issuers in emerging
markets, commodities and similar.
The first three are the classic asset classes. The other two are also termed
“alternative investments” in conjunction with retirement provision.
Managers should only invest in alternative investments offering a high active
return if the following constraints as against classic asset classes can be
accepted: lack of price transparency, high administration/management fees,873
no specific benchmarks874 and frequently a lack of liquidity that may see capital
being tied up for the long term. These features – and in particular the lack of
benchmarks – demand the use of active management,875 preferably by external
specialists. In concrete terms, this means investing in private equity or hedge
funds.876
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Equities
Bonds
Real Estate
Asset Classes
(Asset Allocation in the Gold
narrower sense) Art
etc.
Germany
USA
Strategic Japan
Asset Allocation Country Allocation
UK
Hong Kong
etc.
$
¥
CHF
Asset Currency Allocation
Allocation £
in the broader €
sense etc.
Retailers
Sectors
Breweries
Public Sector
Debtor Classes
Private Sector
Short
Maturities
Tactical Long
Asset Allocation Ford Motor
Securities Kawasaki Steel
Bayer
World Bank
Issuers
KfW
US Government
etc.
Figure 37: Diversification levels of asset allocation in the broader sense
Commodities may be a suitable instrument for inclusion in the portfolio

because they enhance the diversification effect: based on historical data, the
Bridge Commodity Research Bureau Index (CRB) which shows the price trend
of a commodity portfolio displays a negative correlation with the Standard &
Poor’s 500 Composite Total Return Index (S&P), the Morgan Stanley Capital
International Europe, Australasia, Far East Index (EAFE) and US treasuries (see
Table 20). However, more recent studies indicate that if there disruptions on
the main markets, the correlation between certain markets rises
appreciably.877, 878
S&P EAFE US Treasuries

Correlation of CRB Index with: –0.25 –0.08 –0.39
Table 20: Correlation of the CRB Index with S&P, EAFE Index and US treasuries
125
Defining the optimum mix of asset classes is termed strategic asset allocation.
“Optimum” here means a combination of various asset classes that on the
average will best meet the required return of the pension plan over the long
term, without assuming more risk than appears prudent in view of the risk
tolerance of the plan sponsor and the beneficiaries; i.e. the return requirements
and risk preference of the pension plan on the one hand must be merged with
the risk/return opportunities of the capital markets on the other. This process is
also known as “constrained portfolio optimisation”.879
The usual result is the specification of strategic asset allocation as a set of
target percentages of the defined asset classes in the overall portfolio, such as
30% long bonds, 60% equities and 10% cash, although a certain permitted
tolerance should be defined for these target percentages, for instance a target
percentage for bonds of 30% ±5%.880 Once this decision has been taken, its
suitability must be continuously reviewed, and the strategy should be modified
if necessary.881
An example of an analytical approach that can be applied to strategic asset
allocation is described below:882
Step 1: Outline of various scenarios relating to future financial market
development over the relevant planning horizon (e.g. 5 years). Each
scenario is defined by the expected risk/return characteristics of the
three main asset classes: equities, bonds and cash (see Table 21).
Step 2: Definition of alternative asset allocations to be evaluated (see
Table 22).
Step 3: Calculation of the development of the alternative portfolios (from
Step 2) (and the resulting funding situation for a DB plan883) on the
basis of the various scenarios (from Step 1) (see Table 23).
Step 4: Selection of the suitable asset mix: a variety of models can be used
here, some of which are illustrated below. This step puts demands on
the fiduciary because he must understand the model (and in
particular the underlying assumptions and the data used), and
because even if he has not developed the model himself but has
delegated this task, he cannot thereby abandon his responsibility.884
x Min-max strategy: selection of an asset mix that requires the
lowest pension contributions under the worst case scenario. This
approach is based on the notion that the plan sponsor (=
employer) can increase its contribution in good times without any
significant problems, but must minimise its costs in bad times.
x Seeking the lowest possible total contributions, either on the
average or discounted to the present value.
x Seeking the lowest possible volatility of over-/underfunding.
126
Step 5: Further considerations:

x Allocation to passive and active management in each individual
asset class.
x Rebalancing the portfolio: either at fixed intervals (quarterly or
yearly) or if certain bandwidths are exceeded (see above).
Equities Bonds Cash

Scenario A (high inflation, low growth)
Expected return 0.0 2.0 6.0
Expected standard deviation 16.0 10.0 3.0
Equities with Equities with Bonds with
bonds cash cash
Correlation coefficient 0 0 0
Scenario B (normal inflation and growth)

Expected return 12.0 5.5 3.5
Expected standard deviation 20.0 8.5 1.0
Equities with Equities with Bonds with
bonds cash cash
Correlation coefficient 0 0 0
Table 21: Alternative financial market scenarios885
Asset Allocation No. Equities Bonds Cash

1 85% 10% 5%
2 60% 30% 10%
3 20% 70% 10%
Table 22: Alternative asset allocations
Scenario A B
Asset Allocation No. 1 2 3 1 2 3
Expected return 0.50% 1.20% 2.00% 10.93% 9.20% 6.60%
Expected standard
13.64% 10.06% 7.70% 17.02% 12.30% 7.46%
deviation
Expected portfolio value 100,500 101,200 102,000 110,925 109,200 106,600
Expected value of pension
107,000 107,000 107,000 107,000 107,000 107,000
obligations
Expected over-/
–6,500 –5,800 –5,000 3,925 2,200 –400
underfunding
Maximum overfunding886,
887, 888 20,780 14,320 10,400 37,970 26,740 13,940
886,
Minimum underfunding
889, 888 –33,780 –25,920 –20,400 –30,110 –22,340 –14,740
Table 23: Analysis of alternative asset allocations for the alternative financial
market scenarios890
127
Minimum content according to “Rebuilding Pensions”

SIPs should be required for all pension funds, irrespective of whether they are
DB891 or DC892 plans, and irrespective of the size of the fund.893 Any
Asset/Liability Management system already in place will help define strategic
asset allocation and will thus support the development of the SIP.894
As an element of a Pension Fund Directive, SIPs should only define general
principles and minimum requirements, leaving it up to the Member States to
make more detailed arrangements if necessary. The core content covers risk
policy, return objectives, strategic asset allocation and self-imposed prudential
principles.895
The following points should certainly be incorporated into the SIP:896
x The board’s risk perception and risk tolerance, plus how it will manage
and control risk.
x The fund’s strategic asset allocation and its return objectives, reflecting
any liabilities the fund may have897 and the market environment at the
time the SIP is prepared, and with a three-year time horizon.
Strategic asset allocation should be the outcome of a structured process
that ideally consists of three stages:898
1. Return projection using quantitative, qualitative or combined models;
2. Portfolio creation;
3. Performance analysis with non-experimental data: because the
quantitative forecasting model normally involves time series analysis,
for instance using linear regression, the analysis should use time series
data that were not used when working with the model.
x The board’s self-imposed prudential principles.
Minimum content in the USA

In the USA – where they are termed “Statements of Investment Policy” or
“Investment Policy Statements” – SIPs have been mandatory under ERISA
since 1974.899
Core requirements for a SIP are a written definition of the type of pension
plan, the nature of the contributions and their calculation, and the nature of the
asset management, in particular the careful drafting and implementation of an
investment strategy suited to the pension plan.900
In addition to ERISA, which has now been in force for more than a quarter of
a century and is tailored above all to the needs of DB pension plans,901 which
are increasingly losing out to DC plans,902 the following, legally non-binding
proposal for designing a SIP from the US perspective may be considered as a
suggestion for relevant European standards.
The proposal calls for the SIP to be structured as follows in six chapters:903
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1. Objective and background

x The SIP is the board’s most important tool for monitoring and assessing
the pension plan’s investment programme.
x Presentation of the groups of individuals covered by the pension plan and
of the expected future development of contributions and payouts, plus a
list of the individuals involved in the plan’s administration.
2. Statement of goals, i.e. the target interim and final outcome of the pension
plan
x General investment goals: assumption of reasonable risk in respect of the
portfolio as a whole, and maximisation of the return achievable with this
level of risk, risk optimisation by diversification, cost control.
x Specific investment goals, e.g. whether the plan is a defined contribution
or defined benefit scheme.
3. Policies and investment principles
x Risk tolerance
x Investment horizon
x Preferred asset classes
x Expected return
There may be no contradictions between the definition of the policies and
the statement of investment goals, for example the goal of a five percent real
return is not consistent with the policy of a maximum 30% investment in
equities. The second challenge in this chapter of the SIP is to strike the right
balance between sufficient certainty and a reasonable level of residual
freedom to invest.
4. Permitted securities policies
As with the definition of the investment principles, the objective here is to
balance the need for sufficient precision with the avoidance of excessively
tight reins for the asset manager. The asset manager’s decision-making
powers cannot be restricted so much that the sponsor essentially retains
discretionary control over investment decisions; on the other hand, it is
important to clarify which securities and which asset management practice,
such as options writing, securities lending or buying securities on credit, are
desired, and in particular which are prohibited.
5. Selection of the asset manager
x Professional qualification and licensing requirements.
x Minimum requirements to be met by the asset manager’s track record in
investment, for instance compatibility with accepted Performance
Presentation Standards
x Evidence of human and technical resources to cope with the planned
volume of investment.
x Character references and undertaking to notify the sponsor of any future
problems with the law and/or the executive.
129
6. Oversight
x Regular reports on the market value and composition of the fund assets
and the transactions executed during the reporting period, plus review of
consistency with the stipulated criteria (see above).
x Regular performance presentations in accordance with defined standards
x Examination at longer intervals
x of the technical reserves (applies only to DB systems) and their
coverage by fund assets;
x of the cost of asset management and the fees and commissions
incurred.
Preparing and updating the SIP

The board of directors prepares the SIP both in the EU (planned) and in the
USA. There is a consensus that the content should be reviewed at least once a
year, and that there should be an interim review if this is dictated by the
circumstances.904
5.2.2 Content of a prospectus

Prospectuses in the USA
US mutual funds must send their shareholders updated prospectuses each
year. The purpose of this rule is questioned by some experts, who think that
few of these prospectuses are actually read because the information that is
genuinely new is not clear to the recipients, who would have to read the entire
prospectus, including all the information that has not been updated. This is
why the SEC is considering introducing annual prospectus updates that are
designed to provide shareholders every year with a brief outline of material
developments or changes in the fund, and thus enhance the effectiveness of
communication between funds and their shareholders.910
Maximum sales charge imposed on purchase (front-end

905
load)
905
Maximum deferred sales charge (back-end load)
Maximum sales charge (load) on reinvested dividends
906
Redemption fee
Exchange fee907
Account maintenance fee908
Table 24: Shareholder fees909
In 1997, the SEC put forward plans to amend the rules by allowing “profile
prospectuses” – a condensed version of the traditional prospectus. Investors
130
would be given the opportunity of buying funds either on the basis of this
profile, or of ordering the fully prospectus.911
The first page of any US prospectus must contain a standardised table of all
fees and costs, broken down into fees912 to be paid directly by the shareholders
and annual operating expenses913 (see Table 24) paid by the fund, such as
management- and 12b-1 fees.914, 915
The following example illustrates the implementation of this regulation in
the fee table contained in a prospectus dated June 2000 for a family of Fidelity
Investments funds:
Shareholder fees (paid by the investor directly)

Sales charge (load) on purchases and reinvested distributions None
Deferred sales charge (load) on redemptions None
Redemption fee on shares held less than 3 years(as a % of amount 2.00%
redeemed) for Small Cap Stock only
Annual account maintenance fee (for accounts under $2,500) $12.00
916
Figure 38: Typical fee table for a US mutual fund
Annual fund operating expenses (paid from fund assets)

Small Cap Stock Management fee 0.85%
Distribution and Service (12b-1) fee None
Other expenses 0.25%
Total annual fund operating expenses 1.10%
Mid-Cap Stock Management fee 0.67%
Large Cap Stock Management fee 0.69%
Figure 39: Typical part of a US mutual fund’s fee table listing the ongoing
expenses917
As a hypothetical illustration of an original investment of $10,000 in the fund

with an assumed annual return of 5% and unchanged fees and expenses, an
example must show the actual absolute dollar amounts that would be incurred
if the fund shares were held (and then redeemed) for one, three, five and ten
years.918
131
The following example illustrates the implementation of this regulation using

the example from the June 2000 prospectus referred to above for a family of
Fidelity Investments funds:
This example helps you compare the cost of investing in the funds with the cost
of investing in other mutual funds.
Let’s say, hypothetically, that each fund’s annual return is 5% and that your
shareholder fees and each fund’s annual operating expenses are exactly as
described in the fee table. This example illustrates the effect of fees and
expenses, but is not meant to suggest actual or expected fees and expenses or
returns, all of which may vary. For every $10,000 you invested, here’s how
much you would pay in total expenses if you close your account at the end of
each time period indicated and if you leave your account open:
Account Account
open closed
Small Cap Stock 1 year $119 $327
3 years $372 $372
5 years $644 $644
10 years $1,420 $1,420
Mid-Cap Stock 1 year $91 $91
3 years $284 $284
5 years $493 $493
10 years $1,096 $1,096
Large Cap Stock 1 year $93 $93
3 years $290 $290
5 years $504 $504
10 years $1,120 $1,120
Figure 40: Typical fee table of a US mutual fund illustrating the costs of the
investment in this fund for one to ten years919
Because the brokerage fees for buying and selling instruments in the fund’s
portfolio are not known from the outset, they are not contained in this table,
but must be included in any performance-related publicity.
As part of its efforts to educate investors via the Internet, the SEC provides a
variety of tools to help them invest in mutual funds. These also help investors
rate fund costs, for instance using the Mutual Fund Cost Calculator,920 which
compares the cost of owning funds for a particular period once the user has
entered certain data from the prospectus.921 Another guide to investing in
mutual funds922 available online at the SEC’s website contains a section on the
importance of fees.923
132
The EU “Rebuilding Pensions” study,924 US lawmakers and the SEC all

believe that information overload for investors should be avoided, and that the
data published in the prospectus should be extremely user-friendly, for
instance through simple explanations and the use of graphics.
In the USA, the SEC recently completed its “Plain English” campaign925 and
communicated its concrete requirements to the industry: this involves a
controversial attempt to make prospectuses and other information material
designed for shareholders more comprehensible to the average investor, in
particular a requirement that principal investment strategies and risks of
investing process should be summarised in easily understandable form.926
This aims to turn prospectuses into documents that will actually be used by
the investors.927 Although there is substantial support for the principle behind
this requirement, it has met with the following criticism:928
x The investment adviser and the fund board could lose legal certainty
because although it may be stilted, the language that is tried and tested
(including in court) has to be abandoned, with a consequent fear of
litigation.
x There is a risk that the explanation of the investment strategy (e.g. relating to
the hedging or duration policy) will be unclear.
x Trying to simplify complicated terms may clash with the need for adequate
disclosure.
In future, the impact of taxes on performance will also be presented in much
greater detail in the prospectus.929
There are also suggestions for improving the disclosure of risk information,930
although there is a belief that interpreting the published data should be a
matter for intermediaries.
Prospectuses in the EU
The amended UCITS Directive requires publication of a simplified prospectus931
(see below) in addition to the full prospectus. These prospectuses must be
published932 in one of the official national languages933 and filed with the
regulatory authorities.934
Publicity inviting investors to buy shares in the fund must also indicate
where the prospectuses can be obtained.935
The essential elements of the prospectuses (both full and simplified) must
always be kept up-to-date936 and they must enable investors to make an
informed judgement about any investment in the funds;937 their minimum
content is defined by a series of schedules.938 As a rule,939 the fund rules or
investment company’s instruments of incorporation must be annexed to the
full prospectus.940
The accounting information in the prospectus must be audited by persons
authorised to audit accounts, and the auditor’s report and any qualifications
must be reproduced in full.941
133
The European Commission justifies the introduction of simplified

prospectuses as follows: to enable investors to make an informed judgement
about any investment in the fund (as described above), it was originally
believed that they should be provided with a large volume of detailed
information.
This opinion was revised in recent years because the Commission came
round to the view that the current information requirements of the UCITS
Directive did not take sufficient account of the needs of the average investor,
and that effective investor protection can better be achieved through clear and
simple core information.942 As a consequence, the simplified prospectus should
“be structured and written in such a way that it can be easily understood by the
average investor”.943
The simplified prospectus must be offered to all prospective investors free of
charge prior to signature of contract.944 In return, the full prospectus no longer
has to be automatically provided, but – together with the most recent annual
and half-year report – must be made available to investors free of charge on
demand.945
This has seen the European Commission fall into line with the demands of
the European mutual fund industry, as well as keeping abreast of
developments in several Member States (e.g. France946) and in the United
States, which have already introduced simplified prospectuses.947
The key features of the simplified prospectus948 are structured as follows:
x Brief presentation of the UCITS: information on the management
company, the depositary, the auditors and the financial group promoting
the UCITS;
x Investment information: objectives of the UCITS, investment strategy,
historical performance, profile of the typical investor for whom the fund is
designed.
x Economic information: tax regime, entry and exit commissions (i.e. front-
and back-end loads), any other commissions and fees, broken down by
those payable directly by the shareholders and those payable by the fund.
x Trading information: purchase/sale of the shares or units, any rules for
switching, dividends and price publication, indication of a contact point.
x Additional information: an indication of the possibility of obtaining, free
of charge, the full prospectuses and the most recent annual and half-
yearly reports, prior to signature of contract.
The following additional content requirements apply to both types of
prospectuses for specific classes of funds:949
x Index funds must describe the characteristics of the tracked equity index
and contain a prominent statement drawing attention to the fact that the
strategy of the UCITS is to track a certain index and that therefore it may
invest a significant part of its assets in equities issued by a single issuer.950
134
x Funds of funds must describe the characteristics of the funds that will be
bought and contain a prominent statement drawing attention to the fact
that the strategy of the UCITS is to invest partly or fully in other UCITS.951
x Funds that invest partly or fully in bank deposits must describe this fact.952
x Funds that invest partly or fully in financial futures or options953 must
contain a warning that this type of investment is suitable only for
experienced investors or investors whose financial situation allows them
to bear the risks of such an investment.
5.2.3 Annual and half-yearly reports to shareholders and

supervisory authorities in the EU and the USA
The UCITS Directive requires publication of an annual and half-yearly report954
within certain time limits from the end of the relevant reporting period,955 and
the filing of these reports with the supervisory authority.956 The most recent
annual report, plus any subsequent half-yearly report, must be provided free of
charge to prospective957 and existing958 shareholders (on request) together with
the prospectus. A stipulated minimum content959 aims to allow investors to
make an informed judgement about the development of the fund’s activities
and results.
ERISA contains similar rules for US pension funds:960 the annual report to be
filed with the US Secretary of Labor961 and made available to participants and
beneficiaries of the plan962 within a certain period must contain at least a
financial report,963 including a statement by the independent public accountant
concerned, and an actuarial valuation of the plan liabilities, including a
statement by the independent actuary involved.964
The participants and beneficiaries of the plan are also entitled to require at
any time a written report, based on the latest available information, on their
total benefits accrued, and on the status of their personal non-forfeitable
pension benefits (the amount of accrued non-forfeitable pension benefits or the
earliest date on which benefits will become non-forfeitable).965
5.2.4 Stricter disclosure requirements for pension funds in

the EU
There is a suggestion that disclosure requirements – regular reporting to
members966 and regulators – for pension funds under the proposed Pension
Fund Directive967 should be stricter than is the case for UCITS. For example,
disclosures should include not only the annual report, but also the SIP,968 any
existing ALM study and actuarial valuation of the plan liabilities.969
However, the proposal for a Pension Fund Directive that was then published
in October 2000 requires only the publication of the annual accounts and
annual report970 for the members of the pension plan, as well as a statement of
investment policy,971 and these only on request. Additional “asset/liability
studies”,972 actuarial valuations”973 and the “report of the statutory auditor”974
must only be provided to the supervisory authority.
135
Shareholders should be informed in particular975 about the development of

the fund’s net asset position976, especially in the case of DC schemes.977 Efforts
to require information about the costs payable by the fund, and thus by its
members, are relatively cursory compared with the proposed depth of
regulation for other major issues, as there is merely a suggestion to require
disclosure of expense ratios978 or other “precise information on all costs
incurred”.
The intention
x to establish simplified prospectuses979
x and to make the information provided to shareholders in the annual
report more comprehensible to the reader by means of an executive
summary, a glossary, graphics and statistical data, as well as to establish
the principle that readers should not be overloaded with information, but
rather that priority should be given to user-friendliness,980
similar to the efforts for UCITS, is only presented superficially.
In view of the existing edge enjoyed in these areas by US funds – which
evidently served as a model for a number of other proposals, in particular the
establishment of a board of directors subject to fiduciary duties – the disregard
paid to these two issues represents a regulatory gap that must be covered by
standards.
The fund manager should explain the investment strategy in the light of the
structure of the liabilities981 as part of the annual accounts982 filed with the
supervisory authority, and the supervisory authority should be able to monitor
compliance with the principle of risk diversification982. In addition to the
standard accounting information, the annual accounts should also include a
statement by the board of directors and summaries of the reports by the
external actuary and the auditor.983 For DB plans, the actuarial valuations of the
liabilities (when produced984) and any ALM study985 should also be filed in
compliance with the licensing requirements,986 while DC plans should also
inform their members about the fund’s (risk) characteristics and costs (expense
ratio).987
5.2.5 Performance Presentation Standards (PPS)

Definition
The function of Performance Presentation Standards (PPS) is to ensure the fair
presentation of returns to (prospective) clients. Voluntary PPS first emerged in
the late 1980s in the USA in response to the deliberate manipulation of
performance presentation by some investment advisers.988
PPS build firstly on performance measurement, and secondly on the analysis
of performance and of return; these are factors that interact with portfolio
management, the management of portfolio risk and trading, and help reveal
undesirable developments or potential for improvement in these areas.989
136
The analysis of performance examines general factors, such as the efficiency

of transaction implementation in trading and other processes. The analysis of
return, on the other hand, involves basic research in that it aims to discover the
reasons for particularly good or bad performance by presenting those
components that have contributed to portfolio return in quantitative form.990 In
particular, it examines the question of whether (bad) luck or the portfolio
manager’s skill (or lack of it) have driven the performance of the portfolio. This
in turn is based on the underlying assumptions that such skills actually exist,991
that they remain stable over time and that their existence can be demonstrated
by the realisation of exceptional returns.992
Those portfolio managers who have realised an above-average return
(against the market) are divided into two groups: those who were simply lucky,
and those whose good performance is the result of superior skills or
techniques.993
Overview of existing PPS

The first (1993) version of the AIMR PPS994 was the first comprehensive set of
rules governing performance presentation and met with worldwide approval.
Driven by this success, PPS that were closely oriented on the AIMR PPS were
then adopted outside the USA, for example:995
x the pension fund PPS of the National Association for Pension Funds
(NAPF) in the UK;
x the Swiss Performance Presentation Standards;
x the Global Investment Performance Standards996 (GIPS) developed by the
AIMR;
x the DVFA PPS997 developed for the German capital markets.
Compliance with AIMR PPS automatically
involves compliance with Swiss PPS and
vice-versa
DVFA PPS AIMR PPS Swiss PPS
Compliance Compliance with AIMR PPS/

with DVFA PPS Swiss PPS does not
automatically automatically involve
involves compliance with GIPS
compliance with
GIPS
GIPS
Figure 41: Relationships between key standards998
The individual PPS do not differ significantly (see Figure 41), and they are
compatible to a certain extent.
The recommendation put to the European Commission is to include
minimum rules for performance measurement in the proposed Pension Fund
Directive:999: this aims firstly to ensure that fund performance is compared with
137
relevant benchmarks,1000 and secondly to require the disclosure of any risk

measures, with the Sharpe1001 and information1002 ratios being used during the
introductory phase of the Directive, possibly followed at a later point by more
complex measures of risk, such as value-at-risk.1003, 1004 In view of the efforts that
were needed to establish GIPS, it appears sensible to examine whether these
standards would also be suitable for EU pension funds.1005
DVFA PPS in Germany
Definitions
Management
return
+ Market return
– Management fees
= Investment return
Equation 16: Components of investment return as defined by DVFA PPS1006
DVFA PPS are based on GIPS, although the latter only represent minimum
requirements in this context, because stricter requirements were stipulated for a
number of points. Investment return is broken down into several individual
return components that are analysed separately (see Equation 16).
These components will not be analysed in detail below; the aim is rather to
present the core features of DVFA PPS. Attention is drawn to the relevant
literature1007 for an exhaustive treatment of DVFA PPS and a general discussion
of the problems involved in the analysis of performance.
Measuring return
As with GIPS and AIMR PPS, the measurement of return is based on the time-
weighted return,1008 which requires the portfolio to be valued after each cash
flow. This is not always the case in practice, which is why approximation
methods are allowed, although valuation should be performed at least
monthly.1009 Market prices must be used for this valuation, and the prices
should always be drawn from the same source.
The DVFA PPS also recommend (but do not require) the use of gross
return1010 to ensure better comparability with benchmarks: this is the return
gross of management fees and taxes (with the exception of foreign withholding
taxes).1011
The reasoning behind this recommendation is that these costs are not
deducted from benchmarks, and that net return is therefore a poor standard for
measuring investment performance. The AIMR PPS share this view, but this
means that they are also partly at odds with the SEC, which thinks that the use
of gross performance data can only be permitted to a limited extent.1012, 1013
138
Measuring risk
Difficulties in establishing watertight definitions mean that it is much more
difficult to measure risk than it is to measure return. DVFA PPS are not limited
to the presentation of historical risk resulting from time series analysis, but also
cover the areas of corporate management, trading and research; these all
influence future performance and entail risks.1014
The investor’s total risk can be broken down into the following constituents:
1. Absolute risk measures the probability that the future return of the
portfolio/fund will deviate from the historical mean, and is expressed by
the following variables, among others:
x As a measure of absolute risk, volatility is particularly important for
investors who have invested all or most of their assets in the
portfolio/funds concerned.1015
x For bond portfolios, duration1016 is a key measure of sensitivity to
interest rate changes.
x Value-at-risk1017 is becoming increasingly important in asset
management.1018
2. Relative risk measures the probability that the future return will deviate
from the benchmark.
x Tracking Error1019 is the (empirical) standard deviation of the difference
between the returns of the portfolio/fund and benchmark returns.1020
Selecting the wrong valuation sources can distort the results.1021
x Beta measures the sensitivity of the portfolio return against the market
return, or in practice more commonly the benchmark return.1022
3. If the concept of performance is interpreted not simply as the (differential)
return, but rather as the risk-adjusted return, the return measurement
criteria can be structured as in Figure 42.
4. The dispersion of returns within a composite measures the probability
that the historical return of a portfolio assigned to the composite falls short
of its average return.1023
5. General risks measure the effect of non-market-specific risks, such as:1024
x the possibility that the management company’s ownership structure
may change;
x or the possibility that the composition of the management or analyst
team may change.
139
Total risk Systematic risk
Standardised risk 1025

Sharpe ratio Treynor ratio1026
(ranking possible)
Absolute differential return

against the “passive Differential Jensen’s
portfolio” (no ranking return1027 alpha1028
possible)
Market risk-
Risk-adjusted
“Synthesis” adjusted
return1029
return1029
Figure 42: Classification of various measures of return by risk measure used

and application1030
Minimum periods to be presented

The performance history must be presented for at least a five-year period; if
this is not possible because the portfolio/composite has been in existence for a
shorter period, the presentation must cover the entire period since inception.
Rates of return for periods of less than one year may not be annualised.1031
Relative performance comparison
The relative performance of the portfolio (or composite) and a previously
selected benchmark1032 (normally an index) is compared. This aims to measure
management performance, i.e. the ability of a portfolio manager to vary the
portfolio structure within the limits of the investment policies.1033 A comparison
is reasonable only if the portfolio (or composite) and the benchmark are based
on the same price source, and the times when the prices are determined also
coincide.1034
Benchmarks can be well-established “plain vanilla” equity and bond indices,
but also customised benchmarks, i.e. self-constructed benchmarks; these are
useful for balanced (mixed) funds that invest in both equities and bonds.1035
Operating expenses
The definition of operating expenses is not always the same in all countries, so
the DVFA PPS contain the following list of typical fees and expenses:
x Management fees;
x Asset custody fees (e.g. account fees);
x Account management fees;
x Portfolio audit costs;
140
x Payments to public entities;

x Price publication costs:
x Cost of printing prospectuses, annual and half-yearly reports;
x Custodian bank fee.
Regulations in the USA
The SEC’s role in PPS

The SEC has issued a regulation obliging fund managers to publish
performance data in a standardised format. There are also suggestions at
present to subject performance data used for publicity purposes to mandatory
control by an independent auditor; although the fund industry has no
objections in principle, its concerns centre around the issue of cost. Over the
years, the SEC has staked out the bounds of permitted publicity and
advertising through no-action letters,1036 the publication of interpretations of
laws and regulations, and enforcement actions.
The industry is highly critical of the fragmented nature of these
pronouncements and is calling for all the relevant rules to be concentrated in a
single interpretative release. This would not only assist clarity, but would also
eliminate inconsistencies and could produce more generally applicable rules,
rather than the current case-by-case rulings.1037
The SEC frequently takes action on abuses relating to the improper use of:
x Gross performance data;
x Performance data achieved at the portfolio manager’s previous
employer;1038
x Inadequately substantiated performance data – records used to
substantiate performance must be kept for a minimum of five years;
x Quality standards, e.g. frequent misrepresentation that the investment
adviser complies with AIMR Presentation Standards;
x Composites, that are not sufficiently representative, in particular the
extensive exclusion of underperforming accounts;
x Model performance data advertised as real performance;
x Exaggerated claims about the number of investors, the assets under
management, the length of time the adviser has been in business and the
education and experience of their staff;
x Advertising material that misrepresents the adviser’s investment
philosophy, for instance where a “dynamic” investment style is
represented as a conservative strategy.
Ex post performance advertising
The SEC requires any document containing performance information to carry a
legend that performance data represents past performance, and may not reflect
future investment returns. Investment returns and the principal value of the
141
fund will fluctuate, and fund shares may be worth more or less at redemption
than at purchase.
In view of this generally uncontroversial statement, the SEC – and others –
consequently poses the question of why advertising using historical
performance data is allowed in the first place, if there is a generally held view
that such information does not permit any forward-looking conclusions to be
drawn.1039
SEC is trying to turn the general public into educated investors, for instance
by publishing a guide to investing in mutual funds,1040 which includes1041 a
warning not to choose funds only by comparing their historical
performance.1042
Minimum periods to be presented
The SEC prescribes standards for performance presentation that aim to prevent
cherry-picking:1043 if performance for a single year is presented, for instance, it
must also be presented for five and for ten years.
Use of suitable risk measures
Parts of the US fund industry are resisting mandatory publication of
quantitative risk measures, arguing that these tend to confuse investors, rather
than enlighten them.1044
Portability of performance data
References to historical performance results that are not directly attributable to
the fund itself are allowed in certain circumstances, whereby the problems
centre around the following three areas:
x Advertising a fund using the performance data of individual accounts
managed by the same investment adviser.
x Performance data “portability” when portfolio managers change
employer.
x Performance data “portability” when portfolio managers go independent.
For a number of years, the SEC has let investment advisers – subject to
certain restrictions – advertise in prospectuses using the performance data of
private accounts managed by the same adviser. The most significant restriction
is that such performance information may only be presented additionally to the
information relating to the fund itself.1045
In its ruling setting a precedent1046 in the mid-1990s, the SEC established that
a portfolio manager’s performance results may be portable in certain
circumstances; when a portfolio manager moves to another fund management
company, the new employer can advertise with this portfolio manager’s
performance results from his time at the former investment adviser if the
following conditions are met:1047
142
x The other account performance must relate to assets under management

with similar investment objectives.
x The portfolio manager who has switched employer must have been
substantially responsible for the performance being advertised, although
this is very difficult to prove in practice. Moreover, investment decisions
are often not the result of solo efforts, but are based on teamwork.1048
x Advertising material and other sales literature must:
x prominently disclose that the other account/fund performance is not
the fund's own performance, and should not be considered indicative
of the past or future performance of the fund;
x prominently disclose that the other account performance should not be
considered a substitute for the fund's performance.
x Other account performance information must be presented in addition to,
and no more prominently than, the fund's own performance information.
x The promotional material must explain all material differences between
the other accounts/funds and the fund to ensure that the other account's
information is not presented in a misleading manner.
5.2.6 Consideration of the effects of taxes on returns in the

USA
The lack of consideration of the individual investor’s tax situation and its
impact on after-tax performance is sometimes seen as a defect of the US
disclosure rules.
It is estimated that US investors lose two and a half percentage points of their
funds’ returns to taxes. US equity funds surrender around 15% of their returns
to taxes. In 1997, taxes of $34 billion were paid on distributions, and in 1998, US
funds distributed $166 billion in capital gains and $134 billion in taxable
dividends. The SEC thinks that average investors have no idea that this is
happening, and that they lack a clear understanding of the impact of taxes on
their fund returns. In future, the situation will be made clearer to investors
through more far-reaching disclosure requirements.1049
This does not involve the actual examination of each individual investor’s tax
situation, but rather illustrative calculations based on certain common tax rates.
Tax-efficient funds in particular could benefit from this move, because their
pre-tax return is normally lower than the returns of comparable, non-tax-
efficient funds, while their after-tax return is often higher; this is not evident in
most comparisons – which are usually based on pre-tax returns – thus
potentially misleading investors.1050
The ICI has been lobbying Congress to support the mandatory disclosure of
the effects of taxes on net return, although it emphasises that the tax situation
will vary from investor to investor. SEC regulations to this effect are currently
being reviewed; these focus on creating a standardised calculation formula for
after-tax return.1051
143

Rules on a Statement of Investment Principles (SIP) must be included in
European standards on disclosure requirements. These will firstly help
investors in their fund purchase decision by making the nature of the fund
more transparent. Secondly, they can be used as a tool (especially by the fund
board) for assessing the implementation quality of the assured investment
strategy. The minimum content of standards should therefore require the
description of the investment strategy, including strategic asset allocation and
the associated expected return for a typical investment period, as well as
disclosures on risk tolerance and risk management techniques. The fund board
is the most appropriate author of the SIP.
Regulators (in both the USA and the EU) believe that the prospectus is the
essential means of communication for fund publicity – a view that is
increasingly out of touch with reality, with fund profiles published by the
managers on the Internet becoming increasingly important. Regulators and the
fund board should consequently pay more attention to this communication
medium in future,1052 and standards should also regulate online presentation.
Nevertheless, prospectuses are still very important, although the traditional
prospectus form often fails to consider the needs or information processing
capacity of the average investor. This is why there is a need for action to ensure
that prospectuses are actually read and understood:
1. The required minimum content of simplified prospectuses – which are not a
substitute for the conventional full prospectuses, but should be available to
supplement them – should go beyond the minimum required by law. They
should incorporate the SIP and thus cover all questions relating to the
investment strategy. This would allow the prospectus to focus above all on
the fee structure and amounts, as well as tax aspects of the fund, including
simplified model calculations to assist the reader.
2. The terminology and wording should avoid legal and technical jargon
wherever possible. The language should be as simple as possible, but still
sufficiently precise, supported by user-friendly tables and graphics.
The problem of how to present historical performance in particular could be
solved using established Performance Presentation Standards. The fund
industry itself, as well as financial journalists, would have a hard time accepting
new standards created for this purpose, although certain additions to existing
PPS might still be needed to better suit the specific features of pension funds,
especially DB plans. This would also help eliminate consumer protection
objections about (misleading) fund advertising.
The development process for voluntary standards should also consider tax
effects in performance presentation along the lines currently being debated in
the USA.
144
CHAPTER 6
Control and Enforcement

of Rules and Regulations
6.1 BOARD OF DIRECTORS
6.1.1 Definition
Board of directors – a permanent feature of the US fund
environment
In the late 1970s, US Justice William Brennan described fund directors as
watchdogs who provide “an independent check upon the management of
investment companies”.1053 They represent the interests of the shareholders,
which rank prior to the interests of all other parties. The shareholders therefore
rely on the directors and their independence to assure the integrity of the
fund.1054
The US Investment Company Act states clearly that independent directors
have primary responsibility for safeguarding shareholders’ interests.1055
The SEC believes that it is best practice for the independent directors to
regularly review the effectiveness of the (entire) fund board on the basis of the
following criteria:1056
x frequency of board meetings;
x whether management supplies directors with necessary and timely
information;
x whether the independent directors should meet separately from the other
board members on occasion;
x whether the board’s organisational structure is efficient and effective.
145
CONTROL AND ENFORCEMENT OF RULES AND REGULATIONS
The Investment Company Act lays down that the minimum term of office of
directors is one year, with a maximum term of five years.1057
Recommendation on the future institutionalisation of the board of

directors in the EU
Although the Rebuilding Pensions1058 study expressly recommends the
establishment of a (partly independent) board of directors for European
pension funds as the “highest authority of the pension fund”,1059 this was not
discussed by the European Commission either in the major preparatory
documents1060 for the proposed Pension Fund Directive1061 or in the proposed
directive published in October 2000.
There is therefore an urgent need to amend the final directive to require the
installation of a board of directors with the status outlined in Figure 43.
Sponsor Regulator
Board of directors Management company
Beneficiaries and members Other service providers
Figure 43: The board of directors in the responsibility matrix1062
6.1.2 Organisational structures

It is quite common in the USA for funds not to have their own exclusive board,
but for an individual fund board to oversee a whole family of funds, although
the structures themselves may vary:1063
x In a pooled board structure, all members of the board oversee the entire
family of funds.
x In a clustered board structure, the board is split into different groups, each
of which is responsible for specific defined groups of funds with similar
features. For example, (all) bond and (all) equity funds can be supervised
by two different groups of board members.
The purpose behind this bundling of responsibilities is one of business
efficiency, i.e. to avoid unnecessary duplication of the same duties to be
exercised at all – or at least most – of the funds in a family, such as discussions,
shareholder servicing or audit matters.
The organisation can also (and additionally) be structured along functional
lines, with certain matters being dealt with in committees, rather than the
146
board as a whole. In the USA, these committees normally meet apart from the
full board meets; independent director representation is usually very high on
these committees, and in some cases, they are composed entirely of
independent directors.
A 1998 survey produced the following picture for typical fund committees in
the USA (see Figure 44):
100%
100%
Percentage of funds boards surveyed with this sort of committe
90%
80%
70%
60%
50% 47%
40%
40%
30% 27% 27%
20%
10%
0%
Audit Corporate Executive Brokerage Investment
Governance
Figure 44: Common types of US fund committee1064
6.1.3 Compensation
In the USA, it is the fund board – not the investment adviser – that often sets
the compensation of its members. The ICI recommends that independent
directors be allowed to set the appropriate compensation for serving on fund
boards.1065
The law prohibits directors from receiving shares or units of the fund as
compensation.1066 The reason for this prohibition is that prior to the Investment
Company Act, funds paid for services provided to them by agreeing to transfer
a certain number of shares or units at a certain date in the future. This practice
may have resulted in the dilution of shareholder/unit-holder interests if the
value of the shares or units appreciated by the time they were payable by the
fund, and the compensation paid exceeded the value of the service provided.
The service provider was essentially thus able to acquire shares or units at less
than their net asset value, and thus received preferential treatment over the
other shareholders/unit-holders.1067
Subject to certain conditions, however, the SEC now permits a similar
compensation arrangement that more closely aligns the interests of
independent directors and shareholders/unit-holders:1068 the practice of many
147
funds to require, or at least to encourage, their directors to invest part of their

compensation in shares or units of the funds does not cause dilution, and the
SEC therefore has no objections. The same applies to direct compensation by
shares or units, as long a fixed net asset value is agreed in advance rather than a
fixed quantity of shares or units, thus preventing the directors from receiving
preferential treatment over other shareholders/unit-holders.
6.1.4 Prohibition on delegating the board’s fiduciary duties

in the EU and the USA
The proposed Pension Fund Directive1069 should emphasise that the fund board
can never delegate its control functions, and that responsibility for managing
the assets1070 and complying with the disclosure requirements in particular
must always rest with the board.1071 Drafting the SIP1072 is also one of the fund
board’s primary personal duties.1073
6.1.5 Transactions requiring approval in the USA

The Investment Adviser Act of 1940 and SEC regulations issued on the basis of
this law require the approval of a majority of independent directors for the
following transactions:
x Contracts with the investment adviser (investment advisory contract)1074
and the principal underwriter1075 must be re-approved each year by the
independent directors.1076 The directors are required in this context to
obtain from the investment adviser and to review all reasonable
information necessary for assessing the agreements contained in the
investment advisory contract, and the investment adviser in turn is
required to provide this information.1077 The directors can also consult
external experts to supplement the information provided by the
investment adviser. Advice by an independent counsel is also possible.1078
The information provided should enable the review of the advisory fee,
the services provided by the investment adviser and the profitability of
the fund to the adviser.1078
The SEC would like to strengthen the position of the independent
directors1079 by – among other things – allowing them to terminate the
investment advisory contract1080 without requiring the approval of the
other directors (at present, the approval of the full board is required1081).
The ICI is calling for independent directors to be allowed to meet
separately from the rest of the board in matters relating to the advisory
contract.1082
x Selection of the fund’s independent public accountant.1083
x Selection and appointment of new independent directors in the event of
the (partial) sale of the investment adviser and the subsequent award of
an investment advisory contract to this adviser.1084 For such transactions,
the Investment Company Act1085 requires that at least 75% of the board
must comprise independent directors for at least the next three years.
148
The independent directors have to conduct due diligence in such

consolidation transactions by reviewing the new investment advisory
contract and deciding whether to recommend it to the shareholders/unit-
holders; on this basis, they then decide whether to recommend or oppose
the transaction as a whole. The quality of the investment advisers must
also be examined, for example using the following criteria: controlling and
affiliated companies of the adviser, financial position, compliance practice,
performance, etc. These again are fundamental fiduciary duties, in this
case evaluating the risks and rewards of such a transaction in the interests
of the shareholders/unit-holders, and preventing dilution of their shares
or units.1086
x Approval of the distribution fees paid from the fund’s assets (to be
repeated at least once a year) in the case of 12b-1 plans.1087 The directors
must not only approve, but also regularly renew the 12b-1 plan, and they
can also terminate the 12b-1 plan at any time without penalty.1088
When deciding these matters, the independent directors must in
particular establish whether it can be reasonably assumed that payment of
these distribution fees by the fund will benefit the fund and its
shareholders/unit-holders. The adopting release to Rule 12b-1 contains a
number of criteria that directors should use to evaluate the admissibility of
12b-1 plans.1089 A 12b-1 plan should not be viewed by the directors as a
permanent arrangement: Rule 12b “essentially requires fund directors to
view a fund’s 12b-1-plan as a temporary measure even in situations where
the fund’s existing distribution arrangements would collapse if the rule
12b-1 plan were terminated”.1090 The basis of the evaluation criteria
referred to above is that a 12b-1 plan should typically aim to be used for a
relatively short period, to respond to a particular distribution problem or
to respond to special circumstances, such as net redemptions by
shareholders. 12b-1 plan practice today, however, is normally far removed
from this original intention, which resulted from the situation of the US
mutual fund industry in the late 1970s. Nowadays, 12b-1 plans are used as
a substitute or supplement for sales loads so as to pay for continuing
advertising and distribution costs. 12b-1 plans also helped establish
hitherto unknown distribution methods in the 1970s that presupposed
that 12b-1 plans were a permanent, rather than a temporary
arrangement:1091
x Shares or units of a single fund are offered in several classes,1092 with
some classes defined (partly) by a 12b-1 fee. If 12b-1 plans are viewed as
a merely temporary measure, however, the associated fund class would
have to be wound up if the plan is terminated.
x Funds that are primarily distributed through fund “supermarkets”:1093
many of these funds have a 12b-1 plan that pays the commissions to the
fund supermarket; this plan should also therefore be seen as a
permanent arrangement.
149
x Some investment companies borrow money from banks or the capital

markets using their expected future 12b-1 revenue as collateral. The
issue of asset-backed securities whose backing consists of future 12b-1
revenue is a similar practice.
x Approval and oversight of affiliated securities transactions1094, 1095
x Establishing the fund’s fidelity bond1096, 1097
x Establishing whether participation in joint insurance contracts is in the
fund’s best interests.1098
The entire fund board – i.e. all directors, not just the independents – also has
the following responsibilities:
x Approval of the fund’s valuation methods: the directors must review and
approve the guidelines used by the investment adviser to value the fund’s
assets. If a pricing error occurs, it is the board’s responsibility to decide on
any corrective action to be taken.1099
x Approval of investment objectives and policies1100
x Deciding the policies on proxy voting1101 for securities held by the fund
x Monitoring investments in derivatives1100
x Monitoring fund liquidity1100
x Approving custody agreements1102
x Approving brokerage allocation policy1102
x Oversight of the fund’s investments and performance: the performance of
the fund is evaluated on the basis of the factors stated in the prospectus –
investment objectives, strategies and risks – so that a more detailed
examination can be made if, for instance, the fund is performing much
worse than comparable funds. The directors are also responsible for
reviewing whether the managers are complying with these policies
contained in the prospectus.1103
x Authorising the merger of two or more funds1102
x Declaring dividends in accordance with the fund’s investment policies
and objectives1102
6.1.6 Oversight of internal fund procedures in the USA

Some typical significant procedures whose oversight forms part of the fund
board’s duties are presented below to give an insight into the complexity of this
prudential regime:
x Soft dollar arrangements:1104 the independent directors have a fiduciary duty
to establish – and this often means asking the investment adviser some
tough questions – whose interests are served by any soft dollar
arrangements, and whether they are really in the shareholders’/unit-holders’
best interests; whether they can be used to reduce direct costs to the fund;
and whether the investment adviser can use them to secure research.1105
The soft dollar arrangements should also be considered as part of the
regular review of the investment advisory contract1106 – one of the fund
board’s most important duties. It is evident that in practice, investment
150
advisers comply to a widely varying degree with their duty to provide

comprehensive information to the directors1107 in doing so; compliance is
unsatisfactory in many cases, and it is frequently assumed – wrongly – that
all that is needed is a copy of the (annually updated) registration form.1108, 1109
x Fund portfolio brokerage: this problem is related to the soft dollar issue and
looks at the questions of which broker/dealers are engaged by the
investment adviser and why, as well as why not others? This aims e.g. to
prevent brokers being preferred simply because they also sell the fund’s
shares/units.1110
x Best execution: one of the fiduciary duties of both the management company
and the executing broker/dealer1111 is to obtain the best possible total costs for
the client under the circumstances for each securities transaction.1112 Total
costs in this context cover not only the fees and commissions paid – these are
the least problematic because they are firstly the most transparent costs, and
secondly are normally relatively insignificant – but above all the market
impact,1113 in other words they are mainly a question of the quality of
execution.1114 A low fee makes little sense if the price paid is higher than the
market price.1115 Market impact also depends on the discretion of the
broker/dealer,1116 because if the broker/dealer lets it be known on the market
that a large order is about to be executed, the result will almost automatically
be a higher cost of execution.1117
In addition to the independent directors, portfolio managers also play a
major role in ensuring best execution because their compensation, reputation
and ratings depend on their performance, which is determined – among
other things – by the level of transaction costs they can achieve.1118
x Personal investing by fund managers: one of the directors’ duties is to ensure
that the fund adopts and discloses1119 a code of ethics1120 for personal
investing by its employees.1121 The directors are also responsible for
reviewing the code of ethics of the fund and other service providers working
for the fund. These institutions must report to the fund board at least once a
year1122 on all matters relating to enforcement of the code of ethics.1123 De
facto weaknesses in the oversight of the code often encountered in practice
result from the fact that the number of individuals to be covered by the code
is very large, and the cost of administering it is therefore often unrealistically
high.1124
6.1.7 Personal liability of fund directors in the USA

Although directors may believe that they are acting in the best interests of the
fund and its shareholders/unit-holders, they are still continuously exposed to
the hazard of personal liability. The negative side-effects of this legally exposed
status of the directors is that firstly, qualified individuals are deterred from
becoming fund directors, and secondly, directors are deterred from taking
potentially controversial decisions. The SEC tries to counter these undesirable
consequences by allowing funds to advance legal fees to their directors under
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certain circumstances, because even if a lawsuit stands little chance of success,

defending it can be a very expensive business.1125 This may not clash, however,
with the provision of the Investment Company Act1126 prohibiting funds from
releasing directors from their liability to the fund itself and to its
shareholders/unit-holders in the event of criminal intent, bad faith, gross
negligence or reckless disregard of their duties (know collectively as “disabling
conduct”).
Before any advance is paid, the SEC therefore insists that the fund board
either ensures that the advance can be repaid in the event of an adverse court
ruling (for example by way of insurance or collateral provided by the director)
or that it must reasonably believe that the director has not been involved in
disabling conduct and that the director will therefore be entitled to
indemnification. This belief must either be formed by a majority of
independent directors, or be based on a written opinion by independent legal
counsel.1127
6.1.8 Fees and Expenses

Classification
Shareholder/Unit-holder fees – Sales load

Sales loads are a one-time sales charge payable by the shareholder/unit-holder
when shares or units of the fund are bought or sold and are designed to
compensate the investment advisers for their services, in particular for the
advice they give to investors in selecting a suitable fund. Sales loads vary
considerably, and are sometimes not charged at all, but in any case they are
limited by law to a maximum of 8.5% of the initial investment.1128 For “front-
end load” funds, the charge is due on purchase of the shares or units, and for
“back-end” or “deferred load” funds, it is not payable until the shares or units
are sold, although in the latter case, the level of the charge normally drops the
longer the shares or units are held (usually by 1% a year), until it finally
disappears. “No-load” funds have neither front-end nor deferred sales charges.
Annual operating expenses
Funds incur expenses for services relating to the ongoing operation of the
fund.1129 The most important types of expenses are:
x The management fee is the largest single component and compensates the
investment adviser for managing and selecting the components of the
fund portfolio.1130
x A 12b-1 fee (if applicable), named after the Rule 12b-11131 issued by the SEC
in 1980 under the Investment Company Act: Under certain circumstances,
an investment adviser can also function as the distributor of its fund’s
shares or units. Resulting distribution expenses, such as advertising,
issuing costs, compensating sales professionals and printing and sending
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prospectuses to individuals other than the current shareholders/unit-

holders can be charged directly to the fund on the basis of a written 12b-1
plan. This plan must contain all details of the distribution methods and
must be approved by a majority of voting shareholders/unit-holders and
independent directors (repeated every year).
It is not only the investment adviser which has an interest in
encouraging the growth of the fund (through better distribution, for
example by advertising), but also the shareholders/unit-holders, for
instance if economies of scale can cut the (percentage) management fee.1132
The resulting total expenses are expressed as a percentage of the total
amount invested in the fund to produce the expense ratio (see Equation 17).1133
However, the sales load or brokerage fees for securities transactions relating to
the fund portfolio are never part of the expense ratio (Table 25 shows the
services included in the expense ratio and those that are not).
Management fees
+ Distribution (12b-1) fees
+ Other expenses1134
= Total annual fund operating
expenses
/ Net assets
= Expense ratio
Equation 17: Detailed annual fund operating expenses1135
The drawback of this way of calculating the expense ratio is that distribution
and advertising expenses are only factored into the expense ratio if there is a
12b-1 plan, which restricts the comparability of the expense ratio across fund
families. Before the introduction of Rule 12b-1, these costs were either borne by
the shareholders/unit-holders through the sales load, or by the investment
adviser from its profits. Since the mid-1980s, funds with a contingent deferred
sales load1136 combined with a 12b-1 fee1137 have been increasingly supplanting
front-end sales load funds.1138
The recommendation in the EU for the proposed Pension Fund Directive1139
is also to publish the expense ratio or otherwise to disclose all information
relating to costs.1140, 1141
Classes of fund shares or units
A fund can offer various classes of shares or units in the same fund. These differ
only in the way that costs of the fund are paid, and are typically classified as
follows:1142
Class A shares or units have a front-end sales load;
Class B shares or units have a 12b-1 fee and a deferred sales load;
Class C shares or units charge a higher 12b-1 fee but have no sales load.
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Type of service How Paid For Included in

Expense ratio?
1. Investment management Management fee Yes
(i.e., portfolio advice)
2. Administration and Management fee, fees to service Yes
recordkeeping providers
3. Buying and selling Commissions, bid-asked spreads No
securities
4. Distribution and Sales charge, 12b-1 fee, adviser 12b-1 fee, yes;
marketing profits otherwise, no
5. Financial advice/planning Sales charge; 12b-1 fee; sepa- Sometimes
rate fee or commission paid to a
broker, financial planner, or
investment adviser; wrap fee
6. Consolidated statements Supermarket receives portion of Yes
and other services pro- management fee, 12b-1 fee, or (unless paid
vided by a “mutual fund adviser profits from adviser
supermarket” profits)
Table 25: Allocation of the cost of mutual fund services and components of the
expense ratio1143
The role of the fund board

The US regulatory regime does not explicitly stipulate maximum rates1144 or
similar intervention for controlling fees and expenses, but rather relies on a
dual system comprising the following instruments:1145
1. Disclosure: the requirement of uniform disclosure of fees and expenses is
designed to enable investors to make informed decisions.
2. The independent directors on the fund board: their duty is to resolve
conflicts of interest that could result in unreasonably high fees and
expenses in the interests of the shareholders/unit-holders.
The SEC is thus not empowered by law to adjudicate on what is a reasonable
level of fees. However, the SEC can take action against the investment adviser
if the adviser breaches fiduciary duty in conjunction with fees and
expenses.1146, 1147
The full board is responsible for ongoing oversight and review of fees, and is
required by law to safeguard shareholders’/unit-holders’ interests. Any increase
in fees requires the approval of a majority of shareholders/unit-holders and
SEC Chairman Arthur Lewitt has pointed out that although fund
performance is unpredictable, the impact of fees is certainly not, and that a one
per cent annual fee will reduce the ending account balance after 20 years by 17
per cent.1149 Elsewhere, the SEC justifies an investigation into the fee situation
154
in the US fund industry by stating that: “The focus on fund fees is important
because they can have a dramatic impact on an investor’s return”.1150
In general terms, the impact of higher fees (expressed by the expense ratio)
on the future value after a certain holding period produces the sort of picture
shown in Table 26: this shows the future value of a one-time initial investment
of 25,000 monetary units after a holding period of 10, 20, 25 and 40 years, with
two different returns assumed – 5% per year and 9% per year. These two
return scenarios are subjected to various expense ratios (from 0% to 2% in 0.5%
steps) to illustrate the impact of higher fees on the absolute future value
(“Future value” columns), and the percentage shortfall of the future value over
a zero fee scenario (“Shortfall” columns). It can be seen that assuming a realistic
40-year investment phase (for the pension) and an expense ratio of 1%, the
future value is one third lower than for a zero fee scenario. If the expense ratio
were twice as high, the shortfall would be more than half!
Return Expense Year 0 Year 10 Year 20 Year 25 Year 40

ratio (%)
Future Short- Future Short- Future Short- Future Short-
value fall (%) value fall (%) value fall (%) value fall (%)
5% 0.00 25,000 40,722 66,332 84,659 176,000
0.50 25,000 38,731 5 60,005 10 74,688 12 144,024 18
1.00 25,000 36,829 10 54,254 18 65,849 22 117,739 33
1.50 25,000 35,010 14 49,029 26 58,020 31 96,153 45
2.00 25,000 33,273 18 44,284 33 51,089 40 78,443 55
9% 0.00 25,000 59,184 140,110 215,577 785,236
0.50 25,000 56,291 5 126,745 10 190,186 12 642,574 18
1.00 25,000 53,525 10 114,597 18 167,680 22 525,300 33
1.50 25,000 50,882 14 103,561 26 147,743 31 428,992 45
2.00 25,000 48,358 18 93,539 33 130,093 40 349,980 55
Table 26: Impact of return, expense ratio and holding period on the future value of a fund
investment
What is often observed in practice is that although the fund volume has
multiplied over time, the fees have certainly not fallen (if at all) to the extent
achievable by economies of scale.
According to a study by the US Investment Company Institute,1151 there was
only a very small reduction in the expense ratios of the 100 largest US equity
funds between 1980 and 1997, although the net asset value grew around
twenty fold over the same period.1152 The expense ratio of all equity funds
surveyed actually grew by 12 bp between 1980 and 1997, from 0.76 in 1980 to
0.88 in 1997.1153
155
1980 1997 A recent SEC study shows that

the expense ratios of equity and
Average 0.82 0.70
bond funds (both the unweighted
Sales-weighted average 0.70 0.56
average expense ratio and the
NAV-weighted average 0.62 0.57
asset-weighted ratio, see Table 28)
Median 0.75 0.72
rose between 1979 and 1992. The
Table 27: Operating expense ratios in 1997 average expense ratio remained
of the 100 largest equity funds relatively stable in the 1990s.1155
established prior to 19801154
Unweighted average expense ratio Weighted average expense ratio

1979 1.14% 0.73%
1992 1.19% 0.92%
1995 1.30% 0.99%
1996 1.32% 0.98%
1997 1.33% 0.95%
1998 1.35% 0.91%
1999 1.36% 0.94%
Table 28: Expense ratio growth 1979 to 1999 for all classes of fund shares/units1156
However, this rise in the expense ratio does not necessarily mean an increase
in total shareholder costs (see below), because it is due primarily to a change
since the 1970s in the way in which distribution and advertising expenses are
deducted: many funds have reduced1157 or abolished their front-end sales loads
which – as explained above – are not factored into the calculation of the
expense ratio, but are included in the calculation of total shareholder costs, as
described below, and replaced them by an annual 12b-1 fee.1158 This is now
included in the calculation of the expense ratio.1159 The following two tables
demonstrate this quantitative trend away from load funds and towards funds
with 12b-1 fees, and also illustrate the changes in the expense ratios of these
two types of funds between 1979 and 1999. The “Number” columns in Table 29
and Table 30 record the fund classes, i.e. where funds offer two or more
classes,1160 each fund class is counted separately.
The “content” of the funds offered over the past 20 years has also changed.
This has resulted in higher portfolio management costs and can be seen as a
further cause of expense ratio growth. International and speciality funds, which
generally have higher management costs, now account for a larger share. In
addition, equity funds – which are normally more expensive to manage than
bond funds – have captured market share from bond funds, at least between
1992 and 1999 (see Table 31). These more expensively managed funds
consequently record higher expense ratios (see Table 32).
156
1161 1162
Number Assets Expense
Year
absolute %
1164
absolute % 1164 ratio1163
1979 201 39% $15,451,000,000 30% 0.75%
1992 763 31% $254,441,000,000 26% 0.80%
1995 2,380 36% $916,401,000,000 44% 0.76%
1996 2,506 36% $1,076,530,000,000 45% 0.75%
1997 2,576 37% $1,384,483,000,000 46% 0.72%
1998 3,229 38% $1,751,804,000,000 49% 0.68%
1999 3,418 38% $2,259,836,000,000 51% 0.72%
Table 29: Classes of no-load funds
Number1161 Assets1162
Year 1164 1164
Expense ratio1163
absolute % absolute %
1979 316 61% $36,204,000,000 70% 0.72%
1992 1,720 69% $728,162,000,000 74% 0.96%
1995 4,302 64% $1,158,001,000,000 56% 1.17%
1996 4,459 64% $1,293,730,000,000 55% 1.17%
1997 4,415 63% $1,617,017,000,000 54% 1.14%
1998 5,184 62% $1,807,092,000,000 51% 1.12%
1999 5,483 62% $2,196,776,000,000 49% 1.17%
Table 30: Classes of load funds
US bond funds US equity funds Internat. funds Speciality funds

$m % $m % $m % $m %
1979 17,037 33 34,618 67

1992 522,049 53 363,861 37 65,083 7 31,610 3
1995 732,472 35 999,772 48 273,956 13 68,200 3
1996 776,106 33 1,196,436 50 317,676 13 80,042 3
1997 856,279 29 1,664,553 55 374,760 12 105,907 4
1998 990,132 28 2,056,137 58 391,574 11 121,053 3
1999 944,435 21 2,705,494 61 564,215 13 242,470 5
Table 31: Volume and percentage share of total US mutual funds taken by
individual fund types1165
157
US bond funds US equity funds Internat. funds Speciality funds

1979 0.70% 0.74% - -
1992 0.82% 0.95% 1.36% 1.31%
1995 0.84% 0.98% 1.31% 1.37%
1996 0.84% 0.96% 1.31% 1.34%
1997 0.83% 0.91% 1.24% 1.35%
1998 0.80% 0.88% 1.18% 1.30%
1999 0.80% 0.90% 1.18% 1.36%
Table 32: Expense ratios of individual US fund types1166
There are other explanations for this growth in expense ratios:

x Older funds are larger and therefore benefit from economies of scale (see
below). However, a large number of new funds have been launched in
recent years; because they are still small, their expense ratio is greater than
that of the more established funds.1167
x There has been a trend recently towards creating new, smaller fund
classes whose expense ratio is greater because they offer no or lower
economies of scale.1168
The ICI proposes “total shareholder costs”1169 as a measure of the cost to a
shareholder/unit-holder of investing in an equity fund. It is composed of the
operating expenses, including any 12b-1 fees, plus the annualised sales
loads.1170 This figure is thus comparable with the fee and expense information
required to be disclosed in all US prospectuses.1171 Between 1980 and 1997, the
period covered by the study, the total shareholder cost ratio for equity funds
fell from 2.25% in 1980 to 1.49% in 1997 (and 1.35% in 19981172), i.e. by around
one third (see Figure 45). For bond funds, the total shareholder cost ratio fell by
30% between 1980 and 1998 (from 1.54% to 1.09%), and for money market
funds it fell by 24% from 0.55% to 0.42%.1172
This fall was driven primarily by a decline in distribution expenses (12b-1
fees plus sales loads).1173 coupled with a trend over the survey period towards
investors buying funds with lower costs (especially no-load funds).1174
Some funds define “breakpoints” (in fund size). If these breakpoints are
exceeded, the fees are reduced to a certain level.1175 The underlying reasoning is
that there are economies of scale in the fund industry, as demonstrated by an
ICI study.1176
The SEC has also looked at the issue of economies of scale. A study covering
the period 1997 to 1999 examined the advisory contracts of the 100 largest US
mutual funds1177 for breakpoint clauses and concluded that 76 of these 100
contracts contained some sort of breakpoint agreement. The contracts of all 100
funds were classified into five types by their fee structure, and Table 33
presents the detailed results for these five classes:
158
Sales-weighted total shareholder cost ratio for equity funds (%)

3
2.45
2 .5
2.25 2.24
2.11 2.13 2.12 2.17
2.03 2.04
1.95
2 1.87
1.73 1.71
1.68 1.67
1.58 1.55
1.49
1 .5
0 .5
0
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
Figure 45: Sales-weighted total shareholder cost ratio for equity funds (per cent), 1980–
19971176
x Funds with breakpoints

1. Breakpoints based on total assets: as total assets rise, the percentage
management fee declines when fixed asset breakpoints are exceeded.
2. Breakpoints based on fund family assets: similar to above, but based on
fund family assets rather than portfolio assets.
3. Breakpoints based on portfolio assets plus a performance fee: a
management fee as described in (1) above is supplemented by an
additional fee that varies with fund performance.
x Funds without breakpoints:
4. Funds with a single, all-inclusive fee not tied to fund assets;
5. Funds with at-cost fee arrangements.
There is a frequently voiced view that fund fees are too high. Advocates of
this view argue that the economies of scale that can be realised through asset
growth are not passed on to the shareholders/unit-holders, for instance in the
from of appropriate breakpoints. This view is supported by the fact that not all
funds provide for breakpoints (Table 33 shows that 28% of the 100 largest US
funds had no breakpoints at all between 1997 and 1999), and that many funds
that have already agreed breakpoints have assets above the last breakpoint
(Table 33 again shows that around a quarter of the funds with breakpoints
surveyed have assets in excess of the last breakpoint); all other things being
equal, fees will not therefore be cut further if the portfolio assets record
additional growth. The counter-argument to this is that shareholders/unit-
holders now get more for their money than they did previously in the form of
159
services such as “telephone redemption, exchange privileges, check or wire

redemptions, and consolidated account statements, and greater investment
opportunities, such as international and other specialised funds”.1178
Average fee Average

Total assets for nth assets for Funds with assets above last
Number of funds
1999 Average breakpoint nth breakpoint

Contract type
number of in basis breakpoint

breakpoints points in $bn
% assets of
Assets
$bn % Number this contract
First Last First Last in $bn
type
(1) 47 855.2 41 6 65 41 0.5 10 34 318.2 37
(2) 21 506.3 25 37 52 22 3 1200 0
(3) 8 113.9 6 4 27.5 11.3 0.15 10 5 41.1 36
(4) 19 376 18 65
(low=24,
high=100)
(5) 5 204.7 10
6 100 2056.1 100
Table 33: Fee structure of the 100 largest US funds showing breakpoints1179
between 1997 and 1999
The SEC has said recently that it is satisfied in principle with the existing
system for controlling fund fees (“We believe that the current statutory
framework … is sound and operates in the manner contemplated by
Congress.”1180), but that there is room for improvement in a number of areas.
The following measures have been put forward for discussion:1181
1. Extended disclosure requirements, with two primary goals: firstly to
inform shareholders/unit-holders about the dollar amount of the fees, and
secondly to make a comparison with the fees of other funds or other
investment vehicles:
x Investment advisers could be obliged to send shareholder/unit-holder
account statements that include the dollar amount of the fees that the
investor has paid indirectly.
x Annual/half-yearly reports should include a table showing the cost as
an absolute dollar amount that would be incurred for an investment of
$10,000 in a fund that paid the actual expenses and earned the actual
return of the fund.
x This table should also show the dollar costs incurred for an investment
of $10,000 that paid the actual expenses and earned a standardised return
(e.g. 5%). In this case, the expenses are the only variable, thus giving
160
investors an opportunity to easily compare funds, which the SEC thinks

would lead to greater fees competition in the fund industry.
2. Strengthening the role of independent directors in monitoring fees and
expenses:
x The directors should ensure that an appropriate portion of cost savings
from any economies of scale is passed on to the shareholders/unit-
holders. If no economies of scale are evident, the directors should
consult with the investment adviser – or even put pressure on the
investment adviser – to establish how the fund can be managed in
future to allow shareholders to benefit from economies of scale.
x The SEC wants to encourage efforts to educate directors about issues
related to fees and expenses, for example the type of information they
should request for the annual review of investment advisory
contracts,1182 and the techniques that are available for evaluating this
information. Portfolio transaction costs, that are not a component of the
expense ratio and also represent a substantial cost factor for many
funds, should also be looked at more closely by the fund directors. They
should pay particular attention to soft dollars1183 in this context.
x The SEC is also considering amending Rule 12b-11184 as it is now over
twenty years old and the fund industry has changed substantially
during this period.
Structuring of performance fees

Performance fees are common at the largely unregulated US hedge funds. A
1% management fee, plus a 20% profit share is standard. This is an asymmetric
structure, where the investment adviser takes a share of the profits but does not
participate in losses. These are contrasted with incentive fees in the form of
“fulcrum fees”, where the fee increases if the fund outperforms its benchmark,
and decreases if it underperforms it; no minimum or base fee is charged.1185
However, some people think that looking at just the return and ignoring the
risk is an inadequate way of structuring performance fees,1186 and they
recommend a comparison with both the performance and the implied risk of
the benchmark index.

One of the duties of independent directors is to review and approve the
investment advisory contract every year; this contract also includes an
agreement on the type and amount of fees, which fall under the investment
adviser’s fiduciary duty.1187 When evaluating the appropriateness of the fees,
the directors must be guided by a court ruling in a key case on fees, the
Gartenberg case. The judge in this case ruled that fees may not be so
disproportionately large that they have no relationship to the services provided
and could not have been a result of arm’s-length negotiations, otherwise the
investment adviser would be in breach of fiduciary duty. This standard is very
161
vague, and needs to be put into more concrete form by the factors that underlie
the assessment by the independent directors:1188
x The quality of the services provided by the investment adviser: firstly the
quality of the investment process (the expertise of the people involved,
the research process, compliance responsibilities, performance statistics,
and so on), and secondly the quality of other services provided by the
investment adviser, such as the range of funds on offer (international
funds, speciality funds, etc.) or the quality of fund statements.
x The cost to the investment adviser of performing services for the fund and
the payments received by the adviser should be compared to provide an
estimate of the investment adviser’s profit: a comparison of expense ratios
and fee structures is appropriate in the case of the payments.
x A comparison with the fees (and corresponding performance1189) of other
funds is also advisable.1190
x The scope for economies of scale if the fund grows.1189
x “Fall-out” benefits1191 that may accrue to the investment adviser from its
business relationship with the fund.
Although they are not so important in practice, directors must also review and
approve the fees charged by other service providers to the fund, for example
the distributor and the custodian.1190
The Investment Company Act does not provide explicit answers to some
questions:
x Allocation of the costs and payments of a fund complex to the individual
funds: for example, all funds use research and back office services to a
differing degree.
x Enforcement in practice of the fundamental prohibition on including
distribution and advertising expenses when estimating profit: distribution
expenses can only be charged to the fund if there is 12b-1 plan1192, and
here too, the independent directors have a particular fiduciary duty of
examining whether it is reasonably likely that the shareholders/unit-
holders will benefit if the fund shoulders these costs. Introducing a 12b-1
plan, however, needs the approval of the shareholders/unit-holders, the
board and its independent directors. The fund in question must also have
a majority of independent directors.1193 If there is no 12b-1 plan, the SEC
prohibits these expenses from being included, although they are
nonetheless incurred.
If the Gartenberg case (see above) is taken in isolation, then merely efforts by
the independent directors to examine whether the fees are reasonable appears
to suffice. But if the independent directors are seen above all as the
representatives of the shareholders’/unit-holders’ interests, they must be bound
by the more far-reaching responsibility of doing all they can to negotiate the
lowest possible fee with the investment adviser. These two views can be
162
viewed as extremes between which the independent directors move in practice.

However, they may expose themselves to a legal hazard if they fail to go far
enough with the first, and if they go too far with the second, they may
jeopardise the continued existence of the investment adviser.1194
Quite apart from this legal perspective, there is also the view of the
economist that excessive fund fees may be prevented by the behaviour of
(potential) shareholders/unit-holders:1195 assuming that the market for mutual
funds is competitive, investors will inevitably switch from overpriced funds to
cheaper one (fund switching). This is rarely seen in practice, though, firstly
because the cost of fund switching is too high, and secondly because investors
apparently often make non-rational decisions. The switching costs consist
largely of the deferred capital gains tax that will be triggered if the shares or
units are sold.

Laws, fund rules or fund instruments of incorporation must prescribe the
remuneration and expenses that the management company is able to charge to
the fund and the method used to calculate these costs.1196

A US-style board of directors to oversee the fund could be a partial solution,
especially as regards general rights and obligations under fiduciary duty; less
so, however, in terms of the numerous individual rules and regulations in the
US, based on a mass of case law and therefore highly opaque, which is also
why US fund boards need their own legal counsel. The fund board should
function as an independent oversight body that represents the interests of the
shareholders/unit-holders, particularly in respect of the management company.
In the USA, the right of the independent directors not to prolong the
investment advisory contract is their strongest and probably only really
effective weapon against the investment adviser in the event of conflict.
However, actually exercising this power almost always appears to be going too
far, because many shareholders/unit-holders have decided to invest in the fund
because of the management company’s reputation, among other reasons. This
means that the independent directors can essentially either flick pellets at the
management company or launch a full-scale nuclear assault. The position of
ERISA trustees, who are often compared with independent directors because
both offices are bound by the underlying principle of fiduciary duty, is more
relevant in this respect because investment advisers are switched frequently at
ERISA funds, giving the trustees a strong bargaining position, especially when
it comes to fees.1197
Increasingly opaque, detailed sets of issues concerned with the activities and
responsibilities of (independent) directors are being debated in the USA, with
the discussion centred around their power to terminate the investment
advisory contract a good example of this. Europe, however, has yet to establish
163
a counterpart to this crucial US executive body, and we will have to wait and
see whether calls to emulate US practice here are actually implemented in the
future EU Pension Fund Directive.1198
If the EU does, indeed, opt for a fund board arrangement, standards should
govern the following issues relating to the board, and in particular to its
independent members:1199
1. The organisational structure of a board overseeing several funds.
2. Compensation: to ensure the closest possible harmonisation in practice
of the board’s and the shareholders’ interests, at least partial payment in
the fund’s shares should be considered.
3. Arrangements concerning the personal liability of board directors have
the same aim. The situation in the USA is more of an example of how not
to do it in this respect, because US directors are frequently confronted
with wholly exaggerated – even trivial – lawsuits that often end in out-
of-court settlements to avoid long, expensive court cases and the
potentially damaging media coverage that would ensue – even if the
claims appear to be unjustified from a European perspective. Although
this environment is highly profitable for the lawyers, it also increasingly
deters highly qualified candidates from joining fund boards, negatively
impacting the quality of the board and adversely affecting shareholders’
interests.
4. A clear prohibition on delegating fiduciary duties; even if other service
providers are engaged to perform certain supervisory functions,
responsibility must still remain with the board.
5. Certain transactions of major importance can be made contingent upon
the approval of the fund board or of its independent members. US
boards have extensive powers here, but the different legal system and
historical development, combined with the different structure of the US
and European financial and fund industries, mean that these powers
cannot be simply copied in the EU.
6. Similar to point (5), particularly sensitive areas should be expressly
subject to supervision by the fund board, although here too, the EU
cannot simply take over the US rules unchanged for the same reasons
given in (5).
7. The problem of the fees, especially those charged by the management
company, does not fit easily into either of the preceding two categories:
standards must establish whether the role of the board should be limited
to merely reviewing fees, or whether it should also be responsible for
actually negotiating the fees (as the shareholders’ representative) with
the management company, rather similar to the role of unions
representing employees in pay negotiations.
164
The preceding two chapters, which like the present chapter draw conclusions
for future EU standards,1200 contain numerous detailed proposals on the more
general issues outlined in (5) and (6) above.
6.2 SUPERVISORY AUTHORITY
6.2.1 Responsible authorities in the EU and the USA

EU authorities
The supervisory authorities of the EU Member State in which the fund is
domiciled (“home” country) are primarily responsible for cross-border
distribution.1201 It is up to the individual EU Member States to designate the
supervisory authorities responsible1202 and to give the necessary powers.1203 In
addition, however, the authorities of another (“host”) country where the fund
is distributed are also involved, because the fund must provide them with
substantial documentation, and they are entitled to prohibit distribution under
certain circumstances.1204 In future, a notification to the “competent authorities”
containing precisely defined information1205 will be sufficient;1206 this
notification will then be sent by the authorities in the “home” country to their
counterparts in the “host” country.1207
The supervisory authorities in the home country are also primarily
responsible for taking action in the event of breaches of laws or regulations,1208
but for certain matters1209 or in urgent cases,1210 the supervisory authorities in
the host countries are also able to take action.
The supervisory authorities of the EU Member States are required to
collaborate closely.1211 In practice, the committees1212 that assist the Commission
in interpreting single market legislation have emerged as a focal point for
supervisory cooperation.1213 To implement the “Action Plan”,1214 the European
Commission wants to achieve greater cooperation between regulatory and
supervisory authorities (for the EU’s financial markets as a whole). A coherent
strategy for all supervisory authorities is therefore of utmost importance, and to
achieve this, guidelines and codes of conduct – among other things – will be
introduced for the supervisory authorities (and the markets).
Globalisation and the resulting cross-border mergers will make it increasingly
difficult to define institutions as being domiciled in a single (member) state, and
thus to designate the supervisory authorities responsible. The European
Commission therefore wants to establish a co-ordinator to oversee large
financial services groups.1215 Once the proposed Pension Fund Directive has
been adopted, it is also considering establishing a body that brings together the
various supervisory authorities.1216
165
US authorities
Several authorities are responsible for overseeing bank-related funds at both
federal and state level. For example, a fund related with Bankers Trust is
supervised by the SEC, Federal Reserve of New York and the New York State
Banking Department, as Bankers Trust is a New York State chartered bank.1217
The sole national regulatory and supervisory authority for conventional US
mutual funds, however, is the SEC.1218
Almost 23,000 investment advisers were registered with the SEC in 1997, and
statistically, an investment adviser was only examined once every 44 years.1219
As a consequence of the relevant legislative reform in 1996 (National Securities
Markets Improvement Act – NSMIA), this quite unacceptable situation has now
improved appreciably.1220
Supervision and regulation of ERISA pension funds are shared by the
Federal Department of Labor and the Department of the Treasury. This
necessarily causes inefficiencies in practice, although numerous ERISA
paragraphs require both departments to co-ordinate their activities.
6.2.2 A-priori and a-posteriori controls in the EU and the

USA
A-priori control is equivalent to licensing, while a-posteriori control denotes the
ongoing oversight of the (fund) management process.
UCITS must be authorised by the “competent authorities” of the EU Member
State in which they are domiciled.1221 The authorisation of mutual funds1222
consists of authorisation of the management company and approval of the
fund rules and the custodian (depositary). The instruments of incorporation of
investment companies must be approved, and their custodian must also be
approved.1223 Any change in the management company or custodian, and any
changes in a mutual fund’s rules or the instruments of incorporation of an
investment company must be approved by the competent authorities.1224 Any
authorisation applies to all EU Member States (“Single European Passport”
concept1225).1226
The amended UCITS Directive lays down minimum requirements that must
be satisfied for a management company to be authorised.1227 These conditions
are based on the corresponding provisions of the Investment Services Directive
applicable to investment services firms.1228
These include sufficient initial capital,1229 the integrity and expertise of the
minimum of two directors,1230 the submission of a business plan including the
management company’s organisational structure,1231 no links with persons
preventing the exercise of supervisory functions,1232 and disclosure of the
investments and suitability of shareholders or partners.1233 The application
166
procedure may not exceed six months, and reasons must be given if an
application is rejected.1234
Once authorisation has been granted, the management company must
comply with the conditions for authorisation at all times, not just at the date of
authorisation.1235 Ongoing prudential supervision is the responsibility of the
home Member State in the case of cross-border distribution.1236, 1237 Qualifying
holdings in the management company are subject to the corresponding
provisions of the Investment Services Directive.1238 These require the
purchase/sale or increase/reduction in qualifying holdings to be notified, and
the supervisory authority may oppose such transactions if it believes that the
purchaser does not meet the requirement for “sound and prudent
management”.1239 The supervisory authorities can also take action at a later date
to put an end to a situation where the influence exercised by a qualifying
shareholder or partner is likely to be prejudicial to sound and prudent
management. These measures include injunctions, sanctions against directors
and managers, or suspension of the voting rights of the shareholders or
partners in question.1240
The proposed Pension Fund Directive1241 will include an authorisation
procedure for pension funds. The original intention was for authorisation to be
tied to the following conditions, but only some of these were actually
incorporated into the proposal that was published in October 2000:1242
x The responsibility, professional qualifications1243 and reputation of the
fund managers must satisfy strict criteria.1244
x The professional qualifications and integrity1245 of the members of the
board of directors must also be examined.1246
x The instruments of incorporation and the plan rules must be submitted to
the supervisory authority.1246
x Additionally in the case of DB schemes, evidence that the liabilities are
properly valued1246, a requirement that also applies to ongoing disclosure
duties.1247
x Additionally in the case of DC schemes, evidence that the different
degrees of risk related to the different investment choices are well
documented and are understood by the members prior to their
decisions.1246
x The independent actuary must also be approved by the supervisory
authority.1248

Depending on their size, investment advisers in the USA have to be registered
with the SEC – if the assets under management exceed $25 million – or the
securities regulator of the state in which they are domiciled. The National
Securities Markets Improvement Act (NSMIA) of 1996 abolished the formerly
common duplicate registration of investment advisers with both the state
167
regulator and the SEC, and today around 8,000 advisers are registered with the
SEC and a further 12,000 with state regulators. This clear division of
responsibility has cut the inspection cycle for SEC-registered advisers to five
years, instead of the previous 15 to 20 years,1249 which clearly helps investor
protection. Another modernisation of the registration and supervisory process
is the planned introduction of an electronic, Internet-based reporting system,
the Investment Adviser Registration Depository (IARD). Investors will be able
to use this service free of charge, and it will help advisors satisfy their federal
(SEC) and state reporting obligations with a single electronic filing.1250
When applying for registration with the SEC, the investment adviser must
state its legal form, as well as disclosing if it exercises certain activities,1251 and if
so, to what extent. Investment policies that can only be amended by a
shareholders’ meeting and all other policies deemed to be fundamental must
also be filed.1252 Any subsequent amendments to the policies cited in the
registration statement must be approved by the shareholders.1253
In the case of pension funds falling under the remit of ERISA,1254 there has
been a sharp rise in the number of civil lawsuits in recent years, many of them
focusing on the core problem of inadequate or improper information policies
by sponsors to their plan members in the context of rationalisation plans,
mergers or spin-offs and other forms of corporate reorganisation.1255
6.2.3 The regulatory regime in the EU

Light regulation, detailed supervision
Given the growing globalisation of the capital markets, the European
Commission believes that effective regulatory and supervisory co-ordination is
needed at both European and global levels.1256 It does not believe that the
existing prudential framework needs any “radical surgery”, and that a lean,1257
modern regulatory environment would be the best solution for the fast moving
market for financial services.1258 It believes that structured cooperation between
the national supervisory authorities is sufficient to ensure financial stability,
and has no plans to create new EU-level arrangements.1259
The “Rebuilding Pensions” study also recommends a system of light
regulation combined with more detailed supervision, similar to the current
situation in the Netherlands.1260 This would see the board of directors being
able to act in accordance with criteria it has itself defined – in compliance with
all prudential principles – instead of being constrained by detailed regulations.
This means observing qualitative fiduciary duties rather than have to obey
detailed rules. The supervisory arrangements aim to protect shareholders
without burdening the fund with unnecessary, counterproductive and
expensive obligations and restrictions.1261 Such a system is attractive, firstly
because it conforms with the general goal of liberalisation (with certain
constraints, such as responsibility, accountability and SIPs), and secondly
because of the impossibility in practice of EU-wide harmonisation of detailed
168
regulations.1262 Consequentially, the licensing requirement will be less

important in future than the disclosure requirement, particularly as the latter is
a recurring requirement, in contrast to the former.1263
Remedies, not punishment

Under the amended UCITS Directive, a management company or custodian
cannot discharge its liability by delegating duties to third parties.1264
The proposed Pension Fund Directive1265 will entitle the supervisory
authority to impose remedial measures or penalties where it believes these are
necessary.1266 However, the recommendation to the European Commission is to
design the prudential regime such that it hinges around support to rectify a
problem rather than making the situation worse, and incorporates the principle
that being decisive does not have to clash with fairness and patience in cases
where there is still hope.1267
The proposal published in October 2000 now provides that the supervisory
authority “may take any measures, with regard to the institution or the persons
running the institution, that are appropriate and necessary to prevent or
remedy any irregularities prejudicial to the interests of the members and
beneficiaries”.1268
The “Rebuilding Pensions” study recommends a graduated scheme1269 for
supervisory authorities in the event of irregularities;1270 this starts by trying to
clarify the matter through discussions and on-the-spot checks, and if that does
not work, by informing the sponsor – or further down the line the public,
through press announcements at the fund’s expense. If the situation is still not
remedied, fines should be imposed or any tax exemptions suspended. If even
this is ineffective, and the matter is really serious, the supervisory authority
should be involved in the management of the fund, and in the worst case
actually manage it itself. If certain individuals, such as directors, their advisers
or the sponsor, are guilty of serious misconduct, the supervisory authority
should be able to impose penalties on them, such as withdrawal of licence,
removal of one or all members of the board of directors, or the initiation of
court proceedings.1271
Although the October 2000 proposal does not provide for such a hierarchical
model, it does offer the supervisory authority a range of powers to intervene:
x The powers to manage the fund’s assets may be transferred “wholly or
partly to a special representative who is fit to execute these powers”.1272
x The activities of the institution may be prohibited or restricted under
certain circumstances.1273
6.2.4 Conscious focusing on the board of directors as the

primary instance in the regulatory
In the USA, the Investment Company Act and the SEC regulations based on
this law produced a regulatory structure where the SEC delegated the
169
enforcement of many supervisory duties to the directors, making them the

“…first line enforcers of this regulatory regime...”.1274 For example, if the
directors think that the investment adviser is in violation of the Investment
Company Act, they can notify this to the SEC, which can then launch an
investigation.1275
As part of efforts to achieve a far-reaching reform of the Investment
Company Act of 1940,1276 the SEC is considering delegating some of its own
duties to the fund board so as to enhance the flexibility of the mutual fund
industry.1277
The regulatory structure recommended to the European Commission for the
future Pension Fund Directive1278 would see responsibility lying primarily with
the board of directors,1279 supported by its professional advisers, including
actuaries and accountants. However, there is no mention of a board of directors
in the proposal for the directive published in October 2000.1280
6.2.5 The new Financial Services Authority (FSA) Handbook

providing the regulatory framework in the UK
The regulatory regime in the UK
A reform of the regulatory regime has been under way in the UK since 19981281
with the aim of creating a single regulator: the Financial Services Authority
(FSA).1282 This has seen the three “front-line” regulators1283 responsible for the
different categories of financial services companies transfer their regulatory
powers and staff to the FSA.1284 These front-line regulators are the following
self-regulating organisations:
1. The Investment Management Regulatory Organisation (IMRO) is
responsible for all forms of investment business, including fund managers,
investment companies, pension funds, merchant banks, clearing banks
and venture capital companies.1285
2. The Securities and Futures Authority (SFA) is responsible for firms
operating on the equity, options, financial and commodity futures
markets.1286
3. The Personal Investment Authority (PIA) is responsible for companies
marketing investments to retail investors and providing them with
investment advice.1287
The FSA has supervisory and regulatory powers over investment firms,
banks and other financial services companies, such as building societies,
insurers, financial advisers, credit unions and friendly societies,1288 and its
activities are governed by the following objectives:1289
x Maintaining confidence in the UK financial system;
x Promoting public understanding of the financial system;
170
x Consumer protection, and

x Reduction of financial crime.
The structure of the FSA Handbook of Rules and Guidance

The FSA handbook is a project that is still in progress.1290 It will regulate all
financial services companies in the UK, and is based on the following
objectives: unnecessary rules will be removed and a common approach will be
adopted to the regulation of similar businesses, while at the same time
maintaining appropriate differentiation for different types of business and for
business done with different categories of customer.1291 The Handbook is
divided into the following topic-related blocks:1292
x High-level standards:
i Principles for businesses;1293
i Fitness and propriety;1294
i Threshold conditions;
i Approved persons;1295
i Senior management arrangements, systems and controls.1296
x Business standards: the focus here is on “Interim Prudential Sourcebooks”
for the individual sub-sectors of the financial services industry.
x Regulatory processes: consisting of the Authorisation, Supervision and
Enforcement manuals.
x Financial consumers/Redress: complaints by and compensation for
consumers.
x Specialist Sourcebooks: one of these Sourcebooks covers “collective
investment schemes”, i.e. unit trusts and open-ended investment
companies.
x Other material
Principles for Businesses
Structure and objectives of the Principles

The FSA Principles for Business” represent high-level rules that set out the
fundamental obligations of businesses regulated by the FSA.1297 These rules will
act as a guide for conduct by firms, and at the same time form the basis of the
FSA’s supervision and enforcement.1298 Breaching the Principles makes a firm
liable to disciplinary sanctions (but the Principles cannot be used to substantiate
actions for damages by customers), although the burden of proof is on the
FSA.1299
The benefits of a single set of Principles that does not compete with other
basic rules are as follows:1300
171
x Coverage: abstract Principles help avoid regulatory gaps that often arise in
regimes based on detailed rules. This is a significant advantage, given the
rapidly changing financial services environment.
x Consistency: because the FSA too is bound by these Principles, they
increase the predictability about how the FSA will view fresh regulatory
issues.
x Continuity: the Principles are familiar and incorporate much of the
ground covered by existing UK models.
x Cohesion: An FSA Handbook building on the foundations of the
Principles will be more cohesive and free from contradictions and
inconsistencies.
These Principles are put into more concrete form by the binding rules and non-
binding guidance. The latter is not mandatory, but gives examples of the sort of
behaviour the FSA prefers, and compliance normally has the advantage of
providing a “safe harbour” from disciplinary measures. It has three
functions:1301
1. to explain the scope of rules,
2. to provide additional background information on the Principles, and
3. to be a navigational aid.
However, the FSA is also able to intervene on the basis of the Principles alone
even where there are no rules or guidance tailored to the situation in question.
The FSA’s aim in doing so is to avoid lagging behind fast-moving market
developments.1302
The Principles themselves
1 Integrity A firm must conduct its business with integrity.
2 Skill, care and A firm must conduct its business with due skill, care and
diligence diligence.
3 Management A firm must take reasonable care to organise and control its
and control affairs responsibly and effectively, with adequate risk
management systems.
4 Financial A firm must maintain adequate financial resources.
prudence
5 Market A firm must observe proper standards of market conduct.
conduct
6 Customers’ A firm must pay due regard to the interests of its customers
interests and treat them fairly.
7 Communi- A firm must pay due regard to the information needs of its
cations with customers, and communicate information to them in a way
customers which is clear, fair and not misleading.
8 Conflicts of A firm must manage conflicts of interest fairly, both
interest between itself and its customers and between one customer
and another.
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9 Customers: A firm must take reasonable care to ensure the suitability of

relationships its advice and discretionary decisions for any customer who
of trust is entitled to rely upon its judgment.
10 Customers’ A firm must arrange adequate protection for customers’
assets assets when it is responsible for them.
11 Relations with A firm must deal with its regulators in an open and
regulators cooperative way, and must tell the FSA promptly anything
relating to the firm of which the FSA would reasonably
expect prompt notice.
Table 34: The FSA Principles for Businesses, post-consultative version, October
19991303
Fitness and propriety
Overview
This part of the Handbook governs the conditions for approval of persons who
are to exercise a “controlled function”. Parliament1304 has expressly empowered
the FSA to develop appropriate criteria for defining fitness and propriety;1305
these criteria must be satisfied at all times when the controlled function is being
performed, not just when the application for approval is made,1306 and the FSA
may withdraw its approval in the event of non-compliance.1307 Although they
are not exhaustive,1308 the three principle criteria are:1309
1. Honesty, integrity and reputation;
2. Competency and capability: and
3. Financial soundness.
There are also three secondary criteria:1310
1. The activities of the firm1311
2. The permission held by that firm; and
3. The markets in which the firm operates.
The position held by the individual within the firm and the controlled
functions for which approval is being sought are also relevant factors in
considering the fitness of an individual: somebody who is assessed as being fit
and proper for a “dealing with customers function” may not necessarily be
assessed as fit and proper for a “significant influence function”.1312
If the FSA rejects an application, the individual concerned has the right to
appeal to an independent tribunal, which has the final say.1313
The fit and proper criteria
1. To assess whether an applicant meets the criteria of honesty, integrity and
reputation, the FSA considers the following (current or past) matters relating
to the applicant; this list is not exhaustive:1314
173
x Convictions for criminal offences, in particular those relating to

financial crimes;
x Adverse findings or settlements in civil proceedings;
x Interviews during the course of official investigations;
x Proceedings of a disciplinary of criminal nature;
x Contravention of the rules and regulations of the FSA or other
regulatory authorities;
x Subject of complaints;
x Involvement in a company that has been refused registration or
licensing or has had its registration or licence withdrawn;
x Compulsory cessation of business or profession as a consequence of the
preceding point;
x Insolvency of a (prior) company;
x Investigation, disciplinary action, sanctions;
x Dismissal from a fiduciary appointment;
x Disqualification as director/manager
x Honesty and willingness to cooperate with the regulatory authority.
2. The following examples of criteria are relevant for the assessment of
competency and capability:1315
x Satisfaction of the relevant requirements of the FSA’s Training and
Competence manual;
x Experience and training demonstrates the person’s ability to perform
the intended controlled function;
x Sanctions for drug or alcohol abuse will be considered only in the
context of the person’s continuing ability to perform the controlled
function.
3. The following examples of criteria are relevant for the assessment of
financial soundness:1316
x Judgment debt or award in the UK or elsewhere that remains
outstanding or was not satisfied within a reasonable period;
x Bankruptcy/settlement with creditors in the UK or elsewhere;
x The submission of a statement of assets or liabilities is not normally
required, as the fact that a person may be of limited financial means
does not, in itself, necessarily lead to rejection.
The Regulation of Approved Persons (APER)
Overview
Together with the “Senior management arrangements, systems and
controls”,1317 the “Regulation of Approved Persons” forms the regulatory
framework covering obligations for the appropriate management and control
of business activities imposed on companies and individuals,1318 in particular
directors and senior managers.
174
The Financial Services and Markets Act 2000 provides that “controlled
functions” may only be performed by “approved persons”.1319 Controlled
functions are those linked to the carrying on of a “regulated activity”.
“Regulated activities” in turn include the establishment, operation and winding
up of collective investment schemes, and the safeguarding, administration and
management of investments.1320
Because mutual funds also fall under this regulatory regime, their senior
managers must be approved by the FSA, and are therefore covered by the
“Approved Persons Regime” (APER),1321 which defines the criteria for approved
persons and has a dual structure: the “Statements of Principle for Approved
Persons” consist of seven high-level principles1322 that are implemented in
substantially greater detail in the “Code of Practice for Approved Persons”. The
Code of Practice is the routine means for establishing whether an approved
person has breached the Principles: it describes firstly the sort of conduct that
the FSA believes is in breach of the Principles, and secondly factors that are
relevant in assessing whether conduct does or does not comply with the
Principles.
Statements of Principle for Approved Persons

Statement of Principle 1
An approved person must act with integrity in carrying out his controlled
function.
An approved person must act with due skill, care and diligence in
carrying out his controlled function.
An approved person must observe proper standards of market conduct in
carrying out his controlled function.
An approved person must deal with the FSA and with other regulators1323
in an open and cooperative way and must disclose appropriately any
information of which the FSA would reasonably expect notice.
An approved person performing a significant influence function must
take reasonable steps to ensure that the business of the firm for which he
is responsible in his controlled function is organised so that it can be
controlled effectively.
175
exercise due skill, care and diligence in managing the business of the firm
for which he is responsible in his controlled function.
take reasonable steps to ensure that the business of the firm for which he
is responsible in his controlled function complies with the regulatory
requirements imposed on that business.
Code of Practice for Approved Persons

The Code of Practice is a means for establishing whether the conduct of an
approved person complies with the Statements of Principle or not. The Code is
not exhaustive – i.e. it may be possible to demonstrate that conduct not
described in the Code also complies with the requirements of the Principle
concerned1324 – and may be amended by the FSA at any time.1325
As elsewhere in the FSA Handbook,1326 a distinction is made between binding
rules and non-binding guidance.1327
The Code of Practice contains both1328
1. Descriptions of conduct which does not comply with the Statements of
Principle (see below): non-compliant conduct is listed for each Statement of
Principle“.
2. Factors to be taken into account in determining whether conduct complies
with the Statements of Principle or no:t:
x Factors to be applied to all seven Statements of Principle1329
i Whether the conduct relates to activities that are subject to other
provisions of the FSA Handbook;
i Whether the approved person’s conduct is consistent with the
requirements on his firm.
x Factors to be applied only to Statements of Principle 5 to 71330, 1331
i Did the approved person exercise reasonable care1332 when considering
the information available to him?
i Did the approved person reach a reasonable conclusion which he acted
on?
i The size and complexity of the business;
i The role and responsibility of the approved person;
i Did the approved person have, or should he have had, knowledge of
regulatory concerns, if any?
Conduct must always be assessed after all circumstances of a particular case
have been considered.1333
176
An approved person is only in breach of a Statement of Principle where he is

personally culpable.1334
The examples of non-compliant conduct contained in the Code of Practice:
are set out below:
1. Conduct in breach of Statement of Principle 1:
1.1 Deliberately misleading or attempting to mislead a customer, the
person’s own firm (or its auditors or actuary) or the FSA.1335
1.2 Deliberately1336 or negligently1337 recommending an investment to a
customer or carrying out a discretionary transaction for a customer
where the approved person knows that it is unsuitable for that
customer.1338
1.3 Deliberately failing to provide information on misunderstandings.1339
1.4 Deliberately preparing inaccurate or inappropriate records.1340
1.5 Deliberately misusing the assets (e.g. churning) or confidential
information (e.g. front running) of a customer.1341
1.6 Deliberately designing transactions so as to disguise breaches of
regulatory requirements.1342
1.7 Deliberately1343 failing to disclose a conflict of interest1344 with a customer
or failing to do so without good reason.1345
2.1 Deliberately or negligently failing to inform a customer or the person’s
own firm of material information.1346
2.2 Undertaking/recommending/providing advice on transactions for
customers1347 or the person’s own firm1348 without a reasonable
understanding of the risk exposure of the transaction.1349
2.3 Failure to provide adequate control over a customer’s assets.1350
2.4 Continuing to undertake a controlled function“ despite failure to meet
the standards of knowledge and skill required for this function.1351
3. Conduct in breach of Statement of Principle 3: The proper standards of
market conduct cited in Statement of Principle 3 are covered in most cases1352
by the Inter-Professionals Code, the FSA’s Code of Market Conduct, market
codes and exchange rules.1353
4.1 Failure to report promptly in accordance with the firm’s internal
procedures – or directly to the FSA – information which it would be
reasonable to assume would be of material significance to the FSA.1354
4.2 Failure (without good reason)1355
x to inform a regulator of information in response to questions from the
regulator;
x to attend an interview or answer questions put by a regulator;
x to supply a regulator with appropriate documents or information
when requested or required to do so and within the time limits set.
177
5.1 Failure to take reasonable steps to apportion responsibilities for all areas
of the business under the approved person’s control.1356
5.2 Failure by an approved person tasked under SYSC 2.1.3R1357 to take
reasonable care to maintain a clear and appropriate apportionment of
significant responsibilities among the firm’s directors and senior
executives.1358
5.3 Failure to take reasonable steps to ensure that suitable individuals are
responsible for those aspects of the business under the control of the
individual performing a significant influence function.1359, 1360
6. Conduct in breach of Principle 6:
6.1 Failure by an approved person performing a significant influence
function1359 to take reasonable steps to inform himself about the affairs of
the business for which he is responsible.1361
6.2 Delegating authority1362 without reasonable grounds for believing that
the delegate had the necessary capacity, competence, knowledge or
skill.1363
6.3 Delegating authority without taking reasonable steps to maintain an
appropriate level of understanding about the issue or part of the
business that has been delegated.1364
6.4 Failure to supervise and monitor adequately the individual or
individuals to whom responsibility has been delegated.1365
7. Conduct in breach of Principle 7:
7.1 Failure to take reasonable steps to implement and maintain compliance,
for instance in the form of a compliance department.1366
7.2 Failure by an approved person to take reasonable steps to inform himself
about the reason for significant breaches (whether suspected or actual)
of the regulatory requirements.1367
7.3 Failure to ensure that procedures and systems of control are reviewed
and improved following the identification of significant breaches.1368
7.4 Failure by a Money Laundering Reporting Officer to discharge the
responsibilities imposed on him by Chapter 8 of the Money Laundering
Sourcebooks.1369, 1370
7.5 Failure by an approved person performing a significant influence
function1359 responsible for compliance under SYSC 3.2.8R1371 to take
reasonable steps to ensure that an appropriate compliance system is in
place.1372
Senior management arrangements, systems and controls (SYSC)
Overview
The “Senior management arrangements, systems and controls” (SYSC) serve
the following objectives:1373
1. To encourage directors and senior executives to take appropriate practical
responsibility for their firms’ arrangements on matters likely to be of interest
178
to the FSA because they impinge on the FSA’s statutory functions. These
relate to matters affecting confidence in the financial system, the fair
treatment of firms’ customers, the protection of consumers and the use of the
financial system in connection with financial crime.1374
2. To amplify Principle 3.1375
3. To encourage firms to vest responsibility for effective and responsible
organisation in specific directors and senior executives.
These objectives will be achieved through implementation the following
principles:
1. Apportionment requirement:1376 a firm must take reasonable care to
maintain a clear and appropriate apportionment of significant
responsibilities among its directors and senior executives so that it is clear1377
who has which of those responsibilities and the business of the firm can be
adequately monitored. This apportionment of responsibilities must be
documented in writing and updated as soon as possible after any changes. In
practice, reference to the standard job descriptions, organisational charts and
similar documents (which most firms have in any case) will be sufficient.1378
Some financial industry representatives criticise this requirement because
many firms have shared management responsibilities, and they feel that this
requirement is an attack on the concept of shared responsibilities;
additionally, companies with matrix organisations will find it very difficult to
implement the requirement.1379 The FSA counters by noting that shared
responsibility is allowed as long as it is clearly defined and documented.1380
At a more general level, the FSA believes that this requirement strikes a
balance between the need for robust, enforceable standards that allow the
FSA to identify the individuals responsible for regulated activities, and the
freedom of firms to develop their management structures as they consider
appropriate, instead of subjecting them to detailed, prescriptive rules.1381
To resolve these conflicting goals, SYSC uses a small number of high-level
rules and a much larger body of guidance,1382 not only in this area, but more
generally. This focus on guidance has raised fears in the UK financial
industry of an excessively prescriptive regulatory regime, but this is rejected
by the FSA, which points to the non-binding and non-exhaustive nature of
its guidance.
2. Establishment and maintenance of appropriate systems and controls:1383
firms must take reasonable care to establish and maintain systems and
controls that are appropriate1384 to their business.
As with the apportionment requirement, the FSA’s requirement here is at a
high level so as to avoid constraining firms unnecessarily. However, the
supplementary rules and guidance indicate the areas that are typically
covered by systems and controls:
x Compliance and countering financial crime.1385
x The allocation of compliance oversight to a director or senior executive.1386
179
x Preparation and retention of records of matters subject to regulatory

requirements.1387
3. Allocation requirement:1388 the functions dealing with matters relating to (1)
the apportionment requirement and (2) the systems and controls must be
allocated to an operating officer (CEO or equivalent), either alone or together
with an appropriate number of other directors or senior executives.1389
SYSC in detail
1. Scope and objectives
1.1 Companies falling under the scope of SYSC:1390 EEA companies are
exempted from certain provisions.1391
1.2 Matters regulated:1392 SYSC applies to regulated activities and ancillary
activities,1393 to the promotion of financial products and the carrying on
of dealing as a principal.
1.3 Purpose of SYSC1394
2. Senior management arrangements
2.1 Apportionment requirement1395
2.2 Allocation requirement:1396 SYSC 2.1.4R contains a table of the
individuals or governing bodies who can be entrusted with the
allocation function, broken down by type of firm. SYSC 2.1.6G answers
frequently asked questions (FAQs) about the allocation requirement.
2.3 The arrangements made to satisfy the apportionment and allocation
requirements must be documented, the record must be retained.1397
3. Systems and controls
3.1 Establishment and maintenance of appropriate systems and controls.1394
3.2 Areas to be covered by the systems and controls
3.2.1 The internal and external delegation of functions must be
accompanied by appropriate safeguards. A firm can never
outsource its regulatory obligations.1398
3.2.2 Chinese walls should be installed to prevent crime or
contravention of the regulatory system. In particular, the front and
back offices should be segregated.1399
3.2.3 Establishment and maintenance of a compliance system1400
meeting the following criteria: documented organisation and
responsibilities, appropriate number of competent, independent
staff with adequate resources, unrestricted access to the firm’s
relevant records and to its governing body.1401
Oversight of the compliance system and the related
management reporting requirement must be allocated to a director
or senior executive.1402, 1403
3.2.4 Risk assessment: depending on the scale, nature and complexity
of the business, a separate risk assessment department may be
necessary; this must satisfy the same criteria as the compliance
system.1404
180
3.2.5 Management information: the governing body must be supplied

with relevant, reliable and timely information so that it can
identify, measure, manage and control risks of regulatory
concern.1405, 1406
3.2.6 Employees and agents: the suitability of all persons working for
the firm must be assured.1407
3.2.7 Audit committee: depending on the scale, nature and complexity
of the business, it may be necessary to establish an audit committee
that is responsible for overseeing any internal audit function
required,1408 and must be composed of an appropriate number of
3.2.8 Business strategy: depending on the scale, nature and complexity
of the business, it may be necessary to document business or
strategy plans, which should be regularly updated.1410
3.2.9 Any conflicts of interest between the compliance requirement and
the personal advantage of individuals working for the company
resulting from remuneration policies must be managed
appropriately.1411
3.2.10 Business continuity: arrangements should be in place to ensure
the continued functioning of the business in the event of
unforeseen interruption.1412
3.2.11 Obligation to prepare and maintain1413 adequate records relating to
all matters that are subject to the regulatory system.1414

The regulatory regime for EU funds faces the following challenges:
1. Light regulation combined with detailed supervision is recommended as a
desirable feature of the regulatory regime because this would enable greater
flexibility in the fast-moving financial services market without having to
abandon the need for security. As the primary enforcer – ahead of the
regulator – and equipped with appropriate powers, the fund board would
contribute significantly to the implementation of this system. In the USA, the
SEC is currently considering extending this tried-and-tested principle by
delegating existing SEC functions to the fund board.
2. The question of uniform licensing: in theory, the UCITS Directive should
have implemented a single market for investment funds since 1985 because
licensing in one EU Member State should allow EU-wide distribution. In
practice, however, there are still numerous barriers in place, which is why
the European Commission wants to introduce a “Single European Passport”
for UCITS that will represent EU-wide authorisation and provide for
minimum licensing requirements (fit and proper criteria).
3. There are also efforts to standardise ongoing supervision or at least
improved co-ordination between the national regulators. The problem of
181
multiple regulators in the USA has been reduced in recent years, and in most
cases, the SEC is now the sole supervisory authority responsible.
In addition to the question of regulatory responsibility, there is a particular
need to clarify the content issue – i.e. the reporting obligations to be satisfied
by management companies in particular; the use of modern electronic data
transfer platforms, for example the Internet, should be addressed as a matter
of urgency so as to allow effective supervision that will not drown in a flood
of paper.
The arrangements for intervention and sanctions by the supervisory
authority should follow the primary principle of remedying breaches in the
interests of shareholders rather than imposing penalties, although this
certainly does not mean sanctioning culpable misconduct, but rather taking
appropriate measures, for example dismissal or even court action.
6.3 THE MANAGEMENT COMPANY’S COMPLIANCE

DEPARTMENT
6.3.1 Definition
Compliance means complying with all laws applicable to the fund, as well as all
relevant rules and regulations issued by all government institutions and related
professional associations. The compliance system should be an integrated, self-
contained system providing permanent control, i.e. it should not merely consist
of reviews at greater or lesser intervals.
The SEC believes that the great success of the fund industry in the twentieth
century was due above all to the fact that it has demonstrated integrity and
professionalism.1415 The industry, represented by the ICI, agrees with this view
but thinks that the comprehensive regulation of the industry by the Investment
Company Act has been the key to gaining the confidence of investors, which in
turn has driven the success of the industry. The ICI stresses that the fund
industry was always willing to collaborate to ensure that laws, regulations and
voluntary standards help protect investors.1416
The SEC and the mutual fund industry thus share a common purpose of
protecting investors and their interests – the SEC due to its statutory position,
and the fund industry to safeguard and strengthen its business. To achieve this
objective, the members of a fund’s compliance department have a front-line
role.1417 A compliance department can be seen as an instance that is located
upstream of the fund board, and which relieves it of some of its work and
prevents it from being drawn into micro-management of daily fund operations,
in contravention of the concept and purpose of the Investment Company Act
of 1940. Directors often rely on the support they receive from the compliance
department to fulfil their oversight role. Compliance officers should therefore
have direct access to the board so that they can bring problems to its
182
attention.1418 However, the board cannot reduce its compliance responsibilities

by delegating them.1419
Information technology plays a key role in routine compliance work, with
portfolio transactions (both the fund’s and its managers’ private transactions)
being monitored by software, and contact with the supervisory authority being
maintained electronically.1420
Some fund industry members see the establishment and continuous
operation of a compliance department as nothing more than a cost factor,
rather than as an asset or competitive advantage in an increasingly opaque
market of financial service providers and investment opportunities. However,
excellent compliance offers an opportunity for standing out from the crowd in
this packed market. Nevertheless, even the SEC admits that a good compliance
system alone is not enough to retain or acquire new clients if performance
targets are missed.1421
Although ignoring or failing to comply with compliance standards may cut a
fund’s costs in the short term, these minimal cost savings are out of all
proportion in the longer term to what can be disastrously high costs of non-
compliance; the SEC terms this “pay now or pay a lot more later”.1422
Compliance failure often leads to negative publicity that can permanently
damage reputations and thus erode the customer base. This in turn hurts
profits, and is often accompanied by a raft of individual lawsuits. In other
words, non-compliance can result in a bleak future for both the fund and the
management company.1423
6.3.2 Legal basis

The amended UCITS Directive refers to compliance in that it requires the
management company to institute “adequate internal control mechanisms”.1424
One of the justifications given for these control mechanisms is the need to
ensure that the assets of the funds are invested and managed in accordance
with the fund rules or the instruments of incorporation and the legal provisions
in force. The details of these and other rules, including those relating to internal
administration and accounting, are a matter for the EU Member States.1425
In the USA, federal securities laws require the establishment and
maintenance of a compliance system. Even failing to have such a system is a
violation of the law, even if no “accident” has happened. If a firm fails to
supervise its employees, the SEC can launch a “failure to supervise” case.1426
The SEC does, in fact, repeatedly launch failure to supervise cases. In the
recent past, these have involved the matters described below;1427 one feature
common to all of them is that the breaches only happened because of a lack of –
or poor – supervision by senior executives or the compliance department:
x Abusive trading practice in which advisers or their employees improperly
benefit from positions held for their clients.
x Undisclosed trading of securities of companies affiliated with the adviser.
183
x Ignoring the best execution requirement: undisclosed engagement of a

broker who was also a creditor of the adviser so as to repay debt through
brokerage fees.
x Systematic misleading of investors by a member of the adviser’s sales force
about the content, size and number of shareholders of the fund.
x Investments in risky derivatives in breach of the Statement of Investment
Principles.
In addition to the inevitable cease-and-desist orders and high penalties
imposed by the SEC, a frequent consequence of such violations is a ruling by
the SEC that the adviser must send a copy of the SEC’s order to its clients.
Advisers can also be required to hire independent consultants to review their
compliance procedures and make recommendations, which the advisers must
generally follow.1428
6.3.3 Design
Compliance is a two-stage system1429 comprising1430
1. Preventing violations – preventative compliance:
x A general rule is that procedures must be adopted, and a system for
implementing these procedures must be installed, that can be reasonably
expected to prevent (preventative compliance) or detect (detection
compliance) breaches of the relevant laws.
x Compliance should be anchored throughout the entire organisation, and
not just in the compliance department, which is why all relevant
employees should be regularly updated on changes in the legal (and other
regulatory) environment.
2. Identifying and remedying violations – detection compliance: the following
matters must be considered in addition to those given in 1.) above:
x Ensuring that compliance officers have adequate authority and resources,
both to detect and to remedy, is crucial to the effectiveness of a
compliance system. This authority may also not be (de facto) restricted as
regards the “high-flier” portfolio managers.
x Compliance must start investigations if inappropriate conduct is
suspected; if necessary, they must be able to take further measures and
should not simply let the whole matter rest.
Areas where violations that are supposed to be prevented or detected by a
compliance system occur frequently include:1431
x The duty to obtain best execution for clients.1432
x Any soft dollar arrangements: do the transactions fit within the 28(e) safe
harbour and are they disclosed adequately to the clients?1433
x Valuation of client assets1434
184
x Advertising: is it reviewed prior to publication? Is performance data

properly presented, i.e. returns net of fees and expenses?1435
x Are employee’s personal securities transactions monitored and
recorded?1436

Without compliance – as the integrated, permanent control of internal
procedures with the primary objective of protecting the interests of investors –
all other rules are more or less worthless, because “paper is patient”, as the old
German saying goes. The best fund rules, prospectuses (incl. SIPs), codes of
ethics, legal provisions and so on are of little value whatsoever without
supervision, in the same way that laws that are not enforced do not contribute
to the rule of law. The fund board alone does not have the human resources –
or the mission – to cope with this function, because it is expressly designed not
to be involved in day-to-day management. The compliance department can
thus be seen as a control body that is positioned upstream of the board, and it
too needs to be governed by standards. When designing such standards, the
emphasis should be less on cost and more on the understanding that skimping
on the compliance system may jeopardise the continued existence of the fund
and its adviser if things go seriously wrong because of the legal consequences
and the loss of public confidence:
1. The obligation to establish and maintain a compliance system is
fundamental.
2. The compliance department must have sufficient authority and resources to
allow it to do its job properly. For example, there must be both formal and
informal lines of communication between the compliance officers and the
fund board; the compliance officers must have the power to investigate
anybody in the event of suspicious behaviour, and they must have sufficient
human and technical resources.
3. IT is a suitable tool for monitoring and documenting both the fund’s
portfolio transactions and the personal transactions of the portfolio
managers and other persons. The aim at the fund, for instance, is to ensure
the proper valuation of the fund assets, and compliance with the SIP, the
best execution requirement and soft dollar guidelines; for the portfolio
managers, it can be used to detect front running and insider offences. IT is
also suitable for complying with the routine reporting requirements to the
supervisory authority.1437
185
6.4 SHAREHOLDERS
6.4.1 The possibility of reporting perceived anomalies to the

supervisory authority in the EU
The recommendation to give shareholders the possibility of reporting
perceived anomalies1438 to the supervisory authority in the proposed Pension
Fund Directive1439 was not included in the proposal for the Pension Fund
Directive published in October 2000.1440
For UCITS, the EU reserves the right to introduce compensation
arrangements for shareholders (unit-holders).1441
6.4.2 The right to sue personally liable board directors in the

USA
The Investment Company Act allows shareholders1442 to bring actions against
the directors of the fund, as well as other persons affiliated with the fund,1443 if
they are in breach of their fiduciary duty.1444
Under certain conditions,1445 a fund may advance costs incurred by its
directors for lawsuits.1446, 1447 The SEC thinks that this rule is obsolete and needs
updating, so it wants to revise the conditions under which advances can be
paid and define them more clearly.1448
Directors are subject to state law duties of care and loyalty:1449
x The duty of care requires that directors act in good faith and with the
degree of diligence, care and skill that a person of ordinary prudence
would exercise under similar circumstances in a like position. The business
judgement rule is applied, which protects directors from liability for
wrong decisions as long as they acted in accordance with the
aforementioned requirements.1450 They are also obliged to establish sound
procedures for overseeing and reviewing the performance of the
investment adviser and others that perform services for the fund, and to
obtain all adequate information that they need.1451
x The duty of loyalty requires directors to exercise their powers in the
interests of the fund and not in the directors' own interests or in the
interests of another person or organisation.1452 For example, they cannot
themselves exploit (business) opportunities that properly belong to the
fund.1453
All these duties taken together make the fund directors fiduciaries and impose
fiduciary duties on them.1454, 1455
6.4.3 Direct influence on fund management

As a rule, there are no large shareholders in US retail funds that can influence
management in a similar way to institutional investors in normal publicly
traded corporations, which is why independent directors play such an
important role. Like most retail shareholders, the average fund shareholder
186
simply does not have the economic incentive to exercise the same level of
influence as institutional investors can normally do by virtue of their size.1456

Giving shareholders an opportunity to exercise control over “their” fund
should be seen in terms of providing additional support to the control exercised
by their elected representatives, the board of directors, or as an emergency
measure in the event of (culpable) failure. In practical terms, rules or standards
in this area will be relatively unimportant because the average investor has a
limited capacity to handle information because of a lack of professional
knowledge and very indirect information channels. Intervention by
shareholders would only be necessary in any case if the compliance
department, the fund board and the regulator have all failed in their duties,
which is unlikely to happen if the standards described in the previous chapters
are established.
Guidelines for the following problems could be useful:
1. Possibility for shareholders to report anomalies to the fund board or the
supervisory authority. Guidelines on investor compensation would back up
this instrument.
2. If the board of directors fails to discharge its duty to represent shareholder
interests or only does so inadequately, not only the regulator, but also the
shareholders should be able to take legal action. However, the threshold for
bringing such actions should be set quite high so as to avoid the exaggerated,
opportunistic lawsuits often encountered in the USA.
3. In the above context, there should be rules setting out the extent to which
directors can receive legal costs from the fund.
4. Fund shareholders should be able to exercise the same level of influence as
ordinary shareholders of publicly traded companies, not only for investment
companies, but also for funds managed by investment advisers. The practical
significance of this should not be overestimated, but shareholders are also
able to form pressure groups or join an investor interest or protection
association, and thus increase their influence. It should also be expected that
as mutual funds become increasingly popular – especially for retirement
provision – the level of professional knowledge of the investing public will
also rise, as will its interest in exercising direct influence.
6.5 OTHER PARTIES INVOLVED IN SUPERVISION
6.5.1 Obligations of auditors and actuaries to the supervisory

authority in the EU
Auditors have a duty to report promptly to the supervisory authority certain
matters of which they become aware during the performance of their
functions:1457
187
x Breaches of rules and regulations relating to the authorisation and

continuing business of the fund.
x Matters that might affect the continued existence of the fund.
x Disclaimer or qualification of the audit opinion.
The suggestion that auditors should be subject to secondary compliance
responsibilities under the proposed Pension Fund Directive1458 was not
included in the proposed directive published in October 2000.1459 The original
recommendation was to oblige auditors to verify the following:1460
x the effectiveness of the fund’s internal control system in guaranteeing a
high level of security for the beneficiaries;
x actual compliance by the management company with the prescribed
procedures.
The proposal for the directive provides for internal checks by the pension
plan’s actuary: the actuary’s task is firstly the prudent1461 calculation of the
technical reserves1462 – which exist only in the case of DB schemes1463 – and
secondly to ensure that the type and maturity of the assets and liabilities
actually match. The actuary defines the limits of the investment strategy by
establishing the type and maturity of the assets.1464 Actuarial methods and the
assumptions applied to these1465 – apart from those for mortality tables1466 –
should be largely harmonised at the EU level, but not to such an extent that
actuaries cannot depart from these EU standards where it is necessary or
appropriate to deal with fund-specific issues; such departures from the
standards would have to be substantiated to the board of directors and the
supervisory authority. At any rate, the institutional limits would be the rules
and regulations promulgated by the supervisory authority and/or professional
bodies, and the functional limit would be the objective of a prospective,
coherent and realistic valuation that would avoid excessive over- or
underfunding and result in a level of contributions for each fund that is
appropriate and stable over the longest possible period.1467
Actuaries should be subject to “fit and proper” criteria,1468 and recognition by
the corresponding professional body should be a requirement for licensing by
the supervisory body, which would then be valid throughout the EU.1469
Actuaries should be accountable to the board of directors and the supervisory
authority, and should be subject to reporting requirements similar to those for
auditors.1470 For example, they should be required to report anomalies such as
wilful misconduct, failure to comply with fiduciary duty, omissions or even
simple negligence in management matters.1471
6.5.2 The duties of the custodian in the EU

The UCITS Directive imposes a range of prudential duties on the custodian
(depositary). For example, it has to ensure compliance with laws, fund rules
and the instruments of incorporation of the management company relating to:
188
x the issue, sale, repurchase, redemption and cancellation of fund shares

(units);1472
x the calculation of the value of the fund shares;1473
x instructions of the management company to it;1474
x and the utilisation of the fund’s income.1475
The proposal to allow custodians to report anomalies to the supervisory
authority under the proposed Pension Fund Directive1476 (“custodians etc.
should have a possibility to report”1477) was not incorporated into the proposed
directive published in October 2000.1478
6.5.3 Professional bodies

Definition
Although supervisory functions are not the express objective of professional
bodies or associations (especially those representing the interests of the mutual
fund industry), they often help in practice to lift the integrity of the fund
industry and thus contribute to investor protection.
The US Investment Company Institute

As the national association for the investment company industry, the
Investment Company Institute (ICI) was formed in New York in 1940 by the
then leading investment companies as the National Committee of Investment
Companies. It was renamed ICI in 1961 and moved to Washington, D.C., in
1970.
The ICI’s mission is to advance the interests of investment companies and
their shareholders, to promote public understanding of the investment
company business, and to serve the public interest by encouraging adherence
to high ethical standards by all elements of the business. It does so by lobbying
legislative and regulatory bodies (Congress, the SEC and other federal, state
and foreign regulatory bodies), by spearheading investor awareness initiatives,
by disseminating industry information to the public and the media, by
providing economic policy and other policy research, and by seeking to
maintain high industry standards.1479
The German BVI

The Bundesverband Deutscher Investment-Gesellschaften e.V. (BVI – German
investment companies association) was formed in Frankfurt am Main in 1970
by seven (of the then eighteen1480) investment companies in Germany and has
two primary missions:1481
1. To promote the concept of investment;
2. To represent the interests of its members with government, the general
public, professional bodies and industry associations, both German and
international. Membership is open to investment companies that are
189
regulated by the KAGG – the German Investment Companies Act

(including Special Funds1482). In 1999, 69 of the 75 licensed German
investment companies were members of the BVI, representing total assets
under management of close to €0.87 billion.1483
To fulfil its missions, the BVI provides information to the general public, is
involved in the preparation of many laws and regulations affecting financial
and retirement planning, and is active in professional bodies and at
international conferences. The BVI is a member of FEFSI, the European
umbrella organisation of the investment fund industry, and attends the
international investment conference.

Fund supervision standards should also govern the rights and obligations of
the following groups:
1. Auditors and the actuaries required for DB plans must satisfy certain
suitability criteria – which should be harmonised as far as possible – and
should also be subject to reporting duties to both the fund board and the
supervisory authority. More far-reaching oversight obligations, for instance
relating to the effectiveness of the compliance system, could be introduced
under the proposed EU Pension Fund Directive. Accounting and actuarial
rules applicable to mutual funds should be harmonised – or at least co-
ordinated – to enable comparability by investors and prevent distortions of
competition.
2. The custodian/depositary should also have certain oversight functions over
the independent management company and be subject to reporting
requirements.
3. In the interests of the majority of their members, who are honest in their
business dealings, fund industry bodies should also exercise oversight
functions to minimise the number of black sheep who damage the image of
the industry as a whole. Because these bodies normally cite the promotion of
financial and retirement planning as one of their primary missions, it is only
logical for them to help detect and take action against those firms that might
jeopardise confidence in fund products and thus impair the growth
opportunities for the fund industry.
190
CHAPTER 7
Summary of Findings
We have established the following solutions for the questions posed in Chapter
1 of the study:1484
1. The demographic shift in the population of the EU and the resulting
need for supplementary occupational and private pensions; efforts to
harmonise the European capital markets, most forcefully expressed at
present by the introduction of the single currency; the trend towards
asset accumulation among savers; competitive pressure from the USA,
and the prospect of legislation that fails to consider practical realities, at
least in part, should all be an incentive for the EU fund industry to
develop its own Asset Management Standards.
2. European legislation that can be used as the basis for developing future
standards includes the UCITS Directive, which regulates investment
funds in general, and the proposed Pension Fund Directive, supported
by the Rebuilding Pensions study commissioned by the European
Commission, as well as the relatively recent rules on AS-Fonds
contained in the German KAGG. In the USA, this basis is provided by
the capital market laws dating from the first half of the twentieth
century, in particular the Investment Company Act and the Investment
Adviser Act, together with the 1974 ERISA governing pension plans
(together with the Internal Revenue Code); interpretative decisions by
the SEC also play a significant role. These US rules and regulations are
marked by the principles of fiduciary duty and prudence.
3. Standards can be classified at a high level by the objective of either
controlling management or investment risk, or of overseeing and
enforcing rules and regulations. The next level is characterised by more
detailed functional aspects such as investment rules, separation of
functions and disclosure requirements.
4. and 5. The structure of point 3. above produces the following picture:
I. Management risk
191
SUMMARY OF FINDINGS
a) Investment rules should defuse transactions involving conflicts of

interest, in turn demanding a code of ethics. The USA currently
leads the field here.
b) In the area of institutional and organisation separation of
functions, the (planned) EU rules are well suited to avoiding
potential conflicts of interests from multiple responsibilities that
could damage the interests of investors.
c) The standard US rules on disclosure of conflicts of interest are
viewed sceptically, in part because of the limited information
handling capacity of the average investor.
II. Investment risk
a) Investment rules are currently the most debated area of Asset
Management Standards in the EU. Large parts of the EU are still
dominated by restrictive quantitative investment rules, although
there is now growing support for qualitative criteria
supplemented by less restrictive quantitative rules as a result of
the launch of the single currency and the need for growth-driven
investment to fund adequate (supplementary) retirement
provision. With its long-established prudence rules, the USA has a
similar regime.
b) Although they are still quite rare in the EU, the key desirable
standards on disclosure are:
x The duty to prepare Statements of Investment Principles (SIPs)
complying with certain minimum content requirements.
x Avoiding as far as possible the use of technical and legal jargon
in all communication media directed at consumers, and giving
prominence to easily understandable graphics and tables.
x The incorporation of established Performance Presentation
Standards, which could be supplemented by guidelines and
recommendations for Internet presentation and for the
presentation of the effects of taxation on fund returns.
III. Standards for overseeing and implementing rules and regulations
a) Similar to the US fund system, there should be a fund board
bound by fiduciary duties as an at least partly independent
oversight body representing shareholders’ interests (especially in
respect of the management company).
b) The fund board should be the first-line enforcer, backed up by the
supervisory authority, rather than the other way round.
c) The establishment and maintenance of an adequate compliance
system as an integrated, permanent internal oversight authority
should be mandatory.
d) Shareholders should at least have the possibility of reporting
perceived anomalies to the fund board and the supervisory
authority, which would then have to respond. The ability to take
192
SUMMARY OF FINDINGS
legal action should not permit the level of abuse that is now
entrenched in the USA.
e) Control duties should also be imposed on auditors, actuaries,
custodians and fund industry bodies.
193
ANNEX A
Replacement Migration
Figure 46 shows population growth and its percentage age distribution in

Germany between 2000 and 2040 in ten-year steps for both a best case and a
worst case scenario.1484 The best case estimate assumes both better economic
and demographic trends than the worst case scenario.
195
ANNEX A
Best case scenario Worst case scenario

Age structure 2000
>79 >79
60-79 60-79
45-59 45-59
35-44 35-44
25-34 25-34
15-24 15-24
0-14 0-14
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Age structure 2010
>79 >79
60-79 60-79
45-59 45-59
35-44 35-44
25-34 25-34
15-24 15-24
0-14 0-14
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Age structure 2020
>79 >79
60-79 60-79
45-59 45-59
35-44 35-44
25-34 25-34
15-24 15-24
0-14 0-14
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Age structure 2030
>79 >79
60-79 60-79
45-59 45-59
35-44 35-44
25-34 25-34
15-24 15-24
0-14 0-14
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Age structure 2040
>79 >79
60-79 60-79
45-59 45-59
35-44 35-44
25-34 25-34
15-24 15-24
0-14 0-14
0 2 4 6 8 10 12 14 16 18 20 0 2 4 6 8 10 12 14 16 18 20
Figure 46: Population age structure trends in Germany 2000 to 2040
196
ANNEX A
Country or 1990 1991 1992 1993 1994 1995 1996 1997 1998
region
France 80,000 90,000 90,000 70,000 50,000 40,000 35,000 40,000 40,000
Germany 656,166 602,563 776,397 462,284 315,56 398,26 281,49 93,433 50,821
8 3 3
Italy 24,212 4,163 181,913 181,070 153,36 95,499 149,74 126,55 113,80
4 5 4 4
Japan 2,000 38,000 34,000 -10,000 -82,000 -50,000 -13,000 14,000 38,000
South Korea – – -10,000 – – – – – -20,000
Russian 810,00 502,20 343,60 352,60 285,20
164,000 51,600 176,100 430,100
Federation 0 0 0 0 0
United 68,384 76,416 44,887 90,141 84,242 116,86 104,07 88,476 -12,406
Kingdom 9 5
USA 1,536,48 1,827,16 973,977 904,292 804,41 720,46 915,90798,37 660,47
3 7 6 1 0 8 7
Europe – – 1,047,00 – – – –950,00 –
0 0
EU 1,008,25 1,078,44 1,350,13 1,062,11 782,85 805,36 734,59 512,20 378,68
1 1 2 6 5 3 6 8 7
Table 35: Annual net new migration between 1990 and 1998 by country or
region1485
Scenario A Scenario B Scenario C

Country or region Constant total Constant working Constant potential
population population support ratio
France 1,473,000 5,459,000 93,794,000
Germany 17,838,000 25,209,000 188,497,000
Italy 12,944,000 19,610,000 119,684,000
Japan 17,141,000 33,487,000 553,495,000
South Korea 1,509,000 6,426,000 5,148,928,000
Russian Federation 27,952,000 35,756,000 257,110,000
United Kingdom 2,634,000 6,247,000 59,775,000
USA 6,384,000 17,967,000 592,757,000
Europe 100,137,000 161,346,000 1,386,151,000
EU 47,456,000 79,605,000 700,506,000
Table 36: Total net new migration from 1995 to 2050 by country or region1486
197
ANNEX A

France 27,000 99,000 1,705,000
Germany 324,000 458,000 3,427,000
Italy 235,000 357,000 2,176,000
Japan 312,000 609,000 10,064,000
South Korea 27,000 117,000 93,617,000
Russian Federation 508,000 650,000 4,675,000
United Kingdom 48,000 114,000 1,087,000
USA 116,000 327,000 10,777,000
Europe 1,821,000 2,934,000 25,203,000
EU 863,000 1,447,000 12,736,000
Table 37: Average net new migration per year from 1995 to 2050 by country or
region1487
Percentage of immigrants to total

Country or region Number of immigrants
population
France 5,897,000 10.4
Germany1488 5,037,000 6.4
Italy 1,549,000 2.7
Japan 868,000 0.7
United Kingdom 3,718,000 6.5
USA 19,603,000 7.9
1489
Europe 11,152,000 4.3
EU 21,378,000 5.8
Table 38: Number/percentage of immigrants in 1990 by country or region1490

France 2.9 11.6 68.3
Germany 28.0 36.1 80.3
Italy 29.0 38.7 79.0
Japan 17.7 30.4 87.2
United Kingdom 5.5 13.6 59.2
USA 2.5 7.9 72.7
Europe 17.5 25.8 74.4
EU 16.5 25.7 74.7
Table 39: Percentage of immigrants to total population between 1995 and 2050 by
country or region1491
198
ANNEX B
FSA Handbook Timetable
Timetable for 2001 for completing version one of the FSA Handbook.1492
Title Type of publication Timing

High Level Standards
Principles for Business ‘Final’ Text Quarter 1
Fitness and Propriety ‘Final’ Text Quarter 1
Approved Persons ‘Final’ Text Quarter 1
Senior Management arrangements, systems and ‘Final’ Text Quarter 1
controls
Threshold Conditions ‘Final’ Text Quarter 1
General Provisions ‘Final’ Text Quarter 2
Business Standards
Money Laundering Sourcebook ‘Final’ Text Quarter 1
Interim Prudential Sourcebook: ‘Final’ Text Quarter 1
Investment Business
Banks and Building Societies
Insurance and Friendly Societies
Inter Professional Code ‘Final’ Text Quarter 1
Conduct of Business Sourcebook ‘Final’ Text Quarter 1
Implementing the EC Directive on Insurance ‘Final’ Text Quarter 1
Groups
Polarisation (SHPs and ISAs) Consultation Quarter 1
Paper
Code of Market Conduct ‘Final’ Text Quarter 1
Integrated Prudential Sourcebook Consultation Quarter 2
Paper
Interim Prudential Sourcebook – ‘Final’ Text Quarter 2
Additional Consultation
Endorsement of the Takeover Code ‘Final’ Text Quarter 2
199
ANNEX B
Title Type of publication Timing

Regulatory Processes
Authorisation ‘Final’ Text Quarter 2
Supervision ‘Final’ Text Quarter 2
Enforcement ‘Final’ Text Quarter 2
Decision Making ‘Final’ Text Quarter 2
Redress
Compensation Scheme ‘Final’ Text Quarter 1
Compensation Levies Consultation Quarter 1
Paper
Compensation Transition Consultation Quarter 1
Paper
Complaints against the FSA ‘Final’ Text Quarter 2
Credit Unions Compensation and Complaints Consultation Quarter 2
Paper
Specialist Sourcebooks
Lloyd’s Sourcebook ‘Final’ Text Quarter 1
Collective Investment Schemes Final’ Text Quarter 1
Information Dissemination Consultation Quarter 1
Paper
Exempt Professional Firms ‘Final’ Text Quarter 2
Recognised Investment Exchanges/ ‘Final’ Text Quarter 2
Recognised Clearing Houses
Credit Unions Consultation Quarter 2
Paper
UKLA Listing Rules ‘Final’ Text Quarter 2
Other material
Fees Rules ‘Final’ Text Quarter 1
Fee Tariffs Consultation Quarter 2
paper
Application Fees (SUP 6) Consultation Quarter 2
paper
200
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Notes
1
see Hummler, K., Editorial: Anlagefonds – ein Thema oder keines?, in: Finanzmarkt und
Portfolio Management No. 2, Vol. 14 2000, p. 116
2
The term “shareholder” is used in this study to denote both shareholders and unit-holders.
The term “unit-holder” is used in isolation where this is demanded by the context, and in
certain instances, especially in Chapter 6, both terms appear.
3
see Pragma Consulting, Rebuilding Pensions – Recommendations for a European Code of
Best Practice for Second Pillar Pension Funds, 1999, p. II; European Commission,
Supplementary Pensions in the Single Market, A Green Paper, Com(97) 283, 1997, p. I,
concurs
4
see Bundesverband Deutscher Investment-Gesellschaften e.V. (BVI), Investment 2000 –
Daten, Fakten, Entwicklungen: Altersvorsorge und Investmentfonds – ein internationaler
Vergleich, 2000, p. 45
5
see European Commission, Supplementary Pensions in the Single Market, A Green Paper,
Com(97) 283, 1997, p. 3; or Buttler, Andreas/Stegmann, Volker, Mit der obligatorischen
betrieblichen Altersversorgung aus der Rentenkrise, Munich, December 1997, p. 21
6
The Pension Reform Commission in Germany is forecasting an increase in longevity for
men and women (combined) from 81.73 years in 1995 to 84.38 in 2041 (see Gesamtverband
der Deutschen Versicherungswirtschaft e.V. (GDV), Fakten und Zahlen – Demographische
Perspektiven, Düsseldorf, 1997, p. 179).
7
see Buttler, Andreas/Stegmann, Volker, Mit der obligatorischen betrieblichen
Altersversorgung aus der Rentenkrise, Munich, December 1997, p. 21
8
see Hahne, Peter, Ökonomen fordern längere Lebensarbeitszeit, Die Welt, 22 May 2001
9
see United Nations Population Division, Department of Economic and Social Affairs,
Replacement Migration, USA, 2000, p. 23
10
see Taverne, Dick, Can Europe Pay for its Pensions?, Federal Trust for Education and Trust,
London, 2000, p. 9
11
see ibid, p. 10
12
Best Practice for Second Pillar Pension Funds, 1999, p. 3
13
Com(97) 283, 1997, p. I
14
There have also been contribution hikes in the US in recent years, but these will not be
sufficient to ensure the long-term stability of the system: even if the contributions were to
be further increased to 12% of gross earnings, the system would collapse by 2029. In
211
NOTES
particular the fact that the baby boomers – the largest single group of individuals in US
history – will start retiring in the next ten years will put massive strains on the social
security system. A number of reforms are under discussion, such as the (partial) conversion
of the PAYG system towards a funded system, or the (partial) privatisation of the social
security system (see Gesamtverband der Deutschen Versicherungswirtschaft e.V. (GDV),
Ländervergleich Altersversorgung – Rentenversicherung in den USA vor einer Krise, 1998).
15
Com(97) 283, 1997, p. 1
16
17
Replacement Migration, USA, 2000, Table IV.11, p. 27
18
Ratio of 15–64 year-olds to the over-64s.
19
20
There have been de facto cuts in pensions in recent years in Germany (although these were
reversed again in early 2001 by the Old-Age Provision Extension Act) and in Italy by
pegging the level of pensions to prices rather than wages; by changing the way in which
pensions are calculated, as in France and Italy; or by changes to the period on which the
pension calculation is based (see Taverne, Dick, Can Europe Pay for its Pensions?, Federal
Trust for Education and Trust, London, 2000, p. 15).
21
For measures increasing the de facto pensionable age in Germany, Italy, the Netherlands
and France, see Taverne, Dick, Can Europe Pay for its Pensions?, Federal Trust for
Education and Trust, London, 2000, p. 14f.
22
In Germany, the pension provision burden has been dramatically increased not only by
contribution hikes, but also by increasing the income threshold for contribution
assessment, which rose from DM 78,000 in 1991 to DM 100,800 in 1998 (see Buttler,
Andreas/Stegmann, Volker, Mit der obligatorischen betrieblichen Altersversorgung aus der
Rentenkrise, Munich, December 1997, p. 2f).
23
see Replacement migration, p. 9
24
According to a study by the European Commission, the ratio of pension payments to GDP
will grow to 15% to 20% in a number of Member States, including Germany, from the
average of 10% at the end of the 1990s (see European Commission, Supplementary
Pensions in the Single Market, A Green Paper, Com(97) 283, 1997, p. 1).
25
London, 2000, p. 18f
26
As a percentage of gross earnings, with employee and employer each paying half.
27
Bandwidth from four estimation models (see Gesamtverband der Deutschen
Versicherungswirtschaft e.V. (GDV), Fakten und Zahlen – Demographische Perspektiven,
Düsseldorf, 1997, p. 183).
28
In 1998, an increase to 21% was only avoided by an increase in VAT that was used to
increase the federal subsidy paid to the social security funds (see Buttler,
Andreas/Stegmann, Volker, Mit der obligatorischen betrieblichen Altersversorgung aus der
Rentenkrise, Munich, December 1997, p. 2).
29
see Gesamtverband der Deutschen Versicherungswirtschaft e.V. (GDV), Fakten und
Zahlen – Demographische Perspektiven, Düsseldorf, 1997, p. 182f
30
Annex A, Figure 46 shows this development between 2000 and 2040 in 10 year intervals.
31
The worst-case estimate assumes both a more unfavourable economic and demographic
development than the more optimistic scenario.
32
see Gesamtverband der Deutschen Versicherungswirtschaft e.V. (GDV), Fakten und
Zahlen – Demographische Perspektiven, Düsseldorf, 1997, p. 178
33
For details of the three pillar model, see Table 6, p. 13
212
NOTES
34
The study covered the following countries and regions: France, Germany, Italy, Japan,
South Korea, Russia, United Kingdom, United States, Europe and the European Union.
35
36
see ibid, p. 6f
37
see ibid, p. 10f
38
For details of immigration between 1990 and 1998, see Table 35 in Annex A
39
see Annex A Scenario A in Table 36 (for cumulative net migration up to 2050) and Table 37
(for average annual net migration up to 2050).
40
see Annex A Scenario B in Table 37
41
see Annex A Scenario B in Table 36
42
see Annex A Scenario C in Table 36 (for cumulative net migration up to 2050) and Table 37
(for average annual net migration up to 2050).
43
see Annex Table 39
44
see Annex Table 38
45
Scenarios A and B relate to immigrants and their descendants.
46
47
48
Com(97) 283, 1997, p. 2
49
In the pay-as-you-go system, real wage growth corresponds to the real rate of interest in
the funded system, provided that the population remains constant.
50
Estimates of the nominal return on securities investments assume 9% per annum between
2000 and 2020, which could see the total assets of pension funds in the EU rising by a factor
of seven, from around ECU 1,627bn at the end of 1997 to EUR 11,811 at the end of 2020 (see
Pragma Consulting, Rebuilding Pensions – Recommendations for a European Code of Best
Practice for Second Pillar Pension Funds, 1999, p. II).
51
Altersversorgung aus der Rentenkrise, Munich, December 1997, p. 9f
52
Best Practice for Second Pillar Pension Funds, 1999, p. II; and European Commission,
Supplementary Pensions in the Single Market, A Green Paper, Com(97) 283, 1997, p. 2
53
The features of pillar three largely match those of pillar two defined benefit schemes. The
major difference is that this type of retirement provision is not linked to dependent
employment, but rather that the contract is entered into individually with a product
provider, most of whom are currently still life insurance companies.
54
There were also suggestions to introduce compulsory occupational pensions
(see Overview, p. 16).
55
Best Practice for Second Pillar Pension Funds, 1999, p. II
56
Com(97) 283, 1997, p. 3
57
see ibid, p. 6
58
Best Practice for Second Pillar Pension Funds, 1999, p. II
59
see European Commission, Communication of the Commission: Financial Services –
Building a Framework for Action, Com (1998) 625, Brussels, October 1998, p. 12
60
213
NOTES
61
The European Commission has emphasised repeatedly that the pillar two and three
pension systems should not replace pillar one, but should supplement it (see European
Commission, Communication of the Commission: Towards a Single Market for
Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p. 2; Pragma
Consulting, Rebuilding Pensions – Recommendations for a European Code of Best Practice
for Second Pillar Pension Funds, 1999, p. II, concurs), and that it is a matter for the Member
States to decide which share of the overall pension burden should be borne by each of the
pillars (see European Commission, Communication of the Commission: Towards a Single
Market for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p. 15).
62
Com(97) 283, 1997, p. 3
63
With defined benefit (DB) systems, the pension entitlement is the result of a calculation
that is normally determined by the number of years of service and the development of
income over that period. The investment risk and the risk of having to compensate for any
shortfall are borne by the plan sponsor, which is normally the employer (except for pillar
one schemes).
64
With defined contribution (DC) systems, the pension entitlement equals the cumulative
contributions plus the capital gains from these contributions, meaning that the beneficiary
has to bear the benefit risk. In the USA at least, however, this risk may also pass to the
sponsor as a result of damages claims if the sponsor does not comply with its implicit duty
to educate the beneficiary about investing for retirement (see Louge, Dennis E./Rader, Jack
S., Managing pension plans: a comprehensive guide to improving plan performance,
Boston (Massachusetts), Harvard Business School Press, 1998, p. 22).
Such a pension account is inherently always funded, but purely DC-based pension funds
are relatively rare in Europe (see Pragma Consulting, Rebuilding Pensions –
Recommendations for a European Code of Best Practice for Second Pillar Pension Funds,
1999, p. 13).
Asset allocation is a matter either for the sponsor/employer, although this is increasingly
unattractive because of fears of claims for damages on the grounds of poor performance, or
the beneficiary participates in asset allocation by choosing asset classes or even by
specifying certain investment funds. In the latter case, the advantage of being able to adjust
asset allocation to the individual preferences of the beneficiary is offset by the possibility of
increased risk due to lack of expertise (see Louge, Dennis E./Rader, Jack S., Managing
pension plans: a comprehensive guide to improving plan performance, Boston
(Massachusetts), Harvard Business School Press, 1998, p. 19).
65
There are also “hybrid” plans that combine the features of DB and DC schemes (see
European Commission, Communication of the Commission: Towards a Single Market for
Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p. 26).
66
see Louge, Dennis E./Rader, Jack S., Managing pension plans: a comprehensive guide to
improving plan performance, Boston (Massachusetts), Harvard Business School Press, 1998,
pp. 26–30
67
For the European Commission’s thoughts on imposing uniform EU-wide rules on second
and third pillar institutions for retirement provision European Commission,
Supplementary Pensions in the Single Market, A Green Paper, Com(97) 283, 1997, p. 15f
68
Com(97) 283, 1997, Table XIII
69
see USA – the global pacesetter, p. 21
70
see Investment Company Institute, Annual Report 1999, May 2000, p. 31
71
see Roye, Paul, Maintaining the Pillars of Protection in the New Millenium, Washington
D.C., 21 May 1999
72
see Investment Company Institute, Continuing a Tradition of Integrity, in: Perspective,
Vol. 3/No. 3, July 1997, p. 3
214
NOTES
73
see FAZ.NET, Zum Thema: Rentenreform – Chronik, 17 May 2001
74
see Pauly, C./Reiermann, C./Sauga, M., Riesters Reformruine, in: Der Spiegel 7/2001, pp. 90–
105, p. 96
75
see FAZ.NET, Zum Thema: Rentenreform – Chronik, 17 May 2001
76
see Bundesministerium für Arbeit und Sozialordnung, Die neue Rente fördert, was bisher
fehlte: zusätzliche Eigenvorsorge
77
78
see Porwollik, Ulrich, Rente mit Rendite, Welt am Sonntag, 13 May 2001
79
The Old-Age Provision Extension Act also passed by the Bundestag contains those parts of
the reform that do not require the consent of the Bundesrat: a modification to the
adjustment formula that sees pensions pegged to wage rises again, changes in widows’
pensions and changes for younger insured pensions with gaps in their working life (see
Bundesministerium für Arbeit und Sozialordnung, Schwerpunkte der Rentenreform,
Berlin, 26 January 2001).
80
The changes following the negotiations in the mediation committee related, among other
things, to the inclusion of residential property in the state subsidy programme (see note
104) and improvements to widows’ pensions (see FAZ.NET, Wirtschaft – Wirtschaftspolitik,
Bundesrat – Rentenreform ist beschlossene Sache, 11 May 2001).
81
see Porwollik, Ulrich, Rente mit Rendite, Welt am Sonntag, 13 May 2001
82
see Bundesministerium für Arbeit und Sozialordnung, Auf die gesetzliche Rente ist wieder
Verlass, May 2001
83
see Bundesministerium für Arbeit und Sozialordnung, Schwerpunkte der Rentenreform,
Berlin, 26 January 2001
84
see Bundesministerium für Arbeit und Sozialordnung, Was die neue Rente für
Rentnerinnen und Rentner bedeutet, May 2001
85
see Bundesministerium für Arbeit und Sozialordnung, Auf die gesetzliche Rente ist wieder
Verlass, May 2001
86
see FAZ.NET, Zum Thema: Rentenreform – Altersvorsorge, 17 May 2001
87
see Allianz AG/Dresdner Bank AG, Meine Zukunft. Das Vorsorgemagazin von Allianz und
Dresdner Bank, Issue No. 1, May 2001, Munich/Frankfurt am Main, p. 9
88
see Bundesversicherungsanstalt für Angestellte Online, Zahlen & Fakten: Aktueller
Rentenwert/Rentenanpassungssatz, 2002
89
90
see Hahne, Peter, Experten halten Rentenreform für Makulatur, Die Welt, 15 May 2001
91
see FAZ.NET, Wirtschaft – Wirtschaftspolitik, Interview mit Prof. Herwig Birg: “Vier
Prozent Zusatzvorsorge sind ein Witz”, 10 May 2001
92
see Hahne, Peter, Ökonomen fordern längere Lebensarbeitszeit, Die Welt, 22 May 2001
93
94
As part of a “best treatment comparison”, the tax office examines whether it would be more
favourable for the investor to claim a special tax allowance instead of the state support. If
such a tax saving is more favourable for the taxpayer than the support payments, the
difference is credited to the taxpayer and the support paid remains in the investment
account.
95
up to the maximum income threshold for contribution assessment.
96
Double this amount for married couples, i.e. each spouse is entitled to the amount shown.
97
see FAZ.NET, Wirtschaft – Wirtschaftspolitik, Privatvorsorge – Privatvorsorge und
Förderbeträge, 11 May 2001
98
215
NOTES
99
see FAZ.NET, Wirtschaft – Wirtschaftspolitik, Rentenreform – Eckpunkte des
Altersvermögensgesetzes, 11 May 2001
100
see ibid
101
see note 94
102
103
Pension insurance must cover the benefit phase starting when the pensioner turns 85.
104
The “interim withdrawal model” applies: an amount of EUR 10,000 to 50,000 can be
withdrawn for a defined period to acquire residential property, but must be repaid by the
time the beneficiary turns 65 (see FAZ.NET, Wirtschaft – Wirtschaftspolitik, Rentenreform –
Eckpunkte des Altersvermögensgesetzes, 11 May 2001).
105
106
107
see Bundesministerium für Arbeit und Sozialordnung, Die neue Rente fördert, was bisher
fehlte: zusätzliche Eigenvorsorge
108
see Section 2.1.3 Harmonisation of the European capital markets and the Single Currency,
p. 24
109
110
see Wolber, Cornelia, Allianz will gegen Rentenreform klagen, Die Welt, 12 April 2001
111
see Wirth, Beatrix, Versicherungsbranche gilt als Gewinner der Rentenreform, Die Welt, 11
May 2001
112
113
see note 63
114
see note 64
115
see Section 5.1.1 Prudence, not extensive quantitative restrictions, in the EU and the USA,
p. 79
116
Bundesministerium für Arbeit und Sozialordnung, Die neue Rente: Solidarität mit Gewinn,
Rentenlexikon: Stichwort Pensionsfonds
117
118
119
see ERISA and 401(k), p. 44
120
Portability means that the retirement provision already saved does not expire when the
employee switches to a new employer, but can be “ported” to the new job.
121
see Section 2.1.3 Harmonisation of the European capital markets and the Single Currency
122
Biometric risk involves the risk of disability/incapacity for work, the longevity risk, the
mortality risk and (possibly) survivors’ benefits.
123
Vergleich, 2000, p. 45f
124
see ibid, p. 47
125
see moneyextra, Guide to Personal Equity Plans (PEPs), 2001
126
see moneyextra, Guide – Individual Savings Accounts, 2001
127
For a description of the differences between defined benefit and defined contribution
schemes, see notes 63 and 64.
128
see MDR, Umschau – Aktuell, Sichere Rente?, 21 Nov. 2000
129
see Aktiv – Wirtschaftszeitung für Arbeitnehmer, Bauen an der privaten Säule, 2000
216
NOTES
130
London, 2000, p. 59
131
132
London, 2000, p. 58
133
see Fiduciary duty and prudence, p. 45
134
see note 64
135
London, 2000, p. 59f
136
137
138
139
see European Commission, Communication of the Commission Com (1999) 232, Financial
Services: Implementing the Framework for Financial Markets, Action Plan, Brussels, 11
May 1999
140
see European Commission, Communication of the Commission: Towards a Single Market
for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p. 2
141
see ibid
142
see ibid
143
see European Commission, Financial Services: Commission outlines Action Plan for single
financial market, Brussels, 1999
144
145
see The EU UCITS Directive, p. 37
146
147
see European Commission, Supplementary Pensions: The next Steps, Brussels, 19 May 1998
148
see European Commission, Financial Services: Commission outlines Action Plan for single
financial market, Brussels, 1999
149
To ensure a harmonised scope, the proposed Pension Fund Directive will only cover those
legal entities that are not attributable to social security funds and that use the funded
method, so it will not cover systems and pension provisions using the pay-as-you-go
method (see European Commission, Communication of the Commission: Towards a Single
Market for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p. 20).
150
The proposal is expected by mid-2000, and its adoption is anticipated in 2002 (see European
Commission, Communication of the Commission Com (1999) 232, Financial Services:
Implementing the Framework for Financial Markets, Action Plan, Brussels, 11 May 1999, p.
25).
151
For information on the co-ordination of taxes in EU Member States relating to pension
funds, see European Commission, Communication of the Commission: Towards a Single
Market for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, pp. 38ff
152
Commission of the European Communities, Proposal for a Directive of the European
Parliament and of the Council on the activities of institutions for occupational retirement
provision, Com (2000) 507 final, Brussels, 11 October 2000
153
Best Practice for Second Pillar Pension Funds, 1999, p. 3f
154
May 1999, p. 8
217
NOTES
155
For further information on the components of the fit and proper criteria, such as
professional expertise, integrity and accountability, see Pragma Consulting, Rebuilding
Pensions – Recommendations for a European Code of Best Practice for Second Pillar
Pension Funds, 1999, p. 7. The section “The fit and proper criteria” on p. 173, also provides
an overview of the fit and proper criteria in the United Kingdom.
156
see The changing regulatory situation in the EU, p. 79
157
For a discussion of the differences in interpretation of the prudent man rule, see Table 16,
p. 50.
158
see AS-Fonds – German retirement pension investment funds, p. 38
159
Daten, Fakten, Entwicklungen: BVI-Aktivitäten im Jahre 1999, 2000, p. 28
160
The Commission draws attention to the fact that in the USA, pension funds invest 0.3% of
their assets in venture capital and thus account for 47% of private equity investment in the
USA (see European Commission, Communication of the Commission Com (1999) 232,
Financial Services: Implementing the Framework for Financial Markets, Action Plan,
Brussels, 11 May 1999), and forecasts that pension funds will play a key role in creating
pan-European venture capital markets (see European Commission, Communication of the
Commission: Towards a Single Market for Supplementary Pensions, Brussels, Com (99) 134
final, 11 May 1999, p. 16).
161
For more information on these positive “side-effects” of the increased use of pension funds,
Best Practice for Second Pillar Pension Funds, 1999, p. II.
162
May 1999
163
164
see ibid, p. 2
165
166
see ibid, p. 2
167
see ibid, p. 13
168
see ibid, p. 24
169
170
This figure includes foreign funds of German origin; excluding them, the per capital
invested assets amounted to DM 6,816 DM at the end of 1999.
171
see Brigitte Weining, 1,7 Billionen Mark sind noch lange nicht genug, 20 June 2000
172
Daten, Fakten, Entwicklungen: Entwicklung der Investmentfonds im Jahre 1999, 2000, p. 17
173
see Bundesverband Deutscher Investment-Gesellschaften e.V. (BVI), Statistiken allgemein
Geldvermögen, 1999
174
see Brigitte Weining, 1,7 Billionen Mark sind noch lange nicht genug, 20 June 2000
175
176
incl. investment companies of German origin
177
178
179
see AS-Fonds – German retirement pension investment funds, p. 38
218
NOTES
180
181
see ibid, p. 15
182
see ibid, p. 11
183
see ibid, p. 10
184
see Special Funds – a significant occupational pension instrument in Germany, p. 40
185
see Investment Company Institute, U.S. Household Ownership of Mutual Funds in 2000,
in: Fundamentals, Investment Company Institute Research in brief, Vol. 9/No. 4, August
2000, p. 1
186
see Investment Company Institute, Mutual Fund Factbook 2001 Edition: Chapter 4 Mutual
Fund Ownership and Shareholder Characteristics, May 2001, p. 44
187
Shares held directly via retail funds, as well as employer-financed or personal pension
plans are counted as privately held.
188
189
see Investment Company Institute, U.S. Household Ownership of Mutual Funds in 1999,
in: Fundamentals, Investment Company Institute Research in brief, Vol. 8/No. 5, September
1999
190
191
see ibid, p. 40
192
see Investment Company Institute, Mutual Fund Developments in 1998, in: Perspective,
Vol. 5/No. 2, February 1999, p. 3
193
see Investment Company Institute, Mutual Fund Developments in 1998, in: Perspective,
Vol. 5/No. 2, February 1999, p. 2 and p.5, for 1999 figures see Investment Company
Institute, Mutual Fund Factbook 2000 Edition: Chapter 1 U.S. Mutual Fund Developments
in 1999, May 2000, p. 2; for 2000 figures see Investment Company Institute, Mutual Fund
Factbook 2001 Edition: Chapter 3 U.S. Mutual Fund Developments 1990-2000, May 2001, p.
29
194
see Investment Company Institute, Mutual Fund Factbook 2001 Edition: Data Section, May
2001, p. 64
195
Vol. 3/No. 3, July 1997, p. 8
196
see Roye, Paul, Mutual Funds - A Century of Success; Challenges and Opportunities for the
Future, Washington D.C., 9 December, 1999
197
198
see Investment Company Institute, Mutual Funds and the Retirement Market, in:
Fundamentals, Investment Company Institute Research in brief, Vol. 9/No. 2, May 2000,
p. 1
199
Fundamentals, Investment Company Institute Research in brief, Vol. 9/No. 2, May 2000, p.
2
200
Funds and the Retirement Market, May 2000, p. 49
201
202
Vol. 3/No. 3, July 1997, p. 8
203
Funds and the Retirement Market, May 2000, p. 53
204
Vol. 3/No. 3, July 1997, p. 3
219
NOTES
205
For a list of ICI members at 31 December 1999, see Investment Company Institute, Annual
Report 1999, May 2000, p. 49ff
206
A fund complex is a group of funds that are essentially jointly managed or marketed and
that consist of one or more fund families.
207
see Investment Company Institute, Mutual Fund Factbook 2000 Edition: Chapter 4 The
Structure and Regulation of Mutual Funds, May 2000, p. 38
208
see Affiliated transactions and self-dealing, p. 59
209
see Roye, Paul, Mutual Funds - A Century of Success; Challenges and Opportunities for the
Future, Washington D.C., 9 December, 1999
210
211
212
and The changing regulatory situation in the EU, p. 79
213
see Section 5.1.1 Prudence, not extensive quantitative restrictions, in the EU and the USA
214
215
see Investment Company Institute, Mutual Fund Factbook 2000 Edition: Data Section, May
2000, p. 105
216
The aim is to ensure that investments in US funds should be treated in the same way for
withholding and capital gains taxes as direct investments in US equities or investments via
non-US funds.
217
218
219
Formerly “Twentieth Century Funds” (see Investment Company Institute, Continuing a
Tradition of Integrity, in: Perspective, Vol. 3/No. 3, July 1997, p. 1).
220
see U.S. Securities and Exchange Commission, Transcript of the Conference on the Role of
Independent Investment Company Directors Part II, Washington D.C., 23 & 24 February
1999
221
see ibid
222
In the person of Harvey Goldschmid, the SEC’s General Counsel (see U.S. Securities and
Exchange Commission, Transcript of the Conference on the Role of Independent
Investment Company Directors Part II, Washington D.C., 23 & 24 February 1999).
223
1999
224
In the person of Barry Barbash, Director of the Division of Investment Management at the
SEC (see U.S. Securities and Exchange Commission, Transcript of the Conference on the
Role of Independent Investment Company Directors Part II, Washington D.C., 23 & 24
February 1999; for information on the SEC’s Division of Investment Management, see The
SEC’s role, p. 50).
225
Arthur Levitt, SEC Chairman, favours the voluntary initiative by the Investment Company
Institute (ICI) to achieve better practice (see Levitt, Arthur, Keeping Faith with the
Shareholder Interest: Strengthening the Role of Independent Directors of Mutual Funds, 22
March 1999).
226
227
228
Vol. 3/No. 3, July 1997, p. 3f
220
NOTES
229
The European Commission has plans for a Pension Fund Directive (see Section 2.1.3
Harmonisation of the European capital markets and the Single Currency, and The
changing regulatory situation in the EU, p. 79)
230
Best Practice for Second Pillar Pension Funds, 1999, p. 8 and Remedies, not punishment,
p. 169.
231
see EU authorities, p. 165
232
The general trend towards occupational pensions, including those based on pension funds,
and in turn the steadily gaining importance of DC and hybrid plans (combining the
features of DC and DB systems), plus evidence of the very general trend towards
personalisation and a wider choice, represent challenges for the supervisory authorities
(see Pragma Consulting, Rebuilding Pensions – Recommendations for a European Code of
Best Practice for Second Pillar Pension Funds, 1999, p. 32).
233
234
see ibid, p. 6
235
see ibid, p. 7
236
237
Council Directive 85/611/EEC of 20 December 1985 on the coordination of laws, regulations
and administrative provisions relating to undertakings for collective investment in
transferable securities (UCITS)
238
According to Article 2 Directive 85/611/EEC, closed-end funds are excluded from the scope
of this Directive. However, section 6 in the Explanatory Memorandum states the
Commission’s intention to harmonise other types of UCITS than open-end funds at a later
date.
239
see Preamble to Directive 85/611/EEC
240
Art. 5 Directive 85/611/EEC
241
Second Bank Co-ordination Directive, Directive 90/619 EEC (amended by 92/96/EEC)
“Third Life Insurance Directive”, Directive 93/22/EEC “Investment Services Directive”
242
see European Commission, Proposal to amend Directive Directive 85/611/EEC, 98/0243 –
Com (1998) 451 final, p. 5
243
There are no regulations governing the market access of the management company,
regulatory provisions or regulations on the supervision of the largest shareholders of these
companies.
244
245
The EU Member States must transpose this amended Directive into national law by no later
than 30 June 2002 so that it comes into force no later than 31 December 2002 (see Article 3 of
the Proposal for a European Parliament and Council Directive amending Directive
85/611/EEC on the coordination of laws, regulations and administrative provisions relating
to undertakings for collective investment in transferable securities (UCITS) with a view to
regulating management companies and simplified prospectuses).
246
247
Com (1998) 451 final, p. 2
248
Proposal for a European Parliament and Council Directive amending directive 85/611/EEC
on the coordination of laws, regulations and administrative provisions relating to
undertakings for collective investment in transferable securities (UCITS), 98/0242 – Com
(1998) 449 final
249
Proposal for a European Parliament and Council Directive amending Directive 85/611/EEC
on the coordination of laws, regulations and administrative provisions relating to
221
NOTES
undertakings for collective investment in transferable securities (UCITS) with a view to

regulating management companies and simplified prospectuses, 98/0242 – Com (1998) 451
final
250
Art. 5 (3) 1st indent Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998)
449 final and 98/0243 Com (1998) 451 final
251
Art. 5 (3) 2nd indent leg. cit.
252
Directive 93/22/EEC
253
Art. 2 (2) h) leg. cit. expressly excludes from its scope UCITS, their depositaries and
management companies.
254
The aim is long-term retirement provision (sect. 37h (1) KAGG).
255
sect. 37h (2) KAGG
256
257
sect. 37h KAGG; if AS-Fonds acquire land or shares in property companies, the
corresponding provisions for special property funds apply (sect. 37k (1) in conjunction with
sect. 37d KAGG); if they acquire silent partnerships, the relevant provisions for special
investment funds apply (sect. 37k (1) KAGG).
258
sect. 37i (1) leg. cit.
259
sect. 37i (1) No. 3 in conjunction with sect. 25b (1) sent. 1 No. 2 leg. cit.; these may be both
retail and special funds (see Special Funds – a significant occupational pension instrument
in Germany).
260
261
The terms and conditions of the AS-Fonds must state whether and to what extent property
and silent partnerships may be acquired (directly and indirectly) (sect. 37i (2) leg. cit.).
262
sect. 37i (4) sent. 2 leg. cit.
263
264
265
266
267
268
sect. 37m (1) leg. cit.
269
270
271
272
see ibid, p. 51
273
see Germany’s latest pensions reform, p. 16
274
see Funded supplementary private pension (pillar 3), p. 18
275
276
see Gerke, Wolfgang/Bank, Matthias, Spezialfonds als Instrument im Rahmen der
betrieblichen Altersversorgung, in: Kleeberg, Jochen M./Schlenger, Christian, Handbuch
Spezialfonds: ein praktischer Leitfaden für institutionelle Anleger und Kapital-
anlagegesellschaften, Bad Soden, 2000, pp. 213–230, p. 222
277
sect. 1 (2) KAGG
278
Spezialfonds: ein praktischer Leitfaden für institutionelle Anleger und Kapital-
anlagegesellschaften, Bad Soden, 2000, pp. 213–230, p. 218f
279
see ibid, p. 214f
280
see A quick look at strategic asset allocation, p. 124
222
NOTES
281
see Hilka, Andreas/Schnabel, Herbert, Anforderungen an das Spezialfonds-Management
der Zukunft aus Anlegersicht, in: Kleeberg, Jochen M./Schlenger, Christian, Handbuch
Kapitalanlagegesellschaften, Bad Soden, 2000, pp. 899–915, p. 904
282
283
Practice for Second Pillar Pension Funds, 1999
284
It thus covers certain pillar two retirement provision (see Table 6, p. 13) DC and DB
schemes (see notes 64 and 63).
285
286
see Section 2.1.1 Inherent weakness in pay-as-you-go state pension schemes increases the
need for personal retirement planning, p. 5
287
288
see ibid, p. II
289
1999 and Investment Company Institute, Continuing a Tradition of Integrity, in:
Perspective, Vol. 3/No. 3, July 1997, p. 13
290
Structure and Regulation of Mutual Funds, May 2000, S. 33
291
292
General Rules and Regulations promulgated under the Investment Company Act of 1940
293
see Investment Company Institute, ICI Investor awareness Series, Understanding the Role
of Mutual Fund Directors, 1999
294
see U.S. Securities and Exchange Commission, Rulemaking, How it works, 2000
295
see Roye, Paul, Maintaining the Pillars of Protection in the New Millenium, Washington
D.C., 21 May 1999
296
Written documentation of the fundamental investment policy to the SEC on registration in
accordance with 8(b) Investment Company Act of 1940 and changes in the fundamental
investment policy in accordance with Section 13(a) leg. cit.
297
Safekeeping of fund assets in accordance with Section 17(f) leg. cit. and the right of the SEC
in accordance with section 17(g) leg. cit. to force employees of the management company
to access fund assets have led to the provision of insurance cover for theft or
embezzlement.
298
Redeemable securities in accordance with Sections 22(c) and (d) leg. cit., right of
redemption in accordance with Section 22(e) leg. cit. and definition of redeemable
securities in accordance with section 2(a)(32) leg. cit.
299
300
Transactions by certain related parties and fund issuers in accordance with Section 17 leg.
cit., fund involvement in issues by affiliates in accordance with Section 10(f) leg. cit.,
advisory contract in accordance with Section 15 leg. cit., election rules for the Board of
Directors in accordance with Section 16 leg. cit. and the ability of the SEC or individual
shareholders/unit-holders to take legal action in the event of suspected breach of fiduciary
duty (see Fiduciary duty and prudence, p. 45), by the investment adviser or the fund
directors, in accordance with Section 35 leg. cit.
223
NOTES
301
302
of Mutual Fund Directors, 1999, p. 4
303
Investment advisers are all investment advisers including fund management companies,
although the latter are regulated not only by the Investment Adviser Act, but also by the
Investment Company Act.
304
see Rule 12b-1 in Annual operating expenses, p. 152
305
see Shareholder/Unit-holder fees – Sales load, p. 152
306
Structure and Regulation of Mutual Funds, May 2000, pp. 35ff
307
see U.S. Securities and Exchange Commission – Division of Investment Management, SEC
Roundtable on Investment Adviser Regulatory Issues: Investment Advisers in Today’s
Competitive Markets/Modernization of Adviser Regulation, Washington D.C., 23 May 2000
308
309
Other significant institutions excluded from the application of the Investment Adviser Acts
are the banks.
310
Levitt, Arthur, In the Best Interest of Beneficiaries: Trust and Public Funds, Washington
D.C., 30 March 1999 illustrates the extent of pay-to-play using a number of cases pursued
(including criminal cases), and discusses counter-measures, emphasising in particular the
importance of effective audit committees.
311
312
see Personal investing by affiliated persons, p. 58
313
see note 155
314
since when there have been numerous amendments: 1980, 1983, 1984, 1986, 1987, 1989,
1990 and 1991 Amendments.
315
see Investment Company Institute, Annual Report 1999, May 2000, p. 28f
316
see ERISA Industry Committee (ERIC), Getting the Job done: A White Paper on Emerging
Pension Issues, Washington DC, 11 July 1996, p. 1
317
EET applies, i.e. it is not the contributions that are taxed, but the pension payouts, which
may either take the form of a one-time payout or can be annuitised.
318
319
see note 63
320
see note 64
321
322
For a discussion of ways on how to better integrate unconventional jobs into ERISA, see
Gordon, Michael, Updating ERISA, April 1998.
323
324
see Investment Company Institute, Annual Report 1999, May 2000, p. 28f
325
see Gordon, Michael, Updating ERISA, April 1998, p. 2
326
see Section 5.1.1 Prudence, not extensive quantitative restrictions, in the EU and the USA
327
328
see ibid, p. 1
329
Today, 401(k) plans are the most popular form of private sector DC pension plans. 403(b)
and 457 plans are the public sector counterparts (see Louge, Dennis E./Rader, Jack S.,
224
NOTES
Managing pension plans: a comprehensive guide to improving plan performance, Boston

330
Vergleich, 2000, p. 45f
331
Fundamentals, Investment Company Institute Research in brief, Vol. 9/No. 2, May 2000, p.
7
332
see Rodrick, S./Rosen, C. (eds.), Employee Stock Ownership Plans – A Practical Guide to
ESOPs and Other Broad Ownership Programs, Orlando (Florida), 1999, p. 80
333
Louge, Dennis E./Rader, Jack S., Managing pension plans: a comprehensive guide to
p. 41
334
p. 43f
335
What is important here is the core idea that total risk must be analysed, rather than the risk
of the individual investment (see Diversification, p. 108; Foreign currency assets, p. 112;
and Section 5.1.7 Special criteria for defined benefit plans).
336
Whereas the prudent man rule was the standard for almost the whole of the 20th century,
the prudent investor rule is now well on the way to displacing it from this position of pre-
eminence and to being applied by almost all US courts.
337
Portfolio management in accordance with ERISA must satisfy the following criteria: “with
the care, skill, prudence, and diligence, under the circumstances then prevailing, that a
prudent man acting in a like capacity and familiar with such matters would use in the
conduct of an enterprise of a like character and with like aims” (section 404(a)(1)(B)
Employee Retirement Income Security Act of 1974 (“ERISA”)).
338
see section 404 Employee Retirement Income Security Act of 1974 (“ERISA”)
339
In the case of an ESOP (see Diversification in the USA in general, and for Employee Stock
Ownership Plans (ESOPs) in particular, p. 109), the exclusive benefit rule also means e.g.
that the fiduciary may not accede to employee demands to preserve jobs, to pay out above-
average additional wage payments, to preserve unprofitable plants or retail outlets or to
take other steps that could impair maximisation of the value of the pension plan portfolio
(see Rodrick, S./Rosen, C. (eds.), Employee Stock Ownership Plans – A Practical Guide to
ESOPs and Other Broad Ownership Programs, Orlando (Florida), 1999, p. 81).
340
p. 43
341
see ibid, p. 57
342
Com (1998) 449 final, p. 5
343
see Section 4.1.1 Prohibition of transactions in the USA involving conflicts of interest, p. 58
344
345
see Diversification in the USA in general, and for Employee Stock Ownership Plans
(ESOPs) in particular, p. 109
346
p. 42
347
see Section 5.2.1 SIP – Statement of Investment Principles/Policy, p. 123
348
p. 43
225
NOTES
349
p. 52
350
section 409 Employee Retirement Income Security Act of 1974 (“ERISA”)
351
see discussion of the “prudent man rule“ on p. 47 in Fiduciary duty and prudence, p. 45
352
The corresponding arguments can be found in Section 5.1.1 Prudence, not extensive
quantitative restrictions, in the EU and the USA
353
The time-consuming duty to keep abreast of the latest developments in mainstream capital
market theory and the related empirical studies certainly does not mean that the fiduciary
has to believe in and apply with all new findings, but rather that the fiduciary must
examine them to be in a position to substantiate their rejection or application in respect of
the portfolio under the fiduciary’s charge (see Louge, Dennis E./Rader, Jack S., Managing
pension plans: a comprehensive guide to improving plan performance, Boston
354
p. 44f
355
see Principles for Businesses, p. 171
356
see Financial Services Authority, Policy Statement: The FSA Principles for Businesses,
United Kingdom, October 1999, margin note 20
357
see Principles for Businesses, p. 172: Principle 8
358
see Principles for Businesses, p. 172: Principle 6
359
360
U.S. Securities and Exchange Commission, The investor’s advocate - How the SEC protects
investors and maintains market integrity, Washington D.C., December 1999 provides a
brief overview of these and other US capital market laws that are only of peripheral
importance for investment funds.
361
see U.S. Securities and Exchange Commission, The investor’s advocate - How the SEC
protects investors and maintains market integrity, Washington D.C., December 1999
362
For a list of the most important self-regulatory organisations, see U.S. Securities and
Exchange Commission, The investor’s advocate - How the SEC protects investors and
maintains market integrity, Washington D.C., December 1999.
363
For a description of the differences between court and administrative actions, see ibid.
364
The SEC’s homepage is at http://www.sec.gov
365
366
see ibid, p. 27
367
368
For a discussion of the differences in interpretation of the prudent man rule in the USA and
the EU, see Table 16, p. 50
369
see Diversification, p. 108
370
371
372
373
For a more detailed, albeit not conclusive list, see Pragma Consulting, Rebuilding Pensions
– Recommendations for a European Code of Best Practice for Second Pillar Pension Funds,
1999, p. 25.
374
see Section 5.1.3 Active portfolio management as an example of a structured portfolio
management approach to implementing qualitative investment rules, p. 95
226
NOTES
375
Independent Investment Company Directors Part I, Washington D.C., 23 & 24 February
1999
376
see U.S. Securities and Exchange Commission, SEC Interpretation: Matters concerning
Independent Directors of Investment Companies, Washington D.C., 14 October 1999
377
378
see ibid, p. 27
379
In Germany, only during the one-year securities lock-up period, but in the USA essentially
at all times.
380
see note 64
381
see note 63
382
Best Practice for Second Pillar Pension Funds, 1999, p. VIf
383
384
see Roye, Paul, Mutual Funds – A Century of Success; Challenges and Opportunities for
the Future, Washington D.C., 9 December, 1999
385
386
1999
387
Independent Directors of Investment Companies, Washington D.C., 14 October 1999; and
U.S. Securities and Exchange Commission, Transcript of the Conference on the Role of
1999
388
see McDonald, Michael, Ethics and Conflict of Interest, British Columbia, 1995
389
Section 17 Investment Company Act of 1940
390
391
Rule 17j-1 of the General Rules and Regulations promulgated under the Investment
Company Act of 1940
392
see Section 6.1.6 Oversight of internal fund procedures in the USA, p. 150
393
Roundtable on Investment Adviser Regulatory Issues: Trading Practices, Washington D.C.,
23 May 2000
394
see Section 6.3 The management company’s compliance department, p. 182
395
The UK’s FSA also addresses front running (see p. 177 in Code of Practice for Approved
Persons).
396
Roundtable on Investment Adviser Regulatory Issues: Other Conflicts of Interest,
Washington D.C., 23 May 2000
397
398
399
Section 17(a) Investment Company Act of 1940
400
These rules and regulations are the following General Rules and Regulations promulgated
under the Investment Company Act of 1940: Exemption of Certain Underwriting
Transactions Exempted by Rule 10f-1 in accordance with Rule 17a-1, Exemption of Certain
Purchase, Sale or Borrowing Transactions in accordance with Rule 17a-2, Exemption of
Transactions with Fully Owned Subsidiaries in accordance with Rule 17a-3, Exemption of
227
NOTES
Transactions Pursuant to Certain Contracts in accordance with Rule 17a-4, Pro Rata
Distribution Neither “Sale” nor “Purchase” in accordance with Rule 17a-5, Exemption of
Transactions with Certain Affiliated Persons in accordance with Rule 17a-6, Exemption of
Certain Purchase or Sale Transactions Between an Investment Company and Certain
Affiliated Persons Thereof in accordance with Rule 17a-7, Mergers of Certain Affiliated
Investment Companies in accordance with Rule 17a-8 and Purchase of Certain Securities
From a Money Market Fund by an Affiliate, or an Affiliate of an Affiliate in accordance with
Rule 17a-9.
401
of Mutual Fund Directors, 1999, p. 20f
402
Section 17(b) Investment Company Act of 1940
403
Not to be confused with the equally critical practice of self-investment (see p. 108 in Fixed
maximum percentage of fund assets in securities of a single issuer), which involves
investing the fund’s money in the fiduciary’s own or third party securities.
404
section 406(b)(1) Employee Retirement Income Security Act of 1974 (“ERISA”)
405
Such transactions may be permitted under exceptional circumstances (section 408 leg. cit.),
but the conditions include a requirement that a detailed list of each of this type of
transaction during the reporting period must be provided to the supervisory authority as a
part of the annual report (section 103 leg. cit.).
406
section 406(b)(2) leg. cit.
407
breach of fiduciary duty, see Breach of fiduciary duty, p. 49
408
section 406(a)(1) Employee Retirement Income Security Act of 1974 (“ERISA”) and section
406 ERISA
409
Section 17(d) Investment Company Act of 1940
410
see Investment Company Act and Investment Adviser Act, p. 41
411
Equal treatment as opposed to preferencing does not mean here that all funds must receive
the same allocation, but that at least all funds should have the same investment strategy.
412
413
23 May 2000
414
415
Effective 1 May 1975, the SEC abolished the existing system of fixed fees and introduced a
system of negotiable fees (still in place today) so as to strengthen competition.
416
Breach of fiduciary duty, see Breach of fiduciary duty, p. 49
417
Customer consent is deemed given if disclosure requirements are complied with.
418
Best execution see Section 6.1.6 Oversight of internal fund procedures in the USA
419
see U.S. Securities and Exchange Commission – The Office of Compliance, Inspections and
Examinations, Inspection Report on the Soft Dollar Practices of Broker/Dealers, Investment
Advisers and Mutual Funds, Washington D.C., 22 September 1998
420
This regulation defines in particular the nature and scope of the services covered and
permitted by it; these are the following permitted activities:
x Advice – including in the form of newspapers or similar – concerning the valuation of
securities or their current supply/demand situation, as well as buy/sell
recommendations.
x The preparation of research and reports on issuers, industries, securities, the
macroeconomic environment, portfolio strategies and portfolio performance.
x The execution of securities transactions and ancillary services, such as clearing,
settlement and safekeeping.
x Products and services with mixed applications, i.e. research is only part of the business.
The rest of the business must be paid in “hard” dollars, unless the customer’s consent
228
NOTES
has been obtained in advance following disclosure of the transaction. Appropriate

documentation and storage of this documentation must also be ensured.
421
This paragraph is from 1975; the SEC updated standards in Section 28(e) in 1976 (“1976
Release”) and 1986 (“1986 Release”).
422
As a rule (exceptions in accordance with the “1986 Release”, see note 421), a broker/dealer
cannot therefore sell third party research that is generally obtainable (for a consideration)
without any significant delay against soft dollars.
423
Subject to certain limits, services other than research are permitted, but there is increasing
abuse and inadequate or no disclosure in this area. For example, office rent or office
equipment leases, mobile phones, personal expenses, salaries, advertising expenses, legal
expenses, hotels and hire cars, and travel, including entertainment programmes, etc., are
being illegally paid with soft dollars.
424
A general note that various services and products were “paid” with soft dollars is not
sufficient because of a lack of specification. On the other hand, there is no need to list each
individual service/product, but a classification of these must be presented.
Instruments for complying with these disclosure requirements include the form to be filed
with the SEC by the investment adviser on registration (and updated annually) (“Form
ADV ”, see p. 76 in Section 4.3.1 Disclosure of all material facts in the USA, in particular in
conflict of interest cases) and the prospectus.
425
For case studies on SEC sanctions relating to soft dollars, see note 33 in U.S. Securities and
Exchange Commission – The Office of Compliance, Inspections and Examinations,
Inspection Report on the Soft Dollar Practices of Broker/Dealers, Investment Advisers and
Mutual Funds, Washington D.C., 22 September 1998.
426
The SEC is considering a regulation to require the preparation and storage of files on soft
dollars by investment advisers (see “VIII. Recommendations” in U.S. Securities and
Exchange Commission – The Office of Compliance, Inspections and Examinations,
Inspection Report on the Soft Dollar Practices of Broker/Dealers, Investment Advisers and
Mutual Funds, Washington D.C., 22 September 1998).
427
For a definition of compliance, see Section 6.3 The management company’s compliance
department
428
For a summary of recommended internal control procedures as regards soft dollars, see
U.S. Securities and Exchange Commission – The Office of Compliance, Inspections and
Advisers and Mutual Funds, Washington D.C., 22 September 1998.
429
see Section 6.1.6 Oversight of internal fund procedures in the USA
430
breach of fiduciary duty, see Fiduciary duty and prudence, p. 49
431
section 406(b)(3) Employee Retirement Income Security Act of 1974 (“ERISA”)
432
Best Practice for Second Pillar Pension Funds, 1999, p. III
433
434
435
see Deutschen Vereinigung für Finanzanalyse und Asset Management (DVFA), DVFA-
Standesrichtlinien, Dreieich (undated)
436
sect. 31 (1) No. 2 WpHG: “An investment services enterprise is required to make efforts to
avoid conflicts of interest and to ensure that if conflicts of interest are unavoidable, the
customer order is executed such that the customer’s interests are safeguarded.”
sect. 32 (1) No. 1 and No. 2 WpHG: “An investment services enterprise or an enterprise
affiliated with it is prohibited:
229
NOTES
1. from recommending to customers of the investment services enterprise the purchase or

sale of securities, money market instruments or derivatives if and to the extent that the
recommendation does not coincide with the customers’ interests;
2. from recommending to customers of the investment services enterprise the purchase or
sale of securities, money market instruments or derivatives for the purpose of
manipulating prices in a particular direction for the proprietary transactions of the
investment services enterprise or its affiliated enterprise;”
437
1999
438
see ibid
439
For information on the ICI, see The US Investment Company Institute, p. 189
440
Vol. 3/No. 3, July 1997, p. 14
441
442
1999
443
These rules are the following: General Rules and Regulations promulgated under the
Investment Company Act of 1940: Rule 17f-1: Custody of Securities with Members of
National Securities Exchanges, Rule 17f-2: Custody of Investments by Registered
Management Investment Company, Rule 17f-4: Deposits of Securities in Securities
Depositories, Rule 17f-5: Custody of Investment Company Assets Outside the U.S., Rule
17f-6: Custody of Investment Company Assets with Futures Commission Merchants and
Commodity Clearing Organizations
444
see Section 6.5.2 The duties of the custodian in the EU, p. 188
445
Com (1998) 449 final, p. 5
446
447
448
for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p. 20; and Pragma
Consulting, Rebuilding Pensions – Recommendations for a European Code of Best Practice
for Second Pillar Pension Funds, 1999, p. III
449
450
Com (1998) 449 final, p. 5
451
Art. 10 (1) Directive 85/611/EEC
452
Art. 10 (2) leg. cit.
453
Art. 6 leg. cit.
454
Com (1998) 451 final, p. 5
455
see Proposal for a European Parliament and Council Directive amending Directive
85/611/EEC on the coordination of laws, regulations and administrative provisions relating
to undertakings for collective investment in transferable securities (UCITS) with a view to
regulating management companies and simplified prospectuses, 98/0243 – Com (1998) 451
final
230
NOTES
456
Art. 5 (3) 2nd indent b) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998)
457
see Art. 7 (1) Directive 85/611/EEC
458
459
460
Com (1998) 449 final, p. 5
461
see Section 6.5.1 Obligations of auditors and actuaries to the supervisory authority in the
EU, p. 187
462
463
see Principles for Business, p. 173, Principle 10
464
1999
465
see Section 6.1.2 Organisational structures, p. 146
466
see Section 6.1.5 Transactions requiring approval in the USA, p. 148
467
1999
468
469
1999
470
For a definition of interested person, see Section 2(a)(19) Investment Company Act of 1940.
471
Section 10(a) Investment Company Act of 1940 states that not more than 60% of the
directors may be interested persons.
472
1999, Levitt, Arthur, Keeping Faith with the Shareholder Interest: Strengthening the Role of
Independent Directors of Mutual Funds, 22 March 1999 concurs
473
474
For an overview of the proposals by the ICI’s Advisory Group on best practice for fund
boards, see Investment Company Institute, ICI Investor awareness Series, Understanding
the Role of Mutual Fund Directors, 1999, p. 23f.
475
see Levitt, Arthur, Keeping Faith with the Shareholder Interest: Strengthening the Role of
Independent Directors of Mutual Funds, 22 March 1999
476
see ibid; and Roye, Paul, Avoiding Complacency, Advocating Reform: The Commission’s
Independent Fund Directors Initiative, Washington D.C., 28 October 1999
477
see Nomination of new independent directors and setting compensation by the
independent directors themselves in the USA, p. 70
478
see Independent legal counsel to the board in the USA, p. 71
479
see Extended disclosure requirements concerning directors in the USA, p. 72
480
see Roye, Paul, From Roundtable to Reform: Thoughts on How to Improve Fund
Governance, Washington D.C., 22April 1999
481
see Johnson, Norman, Remarks to the Mutual Fund Directors Education Council,
Washington D.C., 18 February 2000
482
Best Practice for Second Pillar Pension Funds, 1999, p. V
231
NOTES
483
1999
484
see Rule 12b-1 Annual operating expenses, p. 152
485
1999
486
1999
487
see Independence criteria, p. 67
488
489
1999
490
see ibid
491
see ibid
492
493
1999
494
see ibid
495
Section 31(a)(1) Investment Company Act of 1940
496
1999
497
see Definition of a minimum number of independent directors in the EU and the USA,
p. 69
498
see Roye, Paul, Avoiding Complacency, Advocating Reform: The Commission’s
499
500
501
p. 69
502
see Roye, Paul, Avoiding Complacency, Advocating Reform: The Commission’s
503
504
505
506
see Principles for Businesses, p. 172, Principle 3
507
508
For an outline of the market impact problem, see the definition of transaction costs (see The
core terminology of active portfolio management, p. 102).
232
NOTES
509
see Section 6.1.4 Prohibition on delegating the board’s fiduciary duties in the EU and the
USA, p. 148
510
see TIAA-CREF (Teachers Insurance and Annuity Association-College Retirement Equities
Fund), Corporate Governance – Shareholder Rights and Proxy Voting, March 2000
511
512
The legal basis for enforcing these duties is provided by the anti-fraud regulations of the
Investment Adviser Act, Section 206 (Prohibited Transactions by Investment Advisers) and
Section 207 (Material Misstatements) and in the Securities Exchange Act of 1933, Section
10(b) and the ensuing Rule 10b-5 (see U.S. Securities and Exchange Commission – The
Office of Compliance, Inspections and Examinations, Inspection Report on the Soft Dollar
Practices of Broker/Dealers, Investment Advisers and Mutual Funds, Washington D.C.,
22 September 1998).
513
That even modern European regulatory regimes are behind the times when it comes to
disclosing conflicts of interest involving clients is shown by the UK’s FSA, which stipulates
merely that only deliberate non-disclosure or non-disclosure without good reason is a breach of
the rules (see Code of Practice for Approved Persons, p. 176).
514
see Prospectuses in the USA, p. 130
515
This form must be filed with the SEC; it contains in particular important information on the
financial position of the investment adviser. It can normally be obtained by the general
public from the nearest SEC office.
516
Roundtable on Investment Adviser Regulatory Issues: Introductory Remarks, Washington
D.C., 23 May 2000
517
see Section 6.5.2 The duties of the custodian in the EU, p. 188
518
519
Best Practice for Second Pillar Pension Funds, 1999, p. IV
520
521
see ibid, p. 18
522
e.g. using the cost of carry model.
523
524
525
For ERISA pension funds, such a provision is contained in section 103(b)(3)(A) Employee
Retirement Income Security Act of 1974 (“ERISA”).
526
Section 2(a)(41)(A) Investment Company Act of 1940
527
Section 2(a)(41) leg. cit.
528
1999
529
see IRS-Revenue Ruling 59-60, sect. 2.02.; cited in Rodrick, S./Rosen, C. (eds.), Employee
Stock Ownership Plans – A Practical Guide to ESOPs and Other Broad Ownership
Programs, Orlando (Florida), 1999, p. 57
530
see the standards relating to the investment rules for supervising management in
Section 4.1 Investment rules, p. 58
531
Exceptions are the securities and cash and cash equivalents listed in Art. 19 (2) Directive
85/611/EEC (Art. 19 (4) leg. cit.).
532
533
Art. 36 leg. cit.
534
Art. 42 leg. cit.
233
NOTES
535
Com(97) 283, 1997, p. 8
536
Assuming that a supplementary pension is supposed to cover 35% of the previous salary
level after 40 working years, a pension contribution of 19% of the salary is necessary (at an
assumed return of 2%), but 10% for a 4% return and only 5% for a 6% return (see
European Commission, Supplementary Pensions: The next Steps, Brussels, 19 May 1998).
537
see Section 2.1.1 Inherent weakness in pay-as-you-go state pension schemes increases the
need for personal retirement planning, p. 5
538
see European Commission, Supplementary Pensions: The next Steps, Brussels, 19 May 1998
539
540
Portfolio theory was developed by Harry Markowitz (see Markowitz, H.M., Portfolio
Selection, in: Journal of Finance, Vol.7, 1952, pp. 77–91): assuming a risk-averse investor,
portfolios are only efficient if the risk cannot be reduced further for a given expected
return, or if no higher return can be expected for a given risk.
For an outline of the principles of Modern Portfolio Theory, see e.g. Auckenthaler, C.,
Mathematische Grundlagen des modernen Portfoliomanagements, Verlag Paul Haupt,
Berne/Stuttgart, 1996, pp. 14ff
541
542
May 1999
543
544
see Commission of the European Communities, Proposal for a Directive of the European
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 11
545
see ibid, Article 12
546
This also applies to a large extent to second and third pillar product providers.
547
see Restrictions on foreign currency assets in the EU, p. 112
548
Com(97) 283, 1997, p. 8f
549
550
Art. 1 (8) b) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
551
Art. 19 (1) i) leg. cit.
552
Funds of funds have been possible in Germany since April 1998 on the basis of the Third
Financial Markets Promotion Act, and by the end of 1999, German investors had already
invested DM 11.4bn in this type of fund. The rule here is that a maximum of 20% of fund
assets may be invested in the shares of a single subfund. The share of the fund of funds in
the total assets of one of these subfunds may not exceed 10%. If the fund invests in
subfunds of the same fund complex as the fund of funds, fees may not be charged twice
(see Bundesverband Deutscher Investment-Gesellschaften e.V. (BVI), Investment 2000 –
Daten, Fakten, Entwicklungen: Dachfonds – Vermögensverwaltung mit Investmentfonds,
2000, pp. 33ff).
553
The EU Member States may lift this ceiling to a maximum of 35%, but the fund must then
invest in a minimum of five different UCITS (Art. 24 (2) Directive 85/611/EEC as amended
by Proposals 98/0242 – Com (1998) 449 final and 98/0243 Com (1998) 451 final).
554
Art. 24 (1) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
234
NOTES
555
556
557
Art. 19 (1) f) leg. cit.
558
Art. 24a (1) and (2) leg. cit.
559
Art. 24a (4) leg. cit.
560
Art. 19 (1) h) leg. cit.
561
Art. 19 (1) g) leg. cit.
562
Art. 19 (1) b) and c) leg. cit.
563
Art. 24b (1) leg. cit.
564
565
The conditions under which involvement in securities lending is permitted are:
x suitable counterparties, such as recognised securities clearing houses, certain
authorised experts, certain credit institutions or securities firms, certain recognised
investment companies in other countries.
x the furnishing of collateral in at least the amount of the total value of the loaned
financial instruments, whereby the collateral must be deposited with a third party for
securities lending transactions with the depositary.
566
Art. 21 (4) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
567
May 1999
568
569
The European Commission has plans to present a draft Pension Fund Directive in summer
2000 (see European Commission, Communication of the Commission Com (1999) 232,
Financial Services: Implementing the Framework for Financial Markets, Action Plan,
Brussels, 11 May 1999).
570
571
for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999. This
communication presents the political conclusions of the long consultation process
following the green paper on the same topic published by the European Commission in
summer 1997 (see European Commission, Supplementary Pensions in the Single Market, A
Green Paper, Com(97) 283, 1997) and the steps the Commission thinks are required for a
single market for supplementary pensions.
572
For a description of the differing interpretations of the prudent man rule in the EU and the
USA, see the section Fiduciary duty and prudence; and in particular Table 16, p. 50.
573
574
575
Com(97) 283, 1997, p. 10
576
For a presentation of the diversification of pension fund assets in the 11 EU Member States
in 1994, plus Japan and the USA in 1994, see ibid, Table IV
577
see ibid , p. 10f
578
see Jeremy Siegel, Stocks for the long run, Irwin Professional Publishing, 1994, cited in
European Commission, Communication of the Commission: Towards a Single Market for
Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p. 47
235
NOTES
579
see Rohweder, Herold, DVFA-Lehrgang Investment Analyst – CEFA. Handout für den
Ausbildungsabschnitt Praxis des Portfolio Managements I, Dreieich, 2001, pp. 27ff
580
The five portfolio models are: (1) 100% EUR bonds, (2) 75% EUR bonds plus 25%
international equities, (3) 50% EUR bonds plus 50% international equities, (4) 30% EUR
bonds plus 70% international equities and (5) 100% international equities.
The development of the EUR bonds corresponds to the REX Total Market Index from
1 January 1978 to 1 January 1999, and that of the international equities to the Datastream
Total Market Index World from 1 January 1978 to 1 January 1999.
581
see Kraus, Christoph, Privatvermögen richtig anlegen, Vienna, 1999, p. 77
582
B. Solnik, “Fundamental considerations in cross-border investment: the European view”,
Forschungsstiftung des Instituts of Chartered Financial Analysis, April 1994, cited in
European Commission, Supplementary Pensions in the Single Market, A Green Paper,
Com(97) 283, 1997, p. 11
583
Best Practice for Second Pillar Pension Funds, 1999, pp. 17ff
584
see ibid, p. 20
585
see Section 5.1.7 Special criteria for defined benefit plans, p. 114
586
587
see ibid, p. 23
588
589
590
see ibid, p. 17
591
see ibid, p. 47
592
see ibid, p. 4
593
Com(97) 283, 1997, Table IX
594
see ibid, p. 14
595
provision, Com (2000) 507 final, Brussels, 11 October 2000, p. 6
596
Com(97) 283, 1997, p. 13
597
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 18 (6).
598
The portfolio is only the benchmark in the case of a DC plan (see note 64).
599
“Markets providing equity financing to a company during its early growth stages”
(Commission of the European Communities, Proposal for a Directive of the European
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 6 i).
600
However, the European Commission does not view as a restriction a rule that provides for
a ceiling of 70% of fund assets for investments in equities.
601
The European Commission repeatedly emphasises that ALM is most effective without
portfolio diversification in the sense of quantitative investment restrictions that impair risk
diversification (see European Commission, Communication of the Commission: Towards a
Single Market for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p.
21f).
602
236
NOTES
603
Countries that apply the prudent man rule.
604
605
This proposal is based on the 1997 pensions green paper (European Commission,
Supplementary Pensions in the Single Market, A Green Paper, Com(97) 283, 1997) and the
ensuing 1999 communication on the same topic (see European Commission,
Communication of the Commission: Towards a Single Market for Supplementary Pensions,
Brussels, Com (99) 134 final, 11 May 1999).
606
European Commission, Supplementary Pensions in the Single Market, A Green Paper,
Com(97) 283, 1997
607
The BVI thinks that optional coverage of biometric risk (see note 122) is a core criterion for
an ideal retirement provision system (see Bundesverband Deutscher Investment-
Gesellschaften e.V. (BVI), Investment 2000 – Daten, Fakten, Entwicklungen: Altersvorsorge
und Investmentfonds – ein internationaler Vergleich, 2000, p. 50).
608
In 1999, inflows to life insurance policies amounted to DM 114.8bn (DM 119 in 2000, see
Allianz AG/Dresdner Bank AG, Meine Zukunft. Das Vorsorgemagazin von Allianz und
Dresdner Bank, Issue No. 1, May 2001, Munich/Frankfurt am Main, p. 24), while the
pension funds operated by the banks and investment firms only recorded inflows of
DM 2bn (see Michael Sauga, Aufmarsch der Lobbyisten, in: Der Spiegel 31/2000, p. 73).
609
see Gesamtverband der Deutschen Versicherungswirtschaft e.V. (GDV), Die European
Commission hat gemeinschaftliche Regelungen zu einem Binnenmarkt für die zusätzliche
Altersversorgung vorgeschlagen (undated)
610
see ibid, p. 66
611
see ibid, p. 17
612
The second condition is the assurance of a life-long income, i.e. annuitisation of the payout.
613
614
German labour minister Riester has stated that “highly speculative equity funds (are)
unsuited” to partially replacing the state pension (see Michael Sauga, Aufmarsch der
Lobbyisten, in: Der Spiegel 31/2000, p. 73) – however, the fund industry does not
recommend such investment funds for retirement provision in any case, which essentially
cancels out Riester’s argument, playing as it does on the uncertainty factor.
615
see Michael Sauga, Aufmarsch der Lobbyisten, in: Der Spiegel 31/2000, p. 73
616
see Section 5.1.2 Modern Portfolio Theory, p. 90
617
618
see Gesamtverband der Deutschen Versicherungswirtschaft e.V. (GDV), Die European
Commission hat gemeinschaftliche Regelungen zu einem Binnenmarkt für die zusätzliche
Altersversorgung vorgeschlagen (undated)
619
see Wheelan, H., Going for middle ground, in: IPE – Investment & Pensions Europe, IPE
International Publishers Ltd., Volume 5, Number 2, February 2001, p. 8
620
Directive 90/619 EEC (amended by Directive 92/96/EEC) “Third Life Insurance Directive”
621
For a very brief overview of the EU rules on investment policies for life insurance
companies, see European Commission, Supplementary Pensions in the Single Market, A
Green Paper, Com(97) 283, 1997, Table X
622
Com(97) 283, 1997, p. 15
623
May 1999
237
NOTES
624
Nevertheless, there are still quantitative investment restrictions; for example US mutual
funds are prohibited from buying (see Section 12(a) (1) Investment Company Act of 1940)
or selling securities (see Section 12(a) (3) Investment Company Act of 1940) short.
625
626
627
628
see Michaud, R.O., Efficient Asset Management, Harward Business School Press, Boston
Massachusetts, 1998
629
see Loistl, O., Kapitalmarkttheorie, in: Achleitner/Thoma (eds.), Handbuch Corporate
Finance, Düsseldorf, 2001, Chapter 3.3, p. 7
630
The CAPM assumes that there is a risk-free investment and that funds can be borrowed at
the same risk-free rate. The other assumptions are:
x perfect capital market
x non-saturation and risk-aversion on the part of the investor; this demands a utility
function whose first and second derivation are greater than zero. A quadratic utility
function meets these requirements.
x normally distributed returns
x homogeneous investor expectations, i.e. an informationally efficient capital market
631
see Loistl, O., Kapitalmarkttheorie, in: Achleitner/Thoma (eds.), Handbuch Corporate
Finance, Düsseldorf, 2001, Chapter 3.3, p. 8
632
The semi-strict form of the Efficient Market Hypothesis (in addition to the weak and the
strict form) postulates that all publicly available information is already captured in the
prices, i.e. the corresponding securities are quoted at the correct prices, at least as far as the
publicly available information is concerned (this definition of informational efficiency can
be traced back to Fama: see Fama, E.F., Efficient Capital Markets: A Review of Theory and
Empirical Work, in: Journal of Finance, Vol. 25, 1970, pp. 383–418, cited in Bruns,
Christoph/Meyer-Bullerdiek, Frieder, Professionelles Portfolio management: Aufbau.
Umsetzung und Erfolgskontrolle strukturierter Anlagestrategien, Stuttgart, 2nd ed., 2000, p.
80f).
633
p. 45
634
see Ibid, p. 48f
635
see Ibid, p. 49–53
636
“Active risk” in The core terminology of active portfolio management, p. 99
637
see “Prohibition on delegation“, in Fiduciary duty and prudence, p. 49
638
see “Prudent Investor Law“,Fiduciary duty and prudence, p. 49
639
For an outline of the market impact problem, see the definition of transaction costs (The
core terminology of portfolio management, p. 102).
640
see Grinold, R./Kahn, R., Active Portfolio Management: A quantitative approach for
providing superior returns and controlling risk, 2nd ed., New York, 2000, p. 3
641
Inefficiencies are inevitably only temporarily observable phenomena that disappear
immediately as soon as they are known to the market, i.e. the individuals and institutions
operating on the capital market, are then exploited by them and thereby eliminated (see
Schwarz, Günther, Anlageentscheidungsprozess und aktives Risikomanagement, in:
Kutscher, Christof/Schwarz, Günther (eds.), Aktives Portfolio Management, Methodische
Fragen der Vermögensverwaltung Volume 2, Zurich, 1998, pp. 209–239, p. 209f).
642
643
see Ebertz, Th., Scherer, B., Das Rahmenwerk des aktiven Portfoliomanagements, in:
Kleeberg, J./Rehkugler, H. (eds.), Handbuch des Portfoliomanagements, Uhlenbruch, Bad
Soden, 1998, p. 197
238
NOTES
644
see Schwarz, Günther, Anlageentscheidungsprozess und aktives Risikomanagement, in:
Fragen der Vermögensverwaltung Volume 2, Zurich, 1998, pp. 209–239, p. 211
645
see Section 5.2.5 Performance Presentation Standards (PPS), p. 136
646
see Section 5.1.2 Modern Portfolio Theory, p. 135
647
Bruns, Christoph/Meyer-Bullerdiek, Frieder, Professionelles Portfolio management:
Aufbau. Umsetzung und Erfolgskontrolle strukturierter Anlagestrategien, Stuttgart, 2nd ed.,
2000, pp. 85–88 summarises the current state of knowledge on market informational
efficiency: in the past, anomalies were frequently observed, i.e. return trends that
contradict the EMH (e.g. January or small company effect), and these were frequently
regarded as statistically significant. However, the economic significance, i.e. the future
exploitability of such anomalies, is largely non-existent.
648
pp. 45, 48f
649
see Expected total return, p. 100, in The core terminology of active portfolio management,
p. 99
650
see Capital Asset Pricing Model (CAPM), p. 90
651
providing superior returns and controlling risk, 2nd ed., New York, 2000, pp. 1–4
652
see ibid, p. 117f
653
see ibid, p. 17
654
see ibid, p. 6
655
p. 53
656
see Snigaroff, Robert G., The Economics of Active Management: Pension fund
management needs improvement, in: The Journal of Portfolio Management, Winter 2000,
pp. 16–24, p. 16f
657
see ibid, p. 17
658
see ibid, p. 18
659
see prudent investor rule in Fiduciary duty and prudence, p. 47
660
see Information ratio in The core terminology of active portfolio management, p. 101
661
see Thomas, Lee R. III., Active Management: Lessons for investment managers, consultants
and clients, in: The Journal of Portfolio Management, Winter 2000, pp. 25–32, p. 27
662
663
see A quick look at strategic asset allocation, p. 124
664
providing superior returns and controlling risk, 2nd ed., New York, 2000, p. 89f
665
Fragen der Vermögensverwaltung Volume 2, Zurich, 1998, pp. 209–239, p. 210f
666
667
see Fixed maximum percentage of fund assets in securities of a single issuer, p. 108
668
669
expressed as negative alphas (see Alpha in The core terminology of active portfolio
management, p. 99)
670
671
see ibid, p. 426f
239
NOTES
672
For a definition, estimation models for transaction costs and strategies for optimising the
conflicting goals of lower turnover versus far-reaching exploitation of alphas, i.e. optimum
after-costs value added (see note 675) in portfolio regrouping, see ibid, pp. 445–475).
Rohweder, H., Implementing Stock Selection Ideas: Does Tracking Error Optimization Do
Any Good?, in: The Journal of Portfolio Management, Spring 1998, pp. 49–59 argues for the
superiority of Portfolio Segmentation (PS) over Tracking Error Optimization (TEO) under
the following conditions: estimation errors frequently encountered in practice concerning
the expected residual risk/return often lead to an unfavourable ex post TEO outcome, while
TEO ex ante had still proved to be superior to PS. In addition, the transaction costs for PS
are normally lower because of the lower turnover.
673
see Transaction costs in The core terminology of active portfolio management, p. 102
674
675
see Value added in The core terminology of active portfolio management, p. 102
676
677
Inefficiencies are mostly a temporary phenomenon because they are exploited when they
are identified and are thus ultimately eliminated. In simple terms, this represents the
positive effect of the “speculators” (arbitrageurs) exploiting these inefficiencies because
their behaviour also helps improve market efficiency.
The “home country bias” is one example of a more long-term stable inefficiency: international
diversification is lower in practice than it should be in terms of capital market theory,
which results in inter-country inefficiencies that can then be exploited as active returns by
genuinely global investors (see Thomas, Lee R. III., Active Management: Lessons for
investment managers, consultants and clients, in: The Journal of Portfolio Management,
Winter 2000, pp. 25–32, p. 28).
678
see ibid, p. 31
679
see Information ratio in The core terminology of active portfolio management, p. 101
680
see Information coefficient in The core terminology of active portfolio management, p. 101
681
see Breadth in The core terminology of active portfolio management, p. 100
682
and clients, in: The Journal of Portfolio Management, Winter 2000, pp. 25–32, p. 28 and p.
30
683
see Active risk in The core terminology of active portfolio management, p. 99
684
685
see ibid, p. 29f
686
providing superior returns and controlling risk, 2nd ed., New York, 2000, p. 102f
687
see ibid, p. 89f
688
see Poddig, Thorsten/Dichtl, Hubert/Petersmeier, Kerstin, Statistik, Ökonometrie,
Portfoliomanagement, Bad Soden, 2000, p. 147
689
690
691
Information coefficients (ICs) and breadth as the two factors of the Information Ratio have
the following orders of magnitude in the case of benchmark timing: Breadth is very low
because only a single forecasting object – the benchmark – can be used instead of many
individual securities to be forecasted, which is why the IC must be very high to achieve an
Information Ratio that varies substantially from zero.
240
NOTES
692
693
see Bruns, Christoph/Meyer-Bullerdiek, Frieder, Professionelles Portfolio management:
2000, p. 115f
694
695
For a discussion of the independence problem, see Grinold, R./Kahn, R., Active Portfolio
Management: A quantitative approach for providing superior returns and controlling risk,
2nd ed., New York, 2000, p. 158
696
see ibid, p. 148
697
see ibid, pp. 90–92
698
see Steiner, Manfred/Bruns, Christoph, Wertpapiermanagement, Stuttgart, 6th ed., 1998, p.
60f
699
700
701
702
see ibid, p. 272
703
704
705
see ibid, p. 18
706
In passive portfolio management, individual risk aversion only determines the part of the
market portfolio in the overall portfolio that is the same for all.
707
708
see ibid, p. 266
709
AR, MA, ARMA, ARIMA and VARMA are cited in ibid, p. 278f.
710
see ibid, p. 278–285
711
see Bruns, Christoph/Meyer-Bullerdiek, Frieder, Professionelles Portfolio management:
2000, p. 116
712
713
see ibid, p. 447; in Loistl, O., Implementation Issues: Transaction Costs in German Equity
Markets, in: Squires, J.R., ed.: Global Portfolio Management, Proceedings of the AIMR
Seminar Exploring the Frontiers of Global Portfolio Management, AIMR, Charlottesville,
1996, pp. 84–96, Loistl cites a model for calculating transaction costs, but emphasises that
the measurement of transaction costs has yet to be solved theoretically.
714
715
see ibid, p. 5
716
see ibid, p. 122
717
241
NOTES
718
see Kieselstein, Thomas/Sauer, Andreas, Aktives Style-Management für europäische
Aktien-Spezialfonds, in: Kleeberg, Jochen M./Schlenger, Christian, Handbuch Spezialfonds:
ein praktischer Leitfaden für institutionelle Anleger und Kapitalanlagegesellschaften, Bad
Soden, 2000, pp. 519–539, p. 521f
719
720
see Section 5.1.2 Modern Portfolio Theory
721
The origins of style management are to be found in US investment banking in the early
1980s.
722
see Selection in The core terminology of active portfolio management, p. 102
723
see Benchmark timing in The core terminology of active portfolio management, p. 99
724
see Kieselstein, Thomas/Sauer, Andreas, Aktives Style-Management für europäische
Aktien-Spezialfonds, in: Kleeberg, Jochen M./Schlenger, Christian, Handbuch Spezialfonds:
ein praktischer Leitfaden für institutionelle Anleger und Kapitalanlagegesellschaften, Bad
Soden, 2000, pp. 519–539, p. 521
725
Time series STOXX Blue Chips and Broad Europe at http://www.stoxx.com/
incoming_data/hbrbcte.txt
Time series STOXX Large, Mid and Small Europe at http://www.stoxx.com/
incoming_data/hlmste.txt
726
see Bossert, Thomas, Einsatz von Derivaten in Spezialfonds, in: Kleeberg, Jochen
M./Schlenger, Christian, Handbuch Spezialfonds: ein praktischer Leitfaden für
institutionelle Anleger und Kapitalanlagegesellschaften, Bad Soden, 2000, pp. 345–379, p.
347
727
728
For a definition of alpha, see p. 99 in The core terminology of active portfolio management
729
see Transaction costs, p. 102, and Value added, p. 102, in The core terminology of active
portfolio management
730
see Value added in The core terminology of active portfolio management, p. 102
731
see Loistl, O., Computergestütztes Wertpapiermanagement, 5th ed., Munich/Vienna, 1996,
pp. 308ff
732
733
Art. 22 (4) leg. cit. added by Directive 88/220/EEC
734
735
A definition of the trackable equity index is provided by Art. 22a (2) Directive 85/611/EEC as
amended by Proposals 98/0242 – Com (1998) 449 final and 98/0243 Com (1998) 451 final, but
it is up to the EU Member States to notify the European Commission at least once a year of
the equity indices they believe can be tracked. The European Commission in turn then
publishes the list in the Official Gazette. (Art. 22a (3) Directive 85/611/EEC as amended by
Proposals 98/0242 – Com (1998) 449 final and 98/0243 Com (1998) 451 final).
736
Art. 22a (1) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
737
“Significant” is put into more concrete percentage terms by the Member States when they
transpose the UCITS Directive into national law, and Art. 26 (2) Directive 85/611/EEC of the
UCITS Directive specifies certain maximum percentages for equities, bonds and funds,
although it does allow exceptions to these on the basis of national Member State law (see
Art. 26 (3) Directive 85/611/EEC).
738
739
Proxy voting is a fiduciary duty (seeSection 4.2.4 Proxy voting, p. 73).
740
741
242
NOTES
742
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 18 (2) b).
743
section 407 Employee Retirement Income Security Act of 1974 (“ERISA”)
744
section 406 leg. cit.
745
746
see Foreign currency assets, p. 112
747
748
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 18 (3) clause b).
For a general description of the proposed Pension Fund Directive, see Section 2.1.3
Harmonisation of the European capital markets and the Single Currency, and The
changing regulatory situation in the EU, p. 79.
749
750
751
section 404(a)(1)(C) Employee Retirement Income Security Act of 1974 (“ERISA”)
752
see note 64
753
The share classes in question are common stock or convertible preferred stock; see Rodrick,
S./Rosen, C. (eds.), Employee Stock Ownership Plans – A Practical Guide to ESOPs and
Other Broad Ownership Programs, Orlando (Florida), 1999, p. 8f.
754
The definition of an ESOP is contained in Section 407(d)(6) ERISA and in Section 4975(e)(7)
Internal Revenue Code of 1986 (IRC); Rodrick, S./Rosen, C. (eds.), Employee Stock
Ownership Plans – A Practical Guide to ESOPs and Other Broad Ownership Programs,
Orlando (Florida), 1999, p. 93
755
756
IRC Section 409(h)(1); cited in ibid, p. 370
757
IRC Section 409(h)(2); cited in ibid, p. 370
758
see ibid, p. 158
759
in particular the duty of prudence (see Fiduciary duty and prudence, p. 49)
760
761
762
763
see Investment Company Act and Investment Adviser Act, p. 42
764
765
see ibid, p. 3
766
pp. 327–330
767
768
ibid, pp. 212–214 describes the standard legal precedent on the breach of fiduciary duties
during the course of attempts to prevent a hostile takeover using an ESOP.
769
see ibid, p. 166
770
ibid, pp. 14ff describes details of the complicated rules for exercising voting rights applying
to ESOPs.
771
see ibid, p. 371
243
NOTES
772
see ibid, p. 165
773
774
see ibid, p. 172
775
see ibid, p. 161
776
The following parties may be fiduciaries: trustee (custodian, receipt of employer
contributions and payment of benefits to employees), plan administrator (appointed by the
plan sponsor to administer the ESOP; this can also involve self-appointment by the
sponsor) and the members of the Plan Investment Committee (see Rodrick, S./Rosen, C.
(eds.), Employee Stock Ownership Plans – A Practical Guide to ESOPs and Other Broad
Ownership Programs, Orlando (Florida), 1999, pp. 80 and 149).
777
If the CEO and/or directors of the company concerned are also ESOP fiduciaries, this does
not mean that they have to act in the exclusive interest of the ESOP members in all their
corporate decisions and subordinate the company’s interests to the ESOP members, but
that the fiduciary duties only apply if they are administrators of the ESOP. However, such
fiduciaries may become indirectly liable if they do not contest certain management
decisions as representatives of the shareholders’ interests (see ibid, p. 215f).
778
see ibid, p. 7
779
see ibid, p. 169
780
Deductibility is restricted in that the contributions may account for a maximum of 15% or
25% (depending on the type of ESOP) of the payroll of the employees covered by the
ESOP (“covered payroll”) (see ibid, p. 10).
781
see Fixed maximum percentage of fund assets in securities of a single issuer, p. 108
782
Rodrick, S./Rosen, C. (eds.), Employee Stock Ownership Plans – A Practical Guide to ESOPs
and Other Broad Ownership Programs, Orlando (Florida), 1999, p. 206f uses a number of
precedents to describe the conflict – that cannot always be clearly resolved for ESOP
fiduciaries – between the duties of diversification and prudence still applying in some cases
on the one hand, and the obligation to invest primarily in the shares of the employer
company on the other.
783
see ibid, p. 3
784
785
Rodrick, S./Rosen, C. (eds.), Employee Stock Ownership Plans – A Practical Guide to ESOPs
and Other Broad Ownership Programs, Orlando (Florida), 1999, pp. 179–190 discusses this
ESOP/401(k) combination
786
see ibid, p. 154f
787
IRC Section 401(a)(28)(B); cited in Rodrick, S./Rosen, C. (eds.), Employee Stock Ownership
Plans – A Practical Guide to ESOPs and Other Broad Ownership Programs, Orlando
(Florida), 1999, p. 154
788
Com(97) 283, 1997, Table IX
789
790
Com(97) 283, 1997, p. 15
791
May 1999
792
793
794
see ibid, p. 24
244
NOTES
795
Fund-specific factors are above all the liabilities structure (for DB only), risk aversion and
the fund’s investment strategy.
796
see The changing regulatory situation in the EU, p. 79
797
Best Practice for Second Pillar Pension Funds, 1999, p. IVf
798
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 18 (6) clause b)
799
see The fundamental concept of diversification, p. 108
800
USD bonds have maintained their relative share, but also because USD bond issues by non-
US issuers have risen.
801
pp. 332–337
802
For example, the long-standing high (and sometimes double-digit) growth rates for the
Southeast Asian Tigers in the summer of 1997 were abruptly replaced by a recession (the
“Asian crisis”), leading to the decimation of local stock market capitalisation; this was
exacerbated by the accompanying massive currency devaluations against the USD and the
EUR. For example, the Thai baht, which triggered the Asian crisis when it was floated by
the Bank of Thailand, and which was tied to a dollar-denominated basket of currencies for
many years, fell from a more or less fixed USD:THB rate of around 25 to more than 55 in
January 1998. The Indonesian rupee was hit even harder: one USD cost around 2,500
rupees prior to the crisis, but this soared to almost 17,000 at certain times after the crisis.
Market prices suffered similarly: the Thai SET Index was high above 1,000 in the early
1990s, but fell to around 200 in the wake of the crisis.
803
see the discussions of commodities as an asset class in A quick look at strategic asset
allocation, p. 124
804
Institutional efficiency should be distinguished from technical efficiency and information
processing efficiency, and consists of competition efficiency (the activities of a single
market player do not affect the share price), trading efficiency (the realisation of any risk
positions may not be hampered by trading barriers, such as a prohibition on futures or
integrality conditions), transactional efficiency (there can be no explicit transaction barriers
such as stock transfer tax, special terms for any block trades or bid-ask spreads affecting
prices) and market access efficiency. See Loistl, O., Zur neueren Entwicklung der
Finanzierungstheorie, in: Die Betriebswirtschaft, Vol. 50, p. 47–84, 1990, p. 69f
805
see Matthes, Rainer/Klein, Matthias, Professionelle Gestaltung der Investment-Richtlinien
für Spezialfondsmandate, in: Kleeberg, Jochen M./Schlenger, Christian, Handbuch
806
p. 74
807
see ibid, p. 79f
808
Dynamic Minimum Funding Requirement
809
810
Best Practice for Second Pillar Pension Funds, 1999, p. IIf
811
see ibid, p. 9
812
see ibid, p. 10
813
Instead of contribution cuts, there may be improved benefits, granting contribution
holidays or even refunds.
245
NOTES
814
815
EU, p. 187
816
In the case of funds with guaranteed returns or biometric risks covered by the fund (see
note 122), a solvency range may exceptionally be appropriate. Similar to the case of a
DMFR, however, any solvency range should be dynamically structured, e.g. using a value-
at-risk model (see Pragma Consulting, Rebuilding Pensions – Recommendations for a
European Code of Best Practice for Second Pillar Pension Funds, 1999, p. 13). However, a
guaranteed minimum return is viewed as conflicting with the prudent man rule (see The
changing regulatory situation in the EU, p. 79) and the fundamental principle of
fundability (see The “Rebuilding Pensions” study, p. 41) because they are inefficient in
practice and hinder optimum asset allocation (see Pragma Consulting, Rebuilding Pensions
1999, p. 31).
817
The UK’s FSA requires from financial services companies that “a firm must maintain
adequate financial resources.” (see The Principles themselves, p. 172, Principle 4), and
refers for details to the draft “Prudential Sourcebook” (see Financial Services Authority,
Policy Statement: The FSA Principles for Businesses, United Kingdom, October 1999,
margin note 27).
818
see Section 5.1.1 Prudence, not extensive quantitative restrictions, in the EU and the USA,
p. 79
819
The UK’s FSA believes that “adequate risk management systems” are a basic precondition
for the business activities of financial services companies (see The Principles themselves, p.
172, Principle 3). The FSA has plans to published corresponding details on this topic in its
draft “Prudential Sourcebook” (see Financial Services Authority, Policy Statement: The FSA
Principles for Businesses, United Kingdom, October 1999, margin note 23).
820
821
see Foreign currency assets, p. 112
822
Com(97) 283, 1997, p. 10
823
Liabilities to beneficiaries exist only in the case of DB schemes, because with DC schemes,
beneficiaries have the status of owners, and their pension account is inherently always
funded (see note 64).
824
825
see ibid, p. 5
826
see ibid, p. 22
827
828
see ibid, p. IV
829
see The “Rebuilding Pensions” study, p. 41
830
see ibid, p. 16
831
see Löffler, Gunter, Ausfallsorientierte Performanceanalyse, in: Finanzmarkt und Portfolio
Management, Vol. 14, No. 3, 2000, pp. 239–251, p. 239
832
see Jansen, Dennis/Koedijk, Kees/de Vries, Casper, Portfolio selection with limited
downside risk, in: Journal of Empirical Finance 7, 2000, pp. 247–269, p. 247
833
246
NOTES
834
835
see ibid, p. 130
836
see ibid, p. 131
837
Management, Vol. 14, No. 3, 2000, pp. 239–251, p. 239
838
see ibid, p. 242
839
see Capital Asset Pricing Model (CAPM), p. 90
840
Kapitalanlagegesellschaften, Bad Soden, 2000, pp. 285–314, p. 292f
841
see Hilka, Andreas/Schnabel, Herbert, Anforderungen an das Spezialfonds-Management
der Zukunft aus Anlegersicht, in: Kleeberg, Jochen M./Schlenger, Christian, Handbuch
842
843
see ibid, p. 299
844
see Equation 13, p. 117
845
For the calculation of the curvature (“fourth moment”) of a distribution and the
characteristics of leptokurtic distributions, see Bruns, Christoph/Meyer-Bullerdiek, Frieder,
Professionelles Portfolio management: Aufbau. Umsetzung und Erfolgskontrolle
strukturierter Anlagestrategien, Stuttgart, 2nd ed., 2000, p. 41
846
see Jansen, Dennis/Koedijk, Kees/de Vries, Casper, Portfolio selection with limited
downside risk, in: Journal of Empirical Finance 7, 2000, pp. 247–269, p. 249
847
A normal distribution has a curvature of 3, a leptokurtic distribution has one greater than
three and a platykurtic distribution has one less than three (see Poddig, Thorsten/Dichtl,
Hubert/Petersmeier, Kerstin, Statistik, Ökonometrie, Optimierung: Methoden und ihre
praktische Anwendung in Finanzanalyse und Portfoliomanagement, Bad Soden, 2000, p.
143).
848
However, there are no studies of the extent of these estimation errors (see Löffler, Gunter,
Ausfallsorientierte Performanceanalyse, in: Finanzmarkt und Portfolio Management, Vol.
14, No. 3, 2000, pp. 239–251, p. 239).
849
850
The parameters are the mean value and variance.
851
The non-parametric model is the most exact for samples, but it is problematic for out-of-
sample situations(see Jansen, Dennis/Koedijk, Kees/de Vries, Casper, Portfolio selection
with limited downside risk, in: Journal of Empirical Finance 7, 2000, pp. 247–269, p. 252).
852
Management, Vol. 14, No. 3, 2000, pp. 239–251, p. 247f
853
see note 64
854
p. 64f
855
For example, the massive costs to European telecommunications companies of buying
UMTS licences have led to a substantial volume of corporate bond issues.
247
NOTES
856
see Reichert, Horst, Überlegungen zur Benchmarkwahl für Spezialfonds, in: Kleeberg,
Jochen M./Schlenger, Christian, Handbuch Spezialfonds: ein praktischer Leitfaden für
institutionelle Anleger und Kapitalanlagegesellschaften, Bad Soden, 2000, pp. 701–723, p.
721
857
858
see Section 6.2 Supervisory authority, p. 165
859
see Sections 6.1.5 Transactions requiring approval in the USA and 6.1.6 Oversight of
internal fund procedures in the USA
860
For instance ALM (see Section 5.1.7 Special criteria for defined benefit plans).
861
see Section 5.2 Disclosure, p. 123
862
863
USA
864
see Trone, Donald B. et al, The Management of Investment Decisions, 1996, p. 106
865
see ibid, p. 105f
866
867
p. 115
868
see The fundamental concept of diversification, p. 108
869
see Steiner, Manfred/Bruns, Christoph, Wertpapiermanagement, Stuttgart, 6th ed., 1998, p.
87
870
see ibid, p. 88f
871
For a general definition of asset class, see Sharpe, William F., Asset Allocation, in: Magin,
John L., Tuttke, Donald L., Managing Investment Portfolios: A Dynamic Process, 2nd ed.,
New York, 1990. In particular the requirement for the existence of asset class-specific
returns that are not perfectly correlated with the other classes should be mentioned here.
872
p. 105f
873
On average, the management fees for private equity and hedge funds are around double
those for typical equity funds (investing in liquid securities). Profit sharing of between 20%
to 30% comes on top of these high fees.
874
Because there are no benchmarks, success can be measured as a comparison with
opportunity costs, normally in the form of previous investments in liquid securities: a
successful private equity programme should produce a return higher than listed alternative
securities. This return premium is composed of subpremiums for illiquidity, the frequently
high level of gearing and the efficiencies generated by the managers/owners. In concrete
terms, this means creating an artificial benchmark based on a liquid index, plus a premium
of 3–5 percentage points.
875
management approach to implementing qualitative investment rules.
876
see Cullie, B./Smith, M., What they don’t always tell you, in: IPE – Investment & Pensions
Europe, IPE International Publishers Ltd., Volume 5, Number 2, February 2001, p. 55
877
see the remarks on the diversification effect, p. 113 in Growing importance of investment in
foreign currency assets in the USA, p. 113
878
see Peterson, W., Commodities poised for entry, in: IPE – Investment & Pensions Europe,
IPE International Publishers Ltd., Volume 5, Number 2, February 2001, p. 56f
879
see ibid, p. 114f
248
NOTES
880
see ibid, p. 117
881
see ibid, p. 156
882
883
To be able to calculate pension obligation over- or underfunding, an existing discounted
pension obligation of 100,000 is assumed in the case presented; this is 100% covered by the
initial value of the portfolio and which increases at a constant growth rate of 7% per
annum.
884
see Prohibition on delegation in Fiduciary duty and prudence, p. 49
885
p. 152
886
Excluding pension contributions (i.e. growth from capital gains/income only)
887
Return 2 standard deviations above the expected value
888
Assuming normally distributed returns, the actual over-/underfunding is not less than the
minimum underfunding with a 97.75% probability, and lies between the minimum and
maximum overfunding with a 95.5% probability.
889
Return 2 standard deviations below the expected value
890
p. 154
891
see note 63
892
see note 64
893
894
see ibid, p. 16
895
see ibid, p. V
896
see ibid, p. 24
897
There are only liabilities in the case of DB pension funds.
898
899
900
see Trone, Donald B. et al, The Management of Investment Decisions, 1996, p. 104
901
see note 63
902
903
see Trone, Donald B. et al, The Management of Investment Decisions, 1996, pp. 107ff
904
905
see Shareholder/Unit-holder fees – Sales load, p. 152
906
In contrast to the deferred sales load, the redemption fee may be payable directly to the
fund on redemption of the shares/units.
907
The exchange fee may be charged for switching between funds of the same fund family.
908
Some funds charge this account maintenance fee, especially if the account balance is low.
909
see Investment Company Institute, Mutual Fund Factbook 2000 Edition: Chapter 3 U.S.
Mutual Fund Fees and Expenses, May 2000, p. 27
910
911
Vol. 3/No. 3, July 1997, p. 14
912
Fees are “a charge or payment for services”; see U.S. Securities and Exchange
Commission – Division of Investment Management, Report on Mutual Fund Fees and
Expenses, Washington D.C., December 2000, footnote 2).
249
NOTES
913
Expenses are “any cost or charge”; see U.S. Securities and Exchange Commission – Division
of Investment Management, Report on Mutual Fund Fees and Expenses, Washington D.C.,
December 2000, footnote 2).
914
915
see U.S. Securities and Exchange Commission – Division of Investment Management,
Report on Mutual Fund Fees and Expenses, Washington D.C., December 2000
916
see Fidelity Investments, Prospectus June 24, 2000: Small Cap Stock Fund & Mid-Cap Stock
Fund & Large Cap Stock Fund, Boston, 2000, p. 7f
917
Fund & Large Cap Stock Fund, Boston, 2001, p. 8
918
919
Fund & Large Cap Stock Fund, Boston, 2000, p. 8f
920
see http://www.sec.gov/mfcc/mfcc-int.htm
921
922
see http://www.sec.gov/consumer/inwsmf.htm
923
Report on Mutual Fund Fees and Expenses, Washington D.C., December 2000, footnote 51
924
925
U.S. Securities and Exchange Commission – Division of Corporation Finance, Updated
Staff Bulletin No. 7 “Plain English Disclosure”, Washington D.C., 7 June 1999 describes in
detail the Plain English rules to be followed.
926
1999
927
Vol. 3/No. 3, July 1997, p. 14
928
1999
929
see Section 5.2.6 Consideration of the effects of taxes on returns in the USA, p. 143
930
1999
931
Art. 27 (1) 1st indent Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998)
932
933
934
Art. 32 leg. cit.
935
Art. 35 leg. cit.
936
Art. 30 Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final and
98/0243 Com (1998) 451 final
937
938
Schedule A in the Annex to Directive 85/611/EEC applies to full prospectus, and for
simplified prospectuses, Schedule C in the Annex to Directive 85/611/EEC as amended by
Proposals 98/0242 – Com (1998) 449 final and 98/0243 Com (1998) 451 final applies.
939
Exceptions to the rule are defined in Art. 29 (2) Directive 85/611/EEC as amended by
Proposals 98/0242 – Com (1998) 449 final and 98/0243 Com (1998) 451 final
940
941
Art. 31 leg. cit.
250
NOTES
942
Com (1998) 451 final, p. 9
943
see Art. 28 (3) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
944
945
946
947
Com (1998) 451 final, p. 10
948
Schedule C in the Annex to Directive 85/611/EEC as amended by Proposals 98/0242 – Com
(1998) 449 final and 98/0243 Com (1998) 451 final
949
In addition to disclosure in the prospectuses, this must also be disclosed in the terms and
conditions of contract, in the instruments of incorporation of the UCITS and in all its
advertising materials.
950
and 98/0243 Com (1998) 451 final
951
952
953
954
Art. 27 (1) Directive 85/611/EEC; these obligatory enclosures may be dispensed with under
certain circumstances (see Art. 27 (2) leg. cit.).
955
956
Art. 32 leg. cit.
957
958
959
960
For a detailed list of the individual documents that must be disclosed to the supervisory
authorities and to the members and beneficiaries of the pension plan, see section 101
Employee Retirement Income Security Act of 1974 (“ERISA”).
961
section 104(a) Employee Retirement Income Security Act of 1974 (“ERISA”)
962
section 104(b) leg. cit.
963
For information on the scope of this report, see section 103(b) leg. cit..
964
965
966
If shareholder/unit-holder information is regarded as the core element of the security to be
provided by asset management standards, it is difficult to understand why only a few EU
Member States insist on members of pension funds being sent the annual report (see
Practice for Second Pillar Pension Funds, 1999, p. 35).
967
968
969
see Section 5.1.7 Special criteria for defined benefit plans, p. 114
970
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 11
971
ibid, Article 12
972
ibid, Article 13 c) iii)
973
ibid, Article 13 c) ii)
974
ibid, Article 13 c) vi)
251
NOTES
975
The members of pension funds should be entitled to further information on request and to
be informed where this is available. Such a rule appears to be necessary in particular in
view of the trend towards growing simplicity of informational documents (for example
simplified prospectuses, see Prospectuses in the EU, p. 133) (see Pragma Consulting,
Rebuilding Pensions – Recommendations for a European Code of Best Practice for Second
Pillar Pension Funds, 1999, p. VII). For details of a proposal on the minimum content to be
included in annual reports, see Pragma Consulting, Rebuilding Pensions –
1999, p. 35.
976
For example an overview of the key data of the fund over the past five years, including
information on current developments affecting asset allocation, markets and the
macroeconomic environment relevant to the fund (see Pragma Consulting, Rebuilding
Pension Funds, 1999, p. 35).
977
If the principle is observed that greater risk should be accompanied by greater disclosure,
members of DC schemes, who must themselves bear the benefit risk (see note 64), have a
greater need for information (see Pragma Consulting, Rebuilding Pensions –
1999, p. 36).
978
see Annual operating expenses, p. 152
979
see Prospectuses in the EU, p. 133
980
981
see ibid, p. 21
982
983
Best Practice for Second Pillar Pension Funds, 1999, p. VII
984
The proposal is that such a valuation should be required at least every three years.
985
986
see Section 6.2.2 A-priori and a-posteriori controls in the EU and the USA, p. 166
987
988
see Fischer, Bernd, Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001, p. 172
989
see ibid, pp. 3 and 6
990
see ibid, p. 6
991
CAPM and the Efficient Markets Hypothesis in its (semi-) strict form must at least be
qualified, as although these models permit out- and underperformance, they classify them
purely as luck or bad luck.
992
993
see ibid, p. 479
994
Association for Investment Management and Research (ed.), AIMR Performance
Presentation Standards – AIMR PPS, Charlottesville, 12 February 1999
995
see Fischer, Bernd, Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001, pp.
172-174
996
Association for Investment Management and Research (ed.), Global Investment
Performance Standards, Charlottesville, 14 April 1999
997
Deutsche Vereinigung für Finanzanalyse und Asset Management (DVFA) – Kommission
für Performance Presentation Standards, Fischer, B./Lilla, J./Wittrock, C. (eds.), DVFA-
Performance Presentation Standards, 2nd expanded ed., 2000
252
NOTES
998
999
1000
1001
The Sharpe Ratio of a portfolio is the quotient of the surplus return (portfolio return
achieved less the risk-free rate) and total risk, see Fischer, Bernd, Performanceanalyse in
der Praxis, Munich/Vienna, 2nd ed., 2001, p. 271.
1002
For the Information Ratio, see p. 101 in The core technology of active portfolio
management
1003
The value-at-risk of a portfolio is the maximum amount of loss that may affect it with a
certain probability (e.g. 97.7% confidence interval, if fluctuations up to a maximum of 2
standard deviations are included) with a certain period of time, see Fischer, Bernd,
Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001, S 247.
1004
1005
see ibid, p. 40
1006
1007
Fischer, Bernd, Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001 provides a
comprehensive overview of the guidelines and recommendations in DVFA PPS and also
discusses other international PPS and additional related topics, presenting numerous
practical examples.
1008
For the calculation of time-weighted and value-weighted return, see Fischer, Bernd,
Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001, pp. 14–17
1009
AIMR PPS and GIPS have lower standards for the frequency of valuations (see Fischer,
Bernd, Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001, p. 206).
1010
DVFA PPS also allow the use of net return, although this is linked to the recommendation
that the average management fees should also be disclosed.
1011
1012
see The SEC’s role in PPS, p. 141
1013
see Fischer, Bernd, Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001, p. 215f
1014
see ibid, p. 231
1015
see ibid, p. 237
1016
For the calculation of duration, see ibid, p. 241f.
1017
see note 1003
1018
The risk measure of default probability follows a concept similar to value-at-risk, but
instead of calculating a maximum loss from a given probability and period (as with VaR), it
aims to compute a default probability from a given loss and period (see Fischer, Bernd,
Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001, p. 251).
1019
see Active risk in The core terminology of active portfolio management, p. 99
1020
see ibid, p. 257
1021
For the significance of consistent price sources, see 0 Measuring return, p. 138
1022
261-271
1023
ibid, pp. 285–291 presents a number of measures.
1024
see ibid, p. 291f
1025
see note 1001
1026
The Treynor Ratio is calculated in the same way as the Sharpe Ratio, with the difference
that the denominator is portfolio beta rather than volatility (see Fischer, Bernd,
Performanceanalyse in der Praxis, Munich/Vienna, 2nd ed., 2001, p. 274).
1027
Calculation follows the same principle as Jensen’s alpha, but the expected return multiplied
by volatility is subtracted from the actual return, rather than the beta (see ibid, p. 278).
253
NOTES
1028
Jensen’s alpha is the difference between the actual return of the portfolio/fund and the
return of a portfolio with the same systematic risk (i.e. the same beta) calculated using
CAPM (see ibid, p. 275).
1029
1030
see ibid, p. 280
1031
see Deutsche Vereinigung für Finanzanalyse und Asset Management (DVFA) –
Kommission für Performance Presentation Standards, Fischer, B./Lilla, J./Wittrock, C. (eds.),
DVFA-Performance Presentation Standards, 2nd expanded ed., 2000, points 3.7.1 and 3.7.2
1032
Selecting a benchmark is strategic asset management and is thus not a part of the
measurement of management performance, because the portfolio manager is not
responsible for taking decisions at this level.
1033
1034
Consistent price sources for securities are more difficult to achieve than for currencies;
DVFA PPS do not address this problem.
1035
101–103
1036
see The SEC’s role, p. 50
1037
Roundtable on Investment Adviser Regulatory Issues: Advertising and Performance
Reporting, Washington D.C., 23 May 2000
1038
see Portability of performance data, p. 142
1039
see Hunt, Isaac Jr., Remarks to 1997 Investment Adviser Conference Investment Company
Institute, Washington D.C., 6 June 1997
1040
see http://www.sec.gov/consumer/mperf.html
1041
Other suitable criteria recommended for fund selection include reading prospectuses and
annual/half yearly reports, evaluating fund costs (the SEC offers a free tool for this purpose
that can be downloaded from its web site (see “Mutual Fund Cost Calculator“, p. 132 in
Prospectuses in the USA)), the tax implications, the size of the fund and an assessment of
risks (e.g. using volatility).
1042
1043
1999
1044
Vol. 3/No. 3, July 1997, p. 14
1045
1046
see SEC’s no-action letter concerning the Bramwell Growth Fund, August 1996.
1047
1048
Roundtable on Investment Adviser Regulatory Issues: Advertising and Performance
Reporting, Washington D.C., 23 May 2000
1049
see Levitt, Arthur, Mutual Fund Directors Education Council Conference, Washington
D.C., 17 February 2000
1050
1999
1051
254
NOTES
1052
1999
1053
see Levitt, Arthur, Opening Remarks at the SEC Roundtable on the Role of Independent
Investment Company Directors, 23 February 1999
1054
see ibid
1055
1999
1056
1057
1058
1059
1060
These documents are:
x European Commission, Supplementary Pensions in the Single Market, A Green Paper,
Com(97) 283, 1997
x European Commission, Communication of the Commission: Towards a Single Market
for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999
x European Commission, Communication of the Commission Com (1999) 232, Financial
Services: Implementing the Framework for Financial Markets, Action Plan, Brussels,
11 May 1999
1061
1062
The arrows coming from the board signify board responsibility to the entity concerned,
arrows pointing to the board signify that the originating entity is responsible to the board,
Best Practice for Second Pillar Pension Funds, 1999, p. 45.
1063
1064
see ibid, p. 9
1065
see ibid, p. 21
1066
Section 22(g) Investment Company Act of 1940
1067
1068
see ibid
1069
1070
This responsibility also extends to any liabilities present (see notes 63 and 64).
1071
1072
see Definition, p. 123
1073
1074
1075
Section 15(b) leg. cit
1076
As a rule, the investment adviser approves this contract as the original sole shareholder.
After a maximum of two years, annual approval/rejection is then a matter for the
independent directors (see U.S. Securities and Exchange Commission – Division of
Investment Management, Report on Mutual Fund Fees and Expenses, Washington D.C.,
December 2000, footnote 23).
255
NOTES
1077
Section 15(c) leg. cit
1078
1079
p. 69
1080
Governance, Washington D.C., 22 April 1999
1081
Termination is possible at any time with notice of 60 days.
1082
1083
Section 31(a)(1) Investment Company Act of 1940
1084
Section 16(b) leg. cit
In practice, the acquisition of an investment adviser is followed by the termination of its
investment advisory contract (see U.S. Securities and Exchange Commission, Transcript of
the Conference on the Role of Independent Investment Company Directors Part II,
Washington D.C., 23 & 24 February 1999).
1085
Section 15(f)(1) Investment Company Act of 1940
1086
1999
1087
1088
1089
see Bearing of Distribution Expenses by Mutual Funds, Investment Company Act Release
No. 11,414,45 Fd. Reg. 73.898, 73.904 (October 28, 1980); cited in U.S. Securities and
Exchange Commission – Division of Investment Management, Report on Mutual Fund
Fees and Expenses, Washington D.C., December 2000, footnote 29
1090
1091
see ibid
1092
see Classes of fund shares or units, p. 153
1093
“In a typical fund supermarket, the sponsor of the program – a broker-dealer or other
institution – offers a variety of services to a participating fund and its shareholders. The
services include establishing, maintaining, and processing changes in shareholder
accounts, communicating with shareholders, preparing account statements and
confirmations, and providing distribution services. For the services that it provides, the
sponsor charges either a transaction fee to its customer or an asset-based fee, generally
ranging from 0.25% to 0.40% annually of the average value of the shares of the fund held
by the sponsor's customers. The asset-based fee is paid by the fund, its investment adviser,
an affiliate of the adviser, or a combination of all three entities.” (see U.S. Securities and
Exchange Commission – Division of Investment Management, Report on Mutual Fund
Fees and Expenses, Washington D.C., December 2000, footnote 134).
1094
1095
Rules 10f-3, 17a-7, 17a-8 and 17e-1 of the General Rules and Regulations promulgated
under the Investment Company Act of 1940
1096
An insurance policy or (bank) guarantee against embezzlement or other breaches of trust.
1097
Rule 17g-1 of the General Rules and Regulations promulgated under the Investment
Company Act of 1940
1098
Rule 17d-1 leg. cit
1099
256
NOTES
1100
1101
see Proxy voting, p. 73
1102
1103
of Mutual Fund Directors, 1999, p. 14f
1104
see Soft dollars, p. 62
1105
1999
1106
1107
For a summary of the information usually required or provided in this context, see U.S.
Securities and Exchange Commission – The Office of Compliance, Inspections and
Advisers and Mutual Funds, Washington D.C., 22 September 1998.
1108
This is the “Form ADV” (see Section 4.3.1 Disclosure of all material facts in the USA, in
particular in conflict of interest cases).
1109
see U.S. Securities and Exchange Commission – The Office of Compliance, Inspections and
Advisers and Mutual Funds, Washington D.C., 22 September 1998
1110
1999
1111
The SEC emphasises that broker/dealers who (negligently) cause or help another
institution to breach a fiduciary duty to an investor make themselves liable for criminal
charges of aiding and abetting or inciting fraud (see U.S. Securities and Exchange
Commission – The Office of Compliance, Inspections and Examinations, Inspection Report
on the Soft Dollar Practices of Broker/Dealers, Investment Advisers and Mutual Funds,
Washington D.C., 22 September 1998).
1112
The duty of best execution is based on the general statutory obligations of an agent of
unrestricted loyalty and reasonable care to its principal, but it has been spelled out in more
specific terms by special capital market laws (see Investment Company Act and Investment
Adviser Act, p. 42, and Fiduciary duty and prudence, p. 45).
1113
see Transaction costs in The core terminology of active portfolio managment, p. 102
1114
Other quality characteristics are the value of any research services provided under soft
dollar arrangements, order execution efficiency, the assumption of financial risks and
response times to the principal (see U.S. Securities and Exchange Commission – The Office
of Compliance, Inspections and Examinations, Inspection Report on the Soft Dollar
Practices of Broker/Dealers, Investment Advisers and Mutual Funds, Washington D.C.,
22 September 1998).
1115
1999
1116
There are no legal provisions on maintaining this discretion in the USA.
1117
23 May 2000
1118
1999
257
NOTES
1119
23 May 2000
1120
Rule 17j-1 of the General Rules and Regulations promulgated under the Investment
Company Act of 1940
1121
1122
A serious breach of the code of ethics must be notified to the fund board without delay.
1123
1124
23 May 2000
1125
1126
Section 17(h) Investment Company Act of 1940
1127
1128
Mutual Fund Fees and Expenses, May 2000, p. 25f
1129
see Investment Company Institute, Trends in the Ownership Cost of Equity Mutual Funds,
in: Perspective, Vol.4/No. 3, November 1998, p. 3
1130
1131
General Rules and Regulations promulgated under the Investment Company Act of 1940:
Rule 12b-1 – Distribution of Shares by Registered Open-End Management Investment
Company
1132
1133
1134
These involve additional services offered to the shareholders/unit-holders, such as
freephone information services, Internet services, and the printing and mailing of
information.
1135
1136
1137
see “Class B Shares” in Classes of fund shares or units, p. 153
1138
1139
1140
1141
see Section 5.2.4 Stricter disclosure requirements for pension funds in the EU, p. 135
1142
1143
see ibid, chart 1
1144
When the Investment Company Act came into force in 1940, it still contained a number of
such maximum rates for fund fees, including for sales loads and advisory fees (see U.S.
Securities and Exchange Commission – Division of Investment Management, Report on
Mutual Fund Fees and Expenses, Washington D.C., December 2000, footnote 20).
258
NOTES
1145
1146
see The situation in the USA, p. 161
1147
1148
1149
1999
1150
1151
1152
1999
1153
1154
see ibid, p. 13
1155
1156
see ibid, Table 2
1157
The average front-end sales load fell from 8.5% in 1979 to 4.75% in 1999 (see ibid)
1158
see Rule 12b-1 in Annual operating expenses p. 152
1159
1160
see Classes of fund shares or units, p. 153
1161
Report on Mutual Fund Fees and Expenses, Washington D.C., December 2000, Table 3
1162
see ibid, Table 4
1163
see ibid, Table 5
1164
No-load and load funds together amount to 100%.
1165
Report on Mutual Fund Fees and Expenses, Washington D.C., December 2000, Table 8
1166
see ibid, Table 9
1167
see ibid, Table 10
1168
see ibid, Table 11
1169
1170
Annualisation of sales loads is a problem because the actual individual holding periods and
the loads actually paid (which are often reduced by rebates) are unknown (see U.S.
Securities and Exchange Commission – Division of Investment Management, Report on
Mutual Fund Fees and Expenses, Washington D.C., December 2000).
1171
1172
1173
1174
see ibid, p. 10
259
NOTES
1175
1999
1176
1177
These 100 funds accounted for 47% ($1.4trn) of the volume of all equity and bond funds in
the USA in 1997, 45% in 1998 ($1.5trn) and 45% in and 1999 ($2trn).
1178
see ibid
1179
1180
see ibid
1181
see ibid
1182
1183
1184
1185
1999
1186
see remarks by Prof. Ken Scott in ibid
1187
1188
1999
1189
1190
1191
Ancillary remuneration, e.g. in the form of soft dollars (see Soft dollars, p. 62).
1192
1193
1999
1194
see ibid
1195
see ibid
1196
1197
1999
1198
see Recommendation on the future institutionalisation of the board of directors in the EU,
p. 146
1199
For various relevant recommendations, which will not be repeated here, see Section 4.2.5
The essence of future standard-setting, p. 75
1200
see “The essence of future standard-setting” in Sections 4.1.3, p. 64; 4.2.5, p. 75; 4.3.3, p. 78;
5.1.9, p. 122; and 5.2.7, p. 144
1201
1202
1203
1204
Art. 46 leg. cit.
1205
and 98/0243 Com (1998) 451 final
1206
1207
260
NOTES
1208
Art. 52 (1) Directive 85/611/EEC and Art. 6c (3) to (5) Directive 85/611/EEC as amended by
Proposals 98/0242 – Com (1998) 449 final and 98/0243 Com (1998) 451 final
1209
1210
Art. 6c (8) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
1211
Art. 50 (1) Directive 85/611/EEC, Article 50 (2) to (4) Directive 85/611/EEC as amended by
Directive 95/26/EEC and Art. 52a Directive 85/611/EEC as amended by Proposals 98/0242 –
Com (1998) 449 final and 98/0243 Com (1998) 451 final
1212
Including the UCITS Contact Committee.
1213
1214
see Section 2.1.3 Harmonisation of the European capital markets and the single currency,
p. 24
1215
May 1999
1216
1217
1999
1218
Vol. 3/No. 3, July 1997, p. 14
1219
see ibid, p. 4
1220
see The situation in the USA, p. 167
1221
1222
According to Art. 1 (3) leg. cit., investment funds can be established under national law as
investment funds managed by an investment company, as a trust or as an investment
company.
1223
1224
1225
For more details of the Single European Passport, see Pragma Consulting, Rebuilding
Pension Funds, 1999, p. 32 and Section 2.1.3 Harmonisation of the European capital
markets and the single currency, p. 24
1226
Art. 5 (1) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final and
98/0243 Com (1998) 451 final
1227
For the withdrawal of authorisation, see Art. 5a (5) leg. cit.
1228
see Art. 3 to 6 Directive 93/22/EEC
1229
Art. 5a (1) 1st indent Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998)
1230
Art. 5a (1) 2nd indent Directive 85/611/EEC
1231
Art. 5a (1) 3rd indent leg. cit.
1232
and 98/0243 Com (1998) 451 final
1233
1234
1235
Art. 5d (1) leg. cit.
1236
see EU authorities, p. 165
1237
Art. 5d (1) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
1238
261
NOTES
1239
1240
1241
1242
1243
ibid, Art. 9 (1) clause b)
1244
for Supplementary Pensions, Brussels, Com (99) 134 final, 11 May 1999, p. 20f
1245
The UK’s Financial Services Authority (FSA) calls integrity a core principle for conducting
the business of the companies they supervise (see Principles for Businesses, p. 172,
Principle 1).
1246
Best Practice for Second Pillar Pension Funds, 1999, p. VI
1247
see Section 5.2.3 Annual and half-yearly reports to shareholders and supervisory
authorities in the EU and the USA, p. 135
1248
EU, p. 187
1249
Roundtable on Investment Adviser Regulatory Issues: Investment Advisers in Today’s
Competitive Markets/Modernization of Adviser Regulation, Washington D.C., 23 May 2000
1250
Roundtable on Investment Adviser Regulatory Issues: Introductory Remarks, Washington
D.C., 23 May 2000
1251
These activities include borrowing and lending, securities issues, the concentration of
investment business on certain industries or groups of industries, dealing in real estate or
commodities.
1252
Section 8 (b) Investment Company Act of 1940
1253
Section 13 (a) leg. cit.
1254
1255
see Gordon, Michael, Updating ERISA, April 1998, p. 3
1256
1257
If it were possible to enforce the principle that the supervisory authority should be relieved
of all duties that can be performed elsewhere, e.g. by the board of directors, there would be
a good chance of establishing a well define and optimised regulatory regime
1258
1259
see ibid, p. 3
1260
An example of a contrasting regime, e.g. detailed regulation combined with light
supervision is currently provided by Ireland (see Pragma Consulting, Rebuilding Pensions
1999, p. 33).
1261
see ibid, p. 33
1262
see ibid, p. VI
1263
see ibid, p. 34
1264
Art. 5d (2) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
1265
262
NOTES
1266
1267
Best Practice for Second Pillar Pension Funds, 1999, p. VIII
1268
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 14 (2)
1269
1270
For a brief overview by the FSA of the type of problems it encounters in practice and the
groups of persons notifying them, see ibid, p. 42.
1271
see ibid, p. VIII
1272
provision, Com (2000) 507 final, Brussels, 11 October 2000, Article 14 (3)
1273
ibid, Article 14 (4)
1274
1999
1275
see ibid
1276
see SEC initiative to improve mutual fund governance, p. 69, in Definition of a minimum
number of independent directors in the EU and the USA
1277
1278
1279
1280
1281
Financial Services Authority, Plan & Budget 2001/2, United Kingdom, January 2001, p. 50,
provides a summarised overview of the scope and timetable of this reform.
1282
On 28 October 1997, the Securities and Investments Board (SIB) was renamed Financial
Services Authority (FSA), but retained all the responsibilities and powers of the SIB (see
Investment Management Regulatory Organisation (IMRO), Financial Services Authority
(FSA)).
1283
see Investment Management Regulatory Organisation (IMRO), What is IMRO?
1284
see Financial Services Authority, Plan & Budget 1999–2000, United Kingdom, February
1999, p. 3
1285
see. Investment Management Regulatory Organisation (IMRO), What is IMRO?
1286
see Investment Management Regulatory Organisation (IMRO), Securities and Futures
Authority
1287
see Investment Management Regulatory Organisation (IMRO), Personal Investment
Authority
1288
see Financial Services Authority, Plan & Budget 2001/2, United Kingdom, January 2001,
margin note 67
1289
see Financial Services Authority, Plan & Budget 1999-2000, United Kingdom, February
1999, p. 9
1290
The FSA Handbook is supposed to be ready in May/June 2001 (see Financial Services
Authority, Plan & Budget 1999–2000, United Kingdom, February 1999, p. 50). Annex B
263
NOTES
provides an overview of the components of the Handbook and the planned partial
completion dates.
1291
see Financial Services Authority, Plan & Budget 1999-2000, United Kingdom, February
1999, p. 9
1292
see Financial Services Authority, FSA Handbook of Rules and Guidance
1293
see Principles for Businesses, p. 171
1294
see Fitness and propriety, p. 173
1295
see The Regulation of Approved Persons (APER), p. 174
1296
see Senior management arrangements, systems and controls (SYSC), p. 178
1297
The Principles do not apply in full to EEA firms, which are automatically authorised in the
UK (see Financial Services Authority, Policy Statement: The FSA Principles for Businesses,
United Kingdom, October 1999, p. 20).
1298
see ibid, p. 5
1299
see ibid, p. 19f
1300
see ibid, S 6
1301
see Financial Services Authority, Policy Statement: High level standards for firms and
individuals, United Kingdom, June 2000, p. 8
1302
1303
see ibid, p. 4
1304
The legal basis is the Financial Services and Markets Bill of 9 May 2000.
1305
individuals, United Kingdom, June 2000, Annex C, Chapter 1.2.4
1306
see ibid, Annex C, Chapter 1.1.2
1307
1308
1309
1310
1311
Meaning the firm at which the individual to be approved is employed.
1312
individuals, United Kingdom, June 2000, margin note 4.68, p. 38
1313
see ibid, margin note 4.59, p. 37
1314
see ibid, Annex C, Chapter 2.1
1315
1316
1317
1318
Primary responsibility for compliance lies with the company, disciplinary measures against
individuals are imposed only in cases of personal culpability (see Financial Services
Authority, Policy Statement: High level standards for firms and individuals, United
Kingdom, June 2000, p. 10).
1319
In addition to the standard approved persons, there are also those with a more far-reaching
approval because they perform a significant influence function (see ibid, Annex B p. 2).
1320
see ibid, Annex A p. 21f
1321
Approved persons can exercise other functions that are not subject to APER in addition to
controlled functions (APER 1.2.7 G and APER 1.2.8 G; see ibid, Annex B p. 2).
1322
The Statements of Principle 1 to 4 govern all approved persons, whilst the last three are
restricted to those persons with a significant influence function (see ibid, Annex B p. 2).
1323
These “other regulators” include stock exchanges or non-UK supervisory authorities (APER
4.4.2 E in ibid, Annex B p. 12).
1324
see ibid, p. 8
1325
APER 1.2.2 G (see ibid, Annex B p. 1).
1326
see e.g. Senior management arrangements, systems and controls (SYSC), p. 178
264
NOTES
1327
see Structure and objectives of the Principles, p. 171
1328
APER 1.2.3 G (see Financial Services Authority, Policy Statement: High level standards for
firms and individuals, United Kingdom, June 2000, Annex B p. 1).
1329
APER 3.3.1 E and 3.3.2 E (see ibid, Annex B p. 5f).
1330
see note 1322
1331
APER 3.2.1 E (see Financial Services Authority, Policy Statement: High level standards for
firms and individuals, United Kingdom, 2000, Annex B p. 5).
1332
More vague concepts such as “reasonable care”, “appropriate” and “suitable”, which
appear regularly in the Statements of Principle, have repeatedly led to uncertainty at
finance industry representatives reviewing the FSA Handbook because of fears that they
might represent a basis for the FSA to negatively sanction all conduct that turns out in
retrospect to be wrong. The FSA responded to these concerns by clarifying that business
“accidents” do not necessarily have to be viewed as evidence of lack of care, and that care
can only be assessed on the basis of the information that was actually available or should
have been known at the time of the decision. In other words, the assessment of conduct is
not subject to the wisdom of hindsight; see ibid, p.8f
1333
1334
1335
APER 4.1.3 E (see ibid, Annex B p. 7). APER 4.1.4 E provides a list of examples of misleading
conduct.
1336
APER 4.1.5 E
1337
APER 4.2.5 E and thus effectively a breach of Statement of Principle 2; however, because
the matter appears to be of greater significance than the formal classification, it is listed
separately here.
1338
APER 4.1.5 E and 4.2.5 E (see Financial Services Authority, Policy Statement: High level
standards for firms and individuals, United Kingdom, June 2000, Annex B p. 8 and 10).
1339
APER 4.1.6 E (see ibid, Annex B p. 8). APER 4.1.7 E provides a list of examples.
1340
1341
1342
APER 4.1.12 E (see ibid, Annex B p. 9).
1343
APER 4.1.13 E
1344
standards for firms and individuals, United Kingdom, June 2000, Annex B p. 9 and 11).
1345
APER 4.2.10 E and thus effectively a breach of Statement of Principle 2; however, because
the matter appears to be of greater significance than the formal classification, it is listed
separately here.
1346
1347
APER 4.2.6
1348
APER 4.2.8
1349
standards for firms and individuals, United Kingdom, June 2000, Annex B p. 11). APER
4.2.7 E and 4.2.9 E provide a list of examples.
1350
1351
1352
Compliance with these rules is, however, no more than an indication of compliant conduct
and is not conclusive evidence of compliance (see APER 4.3.3 E and 4.3.4 E in ibid, Annex B
p. 11f).
1353
APER 4.3.2. G (see ibid, Annex B p. 11).
1354
APER 4.4.4 E (see ibid, Annex B p. 12). APER 4.4.5 E and 4.4.7 E list criteria that are
significant for the assessment of a breach in accordance with APER 4.4.4 E and 4.4.6 E.
APER 4.4.6 E expressly emphasises the personal responsibility of all approved persons, who
are responsible in accordance with the firm’s internal rules for reporting to the FSA.
265
NOTES
1355
1356
APER 4.5.3 E and 4.5.4 E (see ibid, Annex B p. 13). APER 4.5.5 E provides a list of examples,
which are defined in greater detail by APER 4.5.12 G and 4.5.13 G.
1357
1358
firms and individuals, United Kingdom, 2000, Annex B p. 14). APER 4.5.7 E provides a list
of examples.
1359
see note 1319
1360
APER 4.5.8 E (see ibid, Annex B p. 14). APER 4.5.9 E provides a list of examples, which are
defined in greater detail by APER 4.5.14 G and 4.5.15 G.
1361
APER 4.6.3 E (see ibid, Annex B p. 16). APER 4.6.4 E provides a list of examples, but APER
4.6.12 G restricts this by recognising that it is unlikely that anybody can be an expert in all
areas of complex financial transactions.
1362
APER 4.6.11 G (see ibid, Annex B p. 17) explicitly recognises the need to delegate duties due
to the complexity of the activity.
1363
APER 4.6.5 E (see ibid, Annex B p. 16). APER 4.6.10 E cites the criteria to be taken into
consideration here. APER 4.6.13 G allows the person delegating authority to seek the
advice of legal experts, other external advisers or even the FSA in cases of doubt. The
principle here is that if the decision appears retrospectively to be wrong, no culpability
should be assumed automatically as long as it can be shown that delegation was based on a
reasonable conclusion following appropriate consideration.
1364
APER 4.6.6 E (see ibid, Annex B p. 16). APER 4.6.7 E provides a list of examples, APER 4.6.10
E cites the criteria to be taken into consideration here. APER 4.6.14 G notes the continuing
responsibility of the person delegating authority after its delegation.
1365
APER 4.6.8 E (see ibid, Annex B p. 17). APER 4.6.9 E provides a list of examples, APER 4.6.10
E cites the criteria to be taken into consideration here.
1366
APER 4.7.3 E and 4.7.4 E (see ibid, Annex B p. 19). In accordance with APER 4.7.12 G, the
nature and scope of a compliance system depends on the regulatory requirements imposed
on the business activity and its specific size and complexity.
1367
APER 4.75 E (see ibid, Annex B p. 19). APER 4.7.6 E provides a list of examples.
1368
APER 4.7.7 (see ibid, Annex B p. 20)APER 4.7.8E provides a list of examples and APER 4.7.13
G provides further examples.
1369
see Financial Services Authority, Consultation Paper: Money Laundering: the FSA’s new
role, United Kingdom, April 2000, Annex A p. 15-18
1370
firms and individuals, United Kingdom, June 2000, Annex B p. 20)
1371
see SYSC in detail, p. 180: 3.2.3 Establishment and maintenance of a compliance system, p.
180
1372
firms and individuals, United Kingdom, June 2000, Annex B p. 20). APER 4.7.11 G adds that
not only compliance itself must be ensured, but also the employees’ understanding of the
need for compliance. APER 4.7.14 G explains the action to be taken in the case of a review
and reform of a compliance system.
1373
SYSC 1.2.1 G (see ibid, Annex A p. 3)
1374
SYSC 1.2.2 G (see ibid, Annex A p. 3)
1375
see The Principles themselves, p. 172
1376
SYSC 2.1.1 R (see Financial Services Authority, Policy Statement: High level standards for
firms and individuals, United Kingdom, June 2000, Annex A p. 4).
In accordance with SYSC 1.1.1 R(1)(a), UK branches of EEA firms are exempted from the
apportionment requirement, although application of this rule to non-EEA firms is
mandatory. For the justification, see ibid, margin note 3.26, 3.29 and 3.30.
266
NOTES
1377
There must be clarity about who bears responsibility for which of the duties in question
(SYSC 2.1.1 R(1)).
1378
individuals, United Kingdom, June 2000, margin note 3.17 and 3.21
1379
see ibid, margin note 3.8 and 3.9
1380
SYSC 2.2.3 R (see ibid, Annex A p. 9).
1381
see ibid, margin note 3.17
1382
For a discussion of the difference between rules and guidance, see Principles for
Businesses, p. 171
1383
1384
Appropriateness is determined by the following factors, among others: the nature, scope
and complexity of the business activities, diversification (incl. geographical), transaction
volume and the extent of risk (SYSC 3.1.2 G). The areas typically covered by systems and
controls are governed by SYSC 3.2; see SYSC in detail: 3.2, p. 180.
1385
1386
SYSC 3.2.8 R (see ibid, Annex A p. 11f).
1387
1388
1389
Because the apportionment of responsibilities and oversight of the systems and controls
form part of the controlled functions of the approved persons regime (see Overview,
p. 174), the employees concerned must be approved persons (see Financial Services
Authority, Policy Statement: High level standards for firms and individuals, United
Kingdom, June 2000, margin note 3.16).
1390
1391
Appendix 1 of the SYSC lists those matters that fall under the remit of the home country
supervisory authority (see ibid, Annex A p. 15ff).
1392
SYSC 1.1.3 R to 1.1.5 R (see ibid, Annex A p. 2f).
1393
Ancillary activities are non-regulated activities that occur in conjunction with a regulated
activity (see ibid, Annex A p. 18).
1394
see Overview, p. 178
1395
see ibid, p. 179
1396
see ibid, p. 180
1397
SYSC 2.2.1 R to 2.2.3 G (see Financial Services Authority, Policy Statement: High level
standards for firms and individuals, United Kingdom, 2000, Annex A p. 9).
1398
SYSC 3.2.3 G and 3.2.4 G (see ibid, Annex A p. 10f).
1399
SYSC 3.2.5 G (see ibid, Annex A p. 11).
1400
1401
1402
see Code of Practice for Approved Persons: 7.5 Failure by an approved person performing
a significant influence function responsible for compliance under SYSC 3.2.8R, p. 178
1403
SYSC 3.2.8 G (see Financial Services Authority, Policy Statement: High level standards for
firms and individuals, United Kingdom, June 2000, Annex A p. 11f).
1404
1405
These involve risks relating to the fair treatment of a firm’s customers, consumer
protection, maintaining confidence in the UK financial system, and use of the system for
financial crime (SYSC 3.2.11 G; see ibid, Annex A p. 12f).
1406
SYSC 3.2.11 G (see ibid, Annex A p. 12f).
1407
SYSC 3.2.13 G and 3.2.14 G (see ibid, Annex A p. 13).
1408
1409
267
NOTES
1410
1411
1412
1413
The minimum retention period depends on the purpose of the records (SYSC 3.2.18 G; see
ibid, Annex A p. 14).
1414
SYSC 3.2.20 R to 3.2.22 G (see ibid, Annex A p. 14).
1415
see Richards, Lori, Our Shared Responsibilities for Fund Compliance, Washington D.C., 10
June 1999
1416
1417
June 1999
1418
1419
USA
1420
Roundtable on Investment Adviser Regulatory Issues: Technology and Investment Advisor
Regulation, Washington D.C., 23 May 2000
1421
see Roye, Paul, Meeting the Compliance Challenge, Washington D.C., 23 April 1999
1422
ibid
1423
see ibid
1424
see Art. 5f (1) Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final
and 98/0243 Com (1998) 451 final
1425
Art. 5f (1) leg. cit.
1426
1427
see ibid
1428
see ibid
1429
June 1999
1430
1431
see ibid
1432
see Section 6.1.6 Oversight of internal fund procedures in the USA, p. 150
1433
1434
see Section 4.3.2 Valuation of fund assets, p. 77
1435
see Section 5.2.5 Performance Presentation Standards (PPS), p. 136
1436
1437
see Section 6.2.6 The essence of future standard-setting, p. 181
1438
1439
1440
1441
Art. 5h Directive 85/611/EEC as amended by Proposals 98/0242 – Com (1998) 449 final and
98/0243 Com (1998) 451 final
1442
1443
Section 35(a) leg. cit.
1444
see breach of fiduciary duty in Fiduciary duty and prudence, p. 49
1445
Section 17(h) Investment Company Act of 1940
1446
268
NOTES
1447
see Section 6.1.7 Personal liability of fund directors in the USA, p. 151
1448
1449
Independent Directors of Investment Companies, Washington D.C., 14 October 1999; and
U.S. Securities and Exchange Commission, Transcript of the Conference on the Role of
1999
1450
1451
1452
1453
1999
1454
1455
1456
1999
1457
Art. 50a Directive 85/611/EEC as amended by Directive 95/26/EEC
1458
1459
1460
1461
“The minimum amount of the technical provisions shall be calculated by a sufficiently
prudent actuarial valuation.” (Commission of the European Communities, Proposal for a
Directive of the European Parliament and of the Council on the activities of institutions for
occupational retirement provision, Com (2000) 507 final, Brussels, 11 October 2000, Article
15 (4) clause a).
1462
“All technical provisions are computed and certified by an actuary or other specialist in this
field on the basis of recognised actuarial methods” (Commission of the European
Communities, Proposal for a Directive of the European Parliament and of the Council on
the activities of institutions for occupational retirement provision, Com (2000) 507 final,
Brussels, 11 October 2000, Article 9 (1) clause d).
1463
see note 63
1464
see ibid, p. 23
1465
The most important assumptions relate to estimates of interest rates and inflation. There
should be few problems with EU-wide harmonisation due to the current and expected
further convergence of these key economic indicators.
1466
The mortality tables should be fund and group-specific, because there are, for example,
great differences between the life expectancy of teachers and miners. Consequently,
harmonisation at the level of the individual Member States is as pointless as at EU level (see
Practice for Second Pillar Pension Funds, 1999, p. 12f).
269
NOTES
1467
1468
1469
1470
see ibid, p. III
1471
see ibid, p. VI
1472
Art. 7 (3) (a) Directive 85/611/EEC
1473
Art. 7 (3) (b) leg. cit.
1474
Art. 7 (3) (c) leg. cit.
1475
Art. 7 (3) (e) leg. cit.
1476
1477
1478
1479
1480
see Laux, Manfred, Lobby für Investment: Die Fondsidee politisch definieren, May 1999, p.
2
1481
see Bundesverband Deutscher Investment-Gesellschaften e.V. (BVI), Aufgaben des BVI
(undated)
1482
see Special Funds – a significant occupational pension instrument in Germany, p. 40
1483
1484
The numbering of these solutions corresponds to the number of the questions in Sec-
tion 1.2 The problems, p. 2.
1484
see Gesamtverband der Deutschen Versicherungswirtschaft e.V. (GDV), Fakten und Zah-
len – Demographische Perspektiven, Düsseldorf, 1997, p. 178
1485
see United Nations Population Division, Department of Economic and Social Affairs, Re-
placement Migration, USA, 2000, p. 26
1486
see Ibid, p. 24
1487
see Ibid, p. 24
1488
The data also covers foreign residents in Germany.
1489
Data for the following countries: Bulgaria, Hungary, Poland, Romania, Denmark, Finland,
Iceland, Ireland, Norway, Sweden, UK, Albania, Andorra, Greece, Italy, Malta,
Liechtenstein, Luxembourg, Monaco, Netherlands, Switzerland.
1490
see United Nations Population Division, Department of Economic and Social Affairs, Re-
placement Migration, USA, 2000, p. 26
1491
see Ibid, p. 25
1492
see Financial Services Authority, Plan & Budget 2001/2, United Kingdom, January 2001, p.
51f
270
Index
401(k) plans, 44 Advertising, 44, 132, 141, 142, 143, 149,

and equity investments, 90 152, 156, 185
and ESOP, 112 Advisory fee. see Management fee
change of employer, 45 Affiliated transactions, 59
contributions, 45 bank-related mutual funds, 66
defined contribution, 15 ERISA, 60
diversification, 49 independent directors, 150
Internal Revenue Code, 45 SEC exemptions, 60
mutual funds, 45, 46 supervision, 150
occupational pensions, 21 Age structure, 8, 9
portability, 45 AIMR PPS, 137, 138
tax allowances, 45 abuses, 141
volumes, 45, 46 gross return, 138
Accountants Allocation of securities, 61
and independent directors, 71 fund board, 62
organisational chart, 42 preferral, 61
selection, 71 pro rata. see Pro rata allocation
Action Plan. see Financial Action Plan random allocation, 61
Active portfolio management. see Allocation policy, 61
Portfolio management, active Allocation requirement, 180
Actuarial valuation Alpha, 98, 99, 100, 102
defined benefit pension system, 167 isolation and transfer, 106
ERISA, 135 Alternative investments, 124
Pension Fund Directive, 167 Altersvorsorge-Sondervermögen. see AS-
pension funds, 136 Fonds
Actuary, 67, 87, 115, 116, 135, 136, 170 Analysis model, 95
and fund board, 188 Annual accounts
and supervisory authority, 188 Pension Fund Directive, 25, 80
authorisation, 167, 188 Annual and half-yearly reports, 135
integrity, 188 auditors, 135
suitability, 188 easily understandable, 136
tasks, 188 ERISA, 135
fees & expenses, 160
271
INDEX
minimum content, 135 and strategic asset allocation, 128

pension funds, 135 asset allocation, 116
UCITS, 134 disclosure, 135, 136
Annual prospectus update, 130 European Commission, 116
Annual report objective, 116
Pension Fund Directive, 25, 80 pension funds, 85, 135, 136
pension funds, 135 reservations about, 116
Annuitisation, 22, 23, 39, 89, 109 Auditors
APER, 174 and supervisory authority, 188
Code of Practice. see Code of Practice annual accounts, 136
guidance, 176 annual and half-yearly reports, 135
mutual funds, 175 pension funds, 188
rules, 176 prospectus, 133
Statements of Principle. see Statements Authorisation
of Principle for APER actuary, 167, 188
structure, 175 conditions for pension funds, 167
A-posteriori control, 166 custodian, 166
APER. see APER FSA, 173
fit and proper criteria. see Fit and home country principle. see Home
proper criteria, FSA country principle
SYSC. see SYSC investment adviser, 167
USA, 167 management company, 166
Apportionment requirement, 179, 180 minimum requirements, 166
A-priori control Pension Fund Directive, 25
EU, 166 pension funds, 167
FSA persons exercising a controlled
APER. see APER function (FSA), 173
fit and proper criteria. see Fit and SEC, 167
proper criteria, FSA single European passport. see Single
SYSC. see SYSC European passport
USA, 167 UCITS, 37, 166
Arbitrage, 107 uniform, 181
ARCH, 100, 102 v. disclosure duties, 169
AS-Fonds, 25, 29, 38 AvmG. see German Old-Age Provision
and pension reform, 39 Act (AvmG)
annuitisation, 39 Bank deposit funds (prospectus), 135
dynamic switching, 39 Bank savings schemes, 19
German Old-Age Provision Act Bank-related mutual funds, 65
(AvmG), 39 supervision, 166
investment rules, quantitative, 38 Barriers to market entry for investment
lump-sum payout, 39 companies, 35
pension savings scheme, 39 Basic allowance, 19
switching, 39 Basic pension, state, 22
tax advantages, 39 Basic provision, 17, 22
AS-Investmentrente, 39 Benchmark return, extraordinary, 100
Asset allocation Benchmark selection, 98
and derivatives, 106 Benchmark timing, 99, 100, 103
Asset/liability analysis, 116 Beneficiaries (pensions), 25
strategic. see Strategic asset allocation Benefit cuts, 7, 13
tactical. see Tactical asset allocation Best execution
Asset classes, 124 compliance, 184
Asset/Liability Management definition, 151
and investment restrictions, 86 failure to observe, 184
272
INDEX
fiduciary duty, 62 Bundesaufsichtsamt für das Kreditwesen.

Best practice see German Federal Banking
disclosure duties, 56 Supervisory Office
fund board, 145 Bundesaufsichtsamt für das
Pension Fund Directive, 41 Versicherungswesen. see German
principles, 41 Federal Insurance Supervisory Office
Beta Bundesverband Deutscher Investment-
active, 99, 103 Gesellschaften e.V.. see BVI
as measure of risk, 139 BVI, 189
CAPM, 92 Capital Asset Pricing Model. see CAPM
prediction errors, 100 Capital guarantee, 89
Biometric risks, 22, 87, 89 Capital market efficiency. see Efficient
Birth rates Market Hypothesis
and pay-as-you-go (PAYG) pension Capital market harmonisation, 24, 37
schemes, 5 Capital market inefficiencies, 95, 98, 99
below-replacement fertility, 9 Capital market line, 91
by country/region, 6 Capital market segmentation, 103
measures to increase fertility, 9 Capital misallocation, 34
risk to the pension system, 1 Capital preservation, 121
Blackout period, 59 CAPM, 90, 93, 95, 98, 99, 101
Block trade, 102 Cash balance plans, 15
Board of directors. see Fund board Certification agency, 20
Bonds v. equities Certification guidelines, 20
long-term perspective, 81 Change of employer, 21
Bonds v. equities in Germany, 88 Changes in demographic structures, 1, 5,
Bonds v. equities in selected national 7, 9, 15
markets, 88 Chaos theory, 102
Borrowing, 79 Child allowance, 19
Breach of fiduciary duty Chinese walls, 72, 180
allocation of securities, 62 Churning, 177
fees & expenses, 161 Code of Best Practice, 41
fund board, 186 Code of conduct
investment adviser, 154, 161 affiliated transactions, 60
kickbacks, 63 allocation of securities, 61
soft dollars, 62, 63 DVFA Standards of Professional
transactions involving party in interest, Conduct, 64
61 fair value, 77
valuation of fund assets, 78 personal investing, 59, 151
Breadth, 99, 100 proxy voting
Breadth of information. see Breadth fund board, 73
Breakpoints, 158 review, 74
Broker/dealers, 43 TIAA-CREF, 74
and management company, 55 self-regulation, 36
best execution. see Best execution soft dollars, 63
engagement. see Fund portfolio Code of ethics
brokerage fund board, xviii
management risk, 55 investment adviser, 44
SEC, 51 management risk, 64
soft dollars, 62, 63 personal investing, 151
Brokerage Control Committee, 62 voluntary standards, 64
Brokerage fees, 132 Code of Practice, 176
Budgetary discipline, 8 guidance, 176
rules, 176
273
INDEX
Combined plans, 15 overview, 78

Comparison of fund volumes, 27 proxy voting, 74, 110
Complaints code, 50 restriction on activities of UCITS, 67
Compliance SIP, 123
advertising, 185 soft dollars, 150
affiliated transactions, 60 transactions (EU) involving, 64
and fund board, 60, 182 transactions (USA) involving, 58
APER, 178 transactions involving, 55
best execution, 184 Constraints
breaches, 183 in active portfolio management, 98
competitive advantage, 183 Consumer protection, 24, 26
definition, 182 Contribution rates to statutory pension
delegation, 183 scheme, 8, 16, 17, 23
department, 178, 182 Control
design, 184 and enforcement, 56
failure, 183 fund board, 56
FSA, 179 supervisory authority, 57
identification of violations, 184 SIP, 130
penalties, 184 Controlled functions
personal investing, 59 APER, 177
preventative, 184 definition, 175
professional associations, 182 Core, 95
SEC, 182, 183 Cost averaging effect, 39
soft dollars, 63, 184 Cost-consciousness, 48, 49
supervisory authority, 183 Curvature of distribution, 121
SYSC, 179, 180 Custodian, 42
UCITS, 183 and supervisory authority, 189
valuation of fund assets, 184 authorisation, 166
violations, 184 banks as, 66
voluntary standards, 185 duties, 66, 188
Composite, 139, 140, 141 expenses, 162
Conflict of interests FSA, 67
and separation of functions, 55 in the EU, 66
APER, 177 independence, 66
complaints code, 50 liability, 169
disclosure, 56, 76 management risk, 55
DVFA Standards of Professional organisational chart, 42
Conduct, 64 pension funds, 66, 189
ERISA, 48 requirements, 43
ESOP, 110, 111 separation from management
examples, 57 company, 66
fees & expenses, 154 separation of functions, 65
FSA, 50 suitable institutions, 66
fund board supervision, 67
multiple directorships, 68 UCITS, 66, 67, 188
fund portfolio brokerage, 151 valuation of fund assets, 77, 189
German Securities Trading Act, 64 Customised benchmarks, 140
independent directors, 70 DB. see Pension systems: defined benefit
Investment Adviser Act, 43 DC. see Pension systems: defined
investment advisory contract, 68 contribution
legal counsel, 71 Defined benefit. see Pension systems,
legal counsel, 71 defined benefit
majority of independent directors, 70
274
INDEX
Defined contribution. see Pension PPS, 136

systems, defined contribution prospectus, 130
Delegation rules in the USA prior to 1940, 34
APER, 178 SEC, 51, 56
compliance, 183 SIP, 123
custodian, 169 soft dollars, 63
ERISA, 49 valuation of fund assets, 77
fiduciary duties of the fund board, 148 voluntary standards, xvii
fiduciary duty, 49 Dispersion of returns, 139
fund board, 183 Distribution expenses and Rule 12b-1,
SYSC, 180 162
Derivatives, 105 Distributor, 42
and prudence, 49 expenses, 162
arbitrage, 107 Investment Company Act, 43
fund board, 150 organisational chart, 42
funds Diversification
legal basis in the EU, 38 401(k) plans, 49
prospectus, 135 benchmark timing, 100
hedging, 106 CAPM, 91
options, 107 commodities, 125
performance optimisation, 107 ERISA, 49, 109
tactical risk management, 106 ESOP, 49, 109
trading strategies, 107 European Commission, 81
transaction costs, 107 fiduciary duty, 49, 109
UCITS, 81 foreign currency investments, 113
valuation, 77 investment in sponsor’s securities, 49
writing, 107 levels of asset allocation in the broader
Deviation from benchmark, 99 sense, 125
Differential return, 140 passive portfolio management, 93
Direct commitments, 40 pension funds, 109
Direct insurance, 20, 40 prudent expert rule, 50
Directors’ and officers’ (D&O) insurance, prudent Investor Law, 47
72 prudent investor rule, 48, 50
Disabling conduct, 152 restriction due to quantitative
Disclosure investment rules, 85
and over-regulation, 56 restriction on single issuers, 98
and supervisory authority, 56 stock bonus plans, 49
annual and half-yearly reports, 135 strategic asset allocation, 124
APER, 177 UCITS, 109
as regulatory areas, 3 USA, 109
best practice, 56 Division of Investment Management. see
conflict of interests, 56, 76 SEC, Division of Investment
definition, 56 Management
effects of taxes on returns. see Effects of DMFR. see Dynamic Minimum Funding
taxes on returns Requirement
fees & expenses, 154, 160 Document rule, 49
fund board Downside risk, 116
directors, 72 and Markowitz model, 117
investment risk, 123 expected shortfall, 117
management company, 76 probability of shortall, 117
management risk, 76 probability of shortfall, 117, 120
mutual funds, 56 semivariance. see Semivariance
Pension Fund Directive, 56, 135 shortfall risk, 117
275
INDEX
without normally distributed returns, and index funds, 94

120 annual and half-yearly reports, 135
Drittes Finanzmarktförderungsgesetz. see conflict of interests, 48
German Third Financial Markets cost-consciousness, 48, 49
Promotion Act delegation, 49, 94
Dumping, 60 diversification, 109
Duration, 139 document rule, 49
Duty of care, 186 duty of loyalty, 48
Duty of loyalty, 48, 186 ESOP, 109, 111
DVFA PPS, 138 exclusive benefit rule, 48
and GIPS, 138 fiduciary, 46
compliance, 137 heavier regulation, 44
German capital markets, 137 investment rules, 49
gross return, 138 kickbacks, 49, 63
investment return, 138 lawsuits, 168
measuring return. see Measuring nationwide rules, 44
return need for reform, 36, 44
minimum periods to be presented, 140 prohibited/restricted transactions, 60
risk measurement. see Risk proxy voting, 74, 111
measurement prudent expert rule, 48, 54
Dynamic Minimum Funding self-dealing, 49, 61
Requirement, 115 self-investment, 108
Early retirement, 6, 7 single issuer limit, 111
Earnings points, personal, 17 SIP, 128
Economies of scale supervisory authority, 166
and fund volume, 155, 158 supplementary occupational pension,
and management fee, 153 44
existence, 158 supplementary private pension, 44
independent directors, 161 Errors and omissions (E&O) insurance,
pension funds, 26 72
SEC, 158 ESOP, 109
EET. see Exempt-Exempt-Taxed (EET) advantages, 110
Effects of taxes on returns, 143 conflict of interests, 110, 111
Efficiency and retraints, 98 drawback, 111
Efficient Market Hypothesis, 93, 94, 95, ERISA, 109, 111
96, 103, 112 fiduciary duty, 109, 110, 111
Eligible pension products. see Pensions, hostile takeovers, 111
subsidised investment products IRC, 109, 112
Emerging markets, 113, 114 leveraged, 109
EMH. see Efficient Market Hypothesis plan committee, 110
Employee Retirement Income Security prudence, 111
Act. see ERISA Securities Act of 1933, 109
Employee Stock Ownership Plan. see single issuer limit, 111
ESOP tax allowances, 111
Equities v. bonds European Commission
long-term perspective, 81 Asset/Liability Management, 116
Equities v. bonds in Germany, 88 barriers to market entry, 35
Equities v. bonds in selected national biometric risks, 89
markets, 88 capital allocation, 34
Equity Steering Committee, 62 custodian, 66
ERISA, 44 diversification, 81
affiliated transactions, 60 Dynamic Minimum Funding
and active portfolio management, 96 Requirement, 115
276
INDEX
financial markets and employment, 24 definition, 131

fund board, 146 distributor, 162
harmonisation, 26 management fee, 131, 152
investment rules, 80 Rule 12b-1 fee, 131, 152
investment rules, quantitative, 79, 86 UCITS, 134
matching currency, 112 US example, 131
Pension Fund Directive, xvi, 24 Fair value, 77
pension funds and financial markets, Fees
25 definition, 131
Pensions green paper. see Pensions sales load. see Sales load
green paper types, 130
PPS, 137 UCITS, 134
prospectuses, 134 US example, 131
prudence, 49 Fees & expenses, 152
prudent man rule, 81, 116 annual and half-yearly reports, 160
prudential framework, 36, 37 appropriateness, 161
Rebuilding Pensions, 41 breach of fiduciary duty, 161
regulatory regime, 168 breakpoints. see Breakpoints
single European passport, 57 brokerage fees, 132
supervisory authority, 165 conflict of interests, 154
Towards a single market for disclosure, 154, 160
supplementary pensions economies of scale. see Economies of
(Communication of the scale
Commission), 81 EU, 163
UCITS Directive reform, 38 examples, 131
European Economic and Monetary fiduciary duty, 161
Union fund board, 154
and foreign currency investments, 112 independent directors, 154, 161
and investment rules, quantitative, 80 investment adviser, 160, 161
harmonisation of various pension Investment Company Act, 162
products, 26 macroeconomic perspective, 163
Ex post performance advertising, 141, 142 Mutual Fund Cost Calculator, 132
Excess returns. see Return, active pension funds, 136
Exclusive benefit rule, 48 performance fees. see Performance fees
Exempt-Exempt-Taxed, 25 PPS, 140
Exempt-Exempt-Taxed (EET), 20, 21, 23, room for improvement, 160
25 SEC, 154, 160
Exemptive relief, 52 standardised table, 131
Expected shortfall magnitude. see supervision, 154
Downside risk, expected shortfall total shareholder costs. see Total
Expense ratio shareholder costs
and performance, 154 Fidelity bond, 150
components, 153 Fiduciary duty, 45
development, 155 acquisition of management company,
economies of scale, 158 149
fund classes, 157, 158 affiliated transactions, 60
fund types, 156 allocation of securities, 61, 62
management fee, 154 and ERISA, 46
pension funds, 136, 153 and passive portfolio management, 93
Rule 12b-1, 153, 156 best execution, 62, 151
SEC study, 156 breach. see Breach of fiduciary duty
Expenses, 152 capital market theory, 49
custodian, 162 compensation liability, 49
277
INDEX
conflict of interests, 48, 55 conflict of interests, 50

continuous professional development, custodian, 67
49 diligence, 50
cost-consciousness, 48, 49 fiduciary duty, 50
defined contribution pension systems, powers of approval, 173
121 regulatory objectives, 170
delegation, 49 regulatory powers, 170
diversification, 109 skill, 50
document rule, 49 FSA Handbook, 170
duty of loyalty, 48 APER. see APER
emerging markets, 113 controlled functions. see Controlled
ESOP, 109, 110, 111 functions
exclusive benefit rule, 48 fit and proper criteria. see Fit and
fees & expenses, 161 proper criteria, FSA
foreign currency investments, 113 fundamental principles. see Principles
FSA, 50 for Business
fund board, xviii, 186 objectives, 171
investment advisory contract, 149 regulated activitiy. see Regulated
investment rules, 55 activitiy
kickbacks, 49 structure, 171
liability, personal, 49 SYSC. see SYSC
management company, 76 Fund board, 145
management risk, 53, 55 affiliated transactions, 60
Modern Portfolio Theory, 49 allocation of securities, 62
personal investing, 59 and active portfolio management, 98
prohibition on delegation by the fund and actuary, 188
board, 148 and compliance department, 182
proxy voting, 73, 110 and external advisers, 69
prudent expert rule, 48 and management company, 68
self-dealing, 49 and shareholders, 187
SIP, 123 and supervisory authority, 57, 169
skills, 49 annual accounts, 136
strategic asset allocation, 126 best practice, 145
Financial Action Plan, 24, 26, 34, 38, 165 breach of fiduciary duty, 186
Financial Services Authority. see FSA code of ethics, xviii
Firewalls. see Chinese walls committees, 147
Fit and proper criteria compensation, 147
FSA, 173 compliance, 60
competency and capability, 174 composition, 69
financial soundness, 174 court case, 169
honesty, integrity, reputation, 173 delegation, 183
investment adviser, 44 derivatives, 150
Pension Fund Directive, 25 diligence, 186
Fitness and propriety. see Fit and proper disclosure on directors, 72
criteria effectiveness, 145
Foreign currency investments, tax EU prudential regime, 57
treatment, 114 expansion of duties, 170
Form ADV, 76 fees & expenses, 152, 154
Freedom of investment, 21, 85 fiduciary duty, xviii, 186
Front running, 59, 64, 177 fund portfolio brokerage, 151
FSA. see Financial Services Authority in the EU prudential regime, 146
(FSA) in the EU regulatory regime, 168
Chinese walls, 73 independence, 72, 77
278
INDEX
integrity, 167 Funds of funds

Investment Company Act, 145 legal basis in the EU, 38
lawsuit, 186, 187 prospectus, 135
legal counsel, 71 UCITS, 80
legal liability insurance, 72 GARCH, 100, 102
loyalty, 186 Genetic algorithms, 102
management risk, 53 German Federal Banking Supervisory
matching currency, 113 Office, 21
multiple appointments, 68, 72 German Federal Insurance Supervisory
multiple directorships, 68, 72 Office, 20
organisational chart, 42 German Insurance Supervision Act, 21
organisational structures, 146 German Investment Companies Act
Pension Fund Directive, 170 (KAGG), 38, 190
period of office, 146 German investment companies
personal investing, 59, 151 association. see BVI
personal liability, 36, 151, 164 German Old-Age Provision Act (AvmG),
powers of sanction, 170 16, 18, 39
prohibition on delegating fiduciary German Securities Trading Act, 64
duties, 148 German special retirement pension
proxy voting, 73 investment funds. see AS-Fonds
Rebuilding Pensions, 146 German Third Financial Markets
removal, 169 Promotion Act, 38
responsibility matrix, 146 GIPS, 137
SEC, 36, 145 and DVFA PPS, 138
security of pension funds, 85 compliance, 137
separation from asset management, 67 EU pension funds, 138
separation of functions, 65, 67 measuring return, 138
SIP, xvii, 123, 129, 130, 148 Glass-Steagall Act, 65
soft dollars, 63 Global Investment Performance
suitability examination, 167 Standards. see GIPS
transactions requiring approval, 148 Governing documents, 49
types of director, 56 Government guarantee, 37
USA, 145 Gross return
valuation committee, 77 AIMR PPS, 138
valuation of fund assets, 77 DVFA PPS, 138
watch dog, xviii SEC, 141
Fund classes Growth and Stability Pact, 8
definition, 153 Growth funds, 38
expense ratio, 157, 158 Guidance
Rule 12b-1, 149, 153 definition, 172
Fund companies FSA
number in the USA, 33 APER, 176
Fund portfolio brokerage, 151 SYSC, 179
Fundamental law of active portfolio Harmonisation
management, 96, 100 of financial services. see Single market
Fund-based savings schemes, 19 for financial services
Funded pension schemes, 2, 13, 14, 16, 21, of the capital markets. see Capital
23 market harmonisation
definition, 13 of various pension products, 26
ERISA, 45 Hedging, 105
Internal Revenue Code, 45 historical performance advertising. see Ex
Funding, 115, 117, 118 post performance advertising
Funding adequacy, 114 Home country principle, 24, 37, 167
279
INDEX
ICI, 189 Independent fund board directors. see

Immigration, 8, 9, 10, 12, 17, 18 Independent directors
historical, 11 Independent public accountants, 71, 148
Immigration levels, 10 Index funds
IMRO, 170 and pension funds, 94
Increased contributions, 7, 13 legal basis in the EU, 38
Independent directors portfolio segmentation, 98
2-year period, 68 prospectus, 134
accountants, 71 single issuer limit, 108
acquisition of management company, Individual Retirement Account (IRA), 21,
149 32, 33, 44
affiliated transactions, 60, 150 Individual Savings Accounts, 22
and legal counsel, 36 Information coefficient, 100, 101
appointment, 70, 148 Information Coefficient, 100
collaboration with the management Information quality. see Information
company, 67 coefficient
compensation, 70, 147 Information ratio, 96, 97, 99, 100
compensation and disclosure, 70 ex ante, 100
compensation and independence, 70 ex post, 101
conflict of interest (examples), 57 PPS, 138
conflict of interests, 70 Inside information
definition, 56 Chinese walls, 72
dismissal, 70 DVFA Standards of Professional
economies of scale, 161 Conduct, 64
effectiveness review, 145 Institutional efficiency, 114
election by shareholders, 70 Instruments of incorporation, 167
eligibility standards, 75 Insurance industry on investment rules,
fees & expenses, 154, 161 89
Fidelity bond, 150 Interested fund board directors, 56
fund board committees, 147 Internal Revenue Code. see IRC
in the EU, 70 Internal Revenue Service, fair value, 78
independence Introduction of the euro. see European
criteria, 67 Economic and Monetary Union
effective, 70 Investment adviser
independence and compensation, 70 and public funds, 43
information to be provided to authorisation, 167
shareholders, 69 breach of fiduciary duty, 154, 161
Investment Adviser Act, 148 Competency Exam, 44
investment advisory contract, 148, 161 disclosure, 43
joint insurance contracts, 150 fall-out benefits, 162
legal counsel, 71 fees & expenses, 160, 161
minimum number, 69 fit and proper criteria, 44
multiple appointments, 68 performance fees, 161
nomination, 69, 70 registration, 166
period of office, 71 soft dollars, 150
Rule 12b-1, 70, 149, 153, 162 Investment Adviser. see Management
SEC, 148 company
self-nomination, 70 Investment Adviser Act, 41
separation of functions, 67 allocation of securities, 61
soft dollars, 150 anti-fraud regulations, 43
SYSC, 181 areas regulated, 43
transactions requiring majority conflict of interests, 43
approval, 148 disclosure duties, 43
280
INDEX
fiduciary duties, 43 disclosure, 123

independent directors, 148 diversification, 54
Principal transactions, 59 investment rules, 79
proposed reform, 43 investment rules, quantitative, 54
SEC, 43 prudence, 54
Investment Adviser Competency Exam. rules on, 79
see Investment Adviser, Competency Investment rules, 2, 21, 23, 25, 50
Exam and active portfolio management, 95
Investment advisory contract and Modern Portfolio Theory, 54, 90
conflict of interests, 68 arbitrary limits, 85
independent directors, 161 as regulatory areas, 3
renewal, 68 capital guarantee, 89
soft dollars, 150 defined benefit pension systems, 114
Investment Advisory Contract, 55, 148 defined contribution pension systems,
Investment companies 121
barriers to market entry, 35 definition, 54
Investment Company Act, 41 derivatives, 105
2-year period, 68 ERISA, 49
affiliated transactions, 60 insurance industry view, 89
fees & expenses, 162 investment risk, 79
fund board Life insurance, 87, 89
composition, 69, 148 long-term perspective, 81
lawsuit, 186 management risk, 55, 58
safeguards shareholders’ interests, qualitative, 80, 86, 89
145 qualitative (definition), 55
joint transactions, 61 quantitative, 25, 34, 38, 47, 48, 50, 79,
personal liability of fund board 108, 129
members, 152 diversification, 108
pillars of protection, 42 foreign currency investments, 112
reform, 170 single issuer limit, 108
Rule 12b-1, 152 quantitative (and euro), 80
separation of custodian and quantitative (definition), 54
management company, 66 quantitative (embodying the prudent
situation prior to coming into force, 34 man rule), 88
Investment Company Institute. see ICI quantitative (in the EU), 80
Investment funds. see Mutual funds quantitative (in the USA), 89
Investment horizon, 16, 81, 82, 117, 121, quantitative (UCITS), 80
129 quantitative supplementing
Investment Management Regulatory qualitative, 89
Organisation. see IMRO Rebuilding Pensions, 85
Investment policies. see SIP, see SIP restricting, 81
Investment policy style management, 103
Pension Fund Directive, 80 versus freedom of investment, 85
pension funds, 135 voluntary standards, xvii
Investment policy principles Investment Services Directive, 38, 166,
governing documents, 49 167
Pension Fund Directive, 25, 108, 109, IPOs, 59, 61
148 IR. see Information ratio
Investment Policy Statement. see SIP IRC, 109, 112
Investment principles ISA. see Individual Savings Accounts
SIP, 129 Jensen’s alpha, 140
Investment risk Joint insurance contract, 150
definition, 54 Joint transactions, 61
281
INDEX
KAGG, 38, 190 service provider to the fund, 55

Kickbacks, 49, 63 valuation of fund assets, 78
Kurtosis. see Curvature of distribution Management fee
Labour force participation rate, 11, 12 expense ratio, 154
Large/small cap strategy, 103, 104 investment advisory contract, 148
Legal counsel, independent, 71 Management risk
Legal liability insurance for fund board code of ethics, 64
directors, 72 definition, 53
Length of retirement, 7 disclosure, 76
Leptokurtic distribution, 101, 121 investment rules, 55, 58
Level playing field, 26 rules for, 58
Liability separation of functions, 65
and index funds, 94 Market anomalies, 103
custodian, 169 Market capitalisation strategy. see
fund board, 151 Large/small cap strategy
personal, 36, 49, 152 Market efficiency. see Efficient Market
Licence Hypothesis
withdrawal, 169 Market impact, 60, 73, 94, 102, 151
Life expectancy, 1, 5, 6, 9, 17, 115, 119 Market portfolio, 91, 92, 95
Life insurance, 26 Market risk adjusted return, 140
and ISA, 22 Markowitz
and taxes, 39 downside risk, 117
benefit guarantee, 15 portfolio selection, 90
differences as against pension funds, Matching currency, 112
15 Maximum income threshold (Germany),
harmonisation in the EU, 89 20
investment rules in the EU, 87, 89 Maximum income threshold for
loans, 15 contribution assessment (Germany),
matching currency, 112 19, 20
orientation on nominal value, 15 Mean variance efficiency, 90, 117
retirement provision, 14 Measuring return, 138
Liquidity premium, 100 Members of pension schemes, 21, 25
Litigation, 36, 76 Minimum personal contribution, 19
Longevity. see Life expectancy Modern Portfolio Theory
Long-term perspective and active portfolio management, 95
equities v. bonds, 81 and investment rules, 90
Lump-sum payout, 22, 23, 39, 109 fiduciary duty, 49
Management company investment rules, 54
acquisition, 149 prudent investor rule, 47
and custodian, 66 quantitative investment restrictions, 89
and supervisory authority, 167 Mutual Fund Cost Calculator, 132
appointment/dismissal of independent Mutual fund governance, 69
directors, 70 Mutual funds
authorisation, 166 401(k) plans, 45, 46
conflict of interests, 55 and ICI, 189
disclosure duties, 76 and IRAs, 44
fiduciary duty, 76 authorisation, 166
legal counsel, 71 bank-related. see Bank-related mutual
organisational chart, 42 funds
permitted activities, 67 conflict of interests, 55
responsibility matrix, 146 disclosure, 56
SEC, 51 distribution, 43
separation of functions, 65 employees, 42, 55
282
INDEX
fees & expenses. see Fees & expenses, Occupational pensions. see Pension
see Fees pillars, pillar two
first retail mutual fund, 33 Omega, 101, 102
held by households, 29, 30 Operating expenses. see Fees & expenses
intercontinental sale, 35 Options, 107
Investment Company Act. see Other parties involved in supervision,
Investment Company Act 187
investment rules, quantitative, 79 Overfunding. see Dynamic Minimum
legal framework in the EU, 37 Funding Requirement
litigation, 36 Own account trading, 59
new cash flow Party in tnterest, 61
by fund type, 29, 30 Pay-as-you-go (PAYG) pension schemes,
Germany, 28 1, 2, 5, 7, 9, 13, 16, 23, 24
USA, 30 inequalities, 5
prospectus. see Prospectus PAYG. see Pay-as-you-go (PAYG) pension
proxy voting, 108 schemes
regulated activitiy, 175 Pay-to-play, 43
residual risk aversion, 102 Pension allowances. see Pensions, state
retirement provision, 1, 14, 21, 22 allowances
SEC, 51 Pension Benefit Guarantee Corporation,
separation of functions, 65 45
share of overall mutual fund assets Pension equity plans, 15
invested in equity funds, 33 Pension formula, 17
share of US retirement assets, 31, 32, 33 Pension Fund Directive
share of US retirement assets invested and Financial Action Plan, 38
in equity funds, 33 annual accounts, 80
Specialist Sourcebook (FSA), 171 annual report, 80
structure under US law, 42, 55 Chinese walls, 73
switching, 163 disclosure, 56
total volume in the USA, 31 draft directive, xvi, 1, 24, 34, 64, 66, 73,
types, 38 77, 80, 81, 86, 87, 89, 112, 115, 128,
typical US mutual funds investors, 31 135, 137, 146, 167, 169, 170, 186, 188,
v. direct equity holdings, 30 189
volume fund board, 75
1941-1945 (USA), 34 independent directors, 75
bond funds (USA), 31 investment policy, explanation of, 80
by fund type, 29, 31 investment principles, 86
equity funds (USA), 31 personal investing, 64
equity v. bond funds, 28 PPS, 137
in Germany, 27 qualitative investment rules, 86
money market funds (USA), 31 quantitative investment rules, 86
open-end funds worldwide, 35 recommendations on content, 41
retirement planning investment, 33 separation of functions, 75
voluntary standards, xv Pension fund governance, 41
NAPF PPS, 137 Pension funds
National Association for Pension Funds. 401(k) plans, 21
see NAPF PPS actuarial valuation, 136
Need for reform of ERISA, 44 advantages, 21
Negative size bias, 98 and financial markets, 25
Neuronal networks, 102 and index funds, 94
No-action requests, 52 and Special Funds, 40
Nominal value maintenance, 20, 21, 47 annual and half-yearly reports, 135
annual report, 135
283
INDEX
as user of active portfolio prudent man rule, 23, 87

management, 96 Rebuilding Pensions, 41
Asset/Liability Management, 85, 135, Rebuilding Pensions study, 41
136 retirement provision, 14, 22
assets in the EU, 26 security, 41
auditors, 188 separation from sponsoring
authorisation, 167 undertaking, 66
average country real rates of return, 87 separation of functions, 21, 55
Code of Best Practice, 41 share in total mutual fund volume, 31
concept of risk, 116 single European passport, 57
criteria for active portfolio managers, single issuer limit, 108
98 SIP, 124, 128, 135
custodian, 66, 189 solvency margin, 116
defined benefit, 15, 21, 116 supervision, 24
defined contribution, 21 supervisory authority, 166
derivatives, 77, 106 supervisory authority sanctions, 169
differences as against life insurance surrender, 15
products, 15 Sweden, 23
disclosure, 135 taxation, 20, 24
diversification, 109 v. life insurance, harmonisation, 89
draft directive. see Pension Fund valuation of fund assets, 77
Directive, proposal volume in the EU, 14
Dynamic Minimum Funding voluntary standards, xv
Requirement, 115 Pension levels, 17, 18
emerging markets, 114 Pension pillars
equity investments, 87 pillar one, 5, 13, 14, 22, 23
EU Directive. see Pension Fund pillar three, 9, 13, 14, 15, 16, 18, 20, 21,
Directive 22, 23, 38
expense ratio, 136, 153 pillar two, 9, 13, 14, 15, 16, 20, 21, 22, 23,
fees & expenses, 136 38, 40, 41, 44
foreign currency investments, 113 Pension plan sponsor. see Sponsoring
fund board, 146 undertaking
harmonisation, 26 Pension reform, 16
IMRO, 170 and AS-Fonds, 39
investment horizon, 16, 82 and financial services industry, 21
investment policy, 135 and voluntary standards, xv
investment rules, quantitative, 21, 54, capital guarantee, 89
79 criticism, 17
portfolio optimisation, 79, 85 German Old-Age Provision Act
risk/reward profile, 86 (AvmG), 16
widespread, 87 occupational pensions, 20
lawsuits, 168 pension funds, 20, 39
matching currency, 112 political debate, 1
maturity, 115 private pensions, 18
minimum regulation at EU level, 81 Pension systems
Netherlands, 22 defined benefit, 14, 15, 16, 21, 22, 44, 67,
overfunding, 118 87, 112, 128, 130, 167, 188
over-regulation, 37 defined benefit (specific challenges),
passive portfolio management, 93 114
pension reform, xvi, 20, 39 defined contribution, 15, 16, 21, 22, 23,
pillar two, 14, 20 44, 109, 128, 136, 167
PPS, 137 defined contribution (fiduciary duties),
prudent expert rule, 48 121
284
INDEX
hybrid forms, 15, 22, 23 PIA, 170

Pension type factor, 17 Plain English campaign, 133
Pension value, current, 17 Plan committee, 110
Pensionable age, 6, 7, 12, 17, 23 Platykurtic distribution, 121
Pensions. see also Pension systems, see also Portability of performance data, 142
Pension funds Portfolio management
differing tax treatments, 26 active, 95
funded. see Funded pension schemes active beta. see Beta, active
Netherlands, 22 active return. see Return, active, see
occupational. see Pension pillars, pillar Return, active
two active risk. see Risk, active
private, 21, see Pension pillars, pillar alpha. see Alpha
three analysis model, 95
Scandinavia, 23 and ERISA, 96
state, 16, 26 and prudence, 96
state allowances, 18, 19 benchmark selection, 98
state subsidies, 18, 19, 22 benchmark timing. see Benchmark
statutory. see Pensions, state timing
subsidised investment products, 19 breadth. see Breadth
supplementary, 22, see Three-pillar core terminology, 99
pension system criteria for portfolio managers, 98
Switzerland, 23 diversification, 98
tax allowances, 19, 22, 30 fundamental law of active portfolio
United Kingdom, 22 management. see Fundamental
USA, 21 law of active portfolio
using AS-Fonds, 38 management
using mutual funds, 21 Information coefficient. see
using Special Funds, 40 Information coefficient
Pensions green paper, 81, 87 information ratio. see Information
Pensions shortfall, 13, 17, 18 ratio
Pensionskassen (German staff pension investment decision process, 95
schemes), 20, 40 investment strategy, 95
PEP. see Personal Equity Plan performance analysis, 95
Per capita invested assets, 27 quantitative investment restrictions,
Performance 89
and expense ratio, 154 residual risk aversion. see Residual
Performance analysis risk aversion
strategic asset allocation, 128 restraints, 98
Performance analysis, definition, 137 risk analysis, 95
Performance fees, 161 risk model, 95
Performance measurement, 40, 136 score. see Score
Performance optimisation using selection. see Selection
derivatives. see Derivatives, skill. see Skill
performance optimisation strategic asset allocation, 98
Performance Presentation Standards. see supply and demand, 96
PPS transaction costs, 96, 98
Personal Equity Plan, 22 value added. see Value added
Personal investing, 58 cost of active v. passive, 95
code of ethics, 151 passive
Pension Fund Directive, 64 and Efficient Market Hypothesis, 93
supervision by fund board, 59, 151 and prudence, 93
voluntary standards, 65 diversification, 93
Personal Investment Authority. see PIA
285
INDEX
quantitative investment restrictions, SIP, 129

89 Swiss Performance Presentation
residual return, 101 Standards, 137
risk aversion, 101 value at risk, 138
Portfolio managers Principal transactions. see Affiliated
ability to act as independent director, transactions
68 Principal Transactions
best execution, 151 admissibility, 43
criteria for, 98 Principal underwriter, 42
forecasting ability, 96 Principles for Business, 171
information ratio, 96, 97, 100 11 principles, 173
performance, 137 guidance. see Guidance
performance comparison, 140 objectives, 171
personal investing, 58 Rules. see Rules
portability of performance data, 142 structure, 171
residual risk aversion, 101 Private financial assets (Germany), 27
selection for active portfolio Private placements, 59
management, 97 Pro rata allocation, 61
SIP, 123 Professional associations, 189
skills, 137 BVI. see BVI
valuation of fund assets, 78 compliance, 182
Portfolio optimisation ICI. see ICI
constrained, 126 self-regulation, 43
limited by quantitative investment Profile prospectus, 130
rules, 86 Programming, linear, 98
pension funds, 79 Programming, quadratic, 98
prudent investor rule, 48 Proportion of immigrants, 11, 12
prudent man rule, 47 Proportion of working women, 17
quantitative investment restrictions, 89 Prospectus, 76, 130
supervision, 80 audit, 133
transparency, 80 availability, 133, 135
Portfolio Selection, 90 derivatives funds, 135
PPS, 136 easily understandable, 133
abuses, 141 EU, 133
AIMR PPS. see AIMR PPS fees & expenses. see Fees & expenses
customised benchmarks, 140 full, 133, 134
DVFA PPS. see DVFA PPS fund classes, 134
elements, 136 funds of funds, 135
fees & expenses, 140 index funds, 134
GIPS. see GIPS minimum content (UCITS), 133
information ratio, 138 presentation, 133
minimum periods to be presented, 140, Rebuilding Pensions, 133
142 risk information, 133
NAPF PPS, 137 SEC, 133
Pension Fund Directive, 137 simplified, 133, 134, 136
pension funds, 137 simplified (minimum content), 134
performance comparison, 140 supervisory authority, 133
portability of performance data. see taxes, 133
Portability of performance data USA, 130
purpose, 136 proxy voting, 73
risk measures, 142 fiduciary duty, 110
rules, 137 Proxy voting, 73, 108
SEC, 141 conflict of interests, 74, 110
286
INDEX
directed voting, 110 Prudential regime

ERISA, 111 and voluntary standards, 37
ESOP, 110 fundamental concept in the EU, 169
fiduciary duty, 73 in the EU (planned), 36
pass-through voting, 110, 111 recommendation, 181
TIAA-CREF policies, 74 Qualification requirements, 36
Prudence, 45 Quality of asset management and of
and active portfolio management, 96 assets, 54
and investment rules, 79 Random allocation, 61
and passive portfolio management, 93 Reallocation profiles, dynamic, 40
diversification, 47, 48, 54 Rebalancing, 98
ESOP, 111 Rebuilding Pensions, 41
EU law, 49 fund board, 146
fundamental principles in the EU, 54 investment rules, 85
investing in derivatives, 49 matching currency, 112
investing in equities, 49 prospectus, 133
liquidity, 54 regulatory regime, 168
profitability, 54 separation of functions, 75
quality, 54 SIP, 128
security, 54 Registration
strategic asset allocation, 126 using Form ADV, 76
Prudent expert rule Regulated activitiy, 175
and quantitative investment rules, 89 Regulation of Approved Persons. see
definition, 48 APER
diversification, 50 Regulatory regime
ERISA, 54 in the EU, 168
EU law, 49, 81 in the USA, 169
fiduciary duty, 48 with fund board, 169
pension funds, 48 Regulatory regime in the United
portfolio optimisation, 50 Kingdom, 170
Prudent Investor Law, 47 Relative risk, 139
Prudent investor rule Replacement migration. see Immigration
and quantitative investment rules, 89 Residual return, expected. see Alpha
definition, 47 Residual risk aversion, 98, 101, 102
diversification, 48, 50 Restraints
EU law, 49, 81 and efficiency, 98
investment restrictions, 48 short selling, 98
portfolio optimisation, 50 Retirement age. see Pensionable age
Prudent man rule Retirement provision. see also Pensions
and quantitative investment rules, 25 Return
as an abstraction of quantitative active, 98, 99
investment rules, 88 alpha. see Alpha
definition, 47 and taxes. see Effects of taxes on
differences in interpretation EU/USA, returns
50, 54 derivatives, 105
EU law, 49, 81, 87, 116 dispersion. see Dispersion of returns
investment restrictions, 47, 50, 54 expected, 100, 129
management risk, 53 expected marginal return, 99
pension funds, 23, 87 extraordinary benchmark return. see
portfolio optimisation, 47 Benchmark return, extraordinary
preservation of principal of individual gross. see Gross return
securities, 47, 50 liquidity premium. see Liquidity
US law, 50 premium
287
INDEX
measuring. see Measuring return total risk, 139, 140

minimum return, 116, 117, 118 tracking error, 139
raw forecast. see Score tracking risk. see Tracking error
residual, 99, 101, 102 value at risk, 139
risk premium. see Risk premium volatility, 139
risk-adjusted, 139 Risk measurement, 139
score. see Score Risk model, 95
time-weighted, 138 Risk premium, 100
total return, 109 Risk premium (CAPM), 92
total return, expected, 100, 101 Risk/reward profile
Return analysis equity investments, 80
definition, 137 foreign currency investments, 113
Risk harm from quantitative investment
absolute, 139 rules, 86
active, 98, 99 investment horizon, 81
asymmetric, 116 long-term perspective, 81
bankruptcy risk, 54 Risk-Adjusted Expected Return. see Value
beta, 139 added
biometric. see Biometric risks Risk-adjusted return, 140
counterparty credit risks, 99 Rule 12b-1
derivatives, 105 admissibility, 149
deviation risk, 139 collateralisation, 150
downside risk. see Downside risk development, 158
duration, 139 distribution expenses, 162
equity investments, 82 expense ratio, 153, 156
expected marginal risk, 99 fund classes, 149, 153
foreign currency risk, 113, 114 independent directors, 70, 149, 153, 162
increased risk from quantitative own sale by funds, 43
investment rules, 86 permanence, 149
interest rate risk, 54 purpose, 149
management, 21 reform, 161
market risk, 106 review and renewal, 149
measurement. see Risk measurement sales load, 149
model. see Risk model SEC, 161
non-market specific, 139 total shareholder costs, 156, 158
operational risks, 99 Rules
optimum residual, 102 FSA
poor asset allocation, 54 APER, 176
reinvestment risk, 54 definition, 172
relative, 139 SYSC, 179
residual, 100, 101 SEC, 51
residual risk aversion. see Residual risk Safe harbor, 62, 63
aversion Sales load
risk assessment, 180 definition, 152
risk information, 133 development, 158
risk-adjusted return, 139 prospectus, 130
segment risk, 106 Rule 12b-1, 149
specific security, 106 total shareholder costs, 158
symmetric, 116 types, 152
systematic risk, 140 Score, 102
tactical risk management. see Screening, 98
Derivatives, tactical risk SEC
management 2-year period, 68
288
INDEX
administrative actions, 51 origins, 50

affiliated transactions, 59, 60 personal investing, 58
allocation of securities, 62 Plain English campaign. see Plain
authorisation, 167 English campaign
bank-related mutual funds, 65 portability of performance data, 142
breakpoints, 158 PPS, 141
capital market laws, 51 preliminary investigations, 51
capital market oversight, 51 prospectus, 130, 133
compliance, 182, 183 Rule 12b-1, 161
court case, 51 rules, 51
disclosure, 56 rules and regulations, 42
disclosure duties, 51 SEC Headquarters, 51
Division of Investment Management, self-regulation, 36
34, 51 separation of custodian and
Divisions, 51 management company, 66
duties, structure, 50 soft dollars, 63
economies of scale, 158 supervisory authority, 166
effects of taxes on returns, 143 Securities Act, 42
ex post performance advertising, 141 ESOP, 109
exemptive relief, 52 origins, 50
Expense ratio, 156 Securities and Exchange Commission. see
fees & expenses, 154, 160 SEC
Form ADV, 76 Securities and Futures Authority. see SFA
fund board Securities Exchange Act, 42
best practice, 145 origins, 50
bureaucracy, 36 safe harbor, 62
compensation, 147 Securities lending
compensation of independent SIP, 129
directors, 70 UCITS, 81
composition, 69 UCITS Directive, 79
disclosure rules, 72 UCITS Directive reform, 38
independent directors Security market line, 92
regulations, 148 Selection, 95, 99, 100, 102, 103
self-nomination, 70 Self-dealing, 59
as restraint, 98
strengthening, 148
ERISA, 61
lawsuit, 186
Investment Company Act, 34
legal liability insurance, 72
prohibited transactions, 49
personal liability, 151
Self-investment, 108
gross return, 141
Self-regulation
Initiative to improve mutual fund
United Kingdom, 170
governance, 69
v. statutory regulation, 43
institutional cooperation, 51
voluntary standards, 37
interested person, 69
Semivariance, 117
investment advisory contract, 148
Senior management arrangements,
Investment Company Act, 41
systems and controls. see SYSC
investor protection, 51
Separation of functions
joint transactions, 61
as regulatory areas, 3
legal counsel, 71
broker/dealers, 55
lobbying, 189
Chinese walls, 72
Mutual Fund Cost Calculator. see
conflict of interests, 55
Mutual Fund Cost Calculator
custodian, 55, 65
no-action requests, 52
definition, 55
289
INDEX
fund board, 55, 65, 67 USA, 128

fund board versus management Skill, 99, 101
company, 56 Social Security, 21
independent directors, 67 Social Security, US, 15
management company, 65 Soft dollars, 62
management risk, 65 and fiduciary duty, 62
mutual funds, 65 breaches, 63
Pension Fund Directive, 75 compliance, 63, 184
pension funds, 55 conflict of interests, 150
proxy voting, 73 definition, 62
Rebuilding Pensions, 75 disclosure, 63
separation of custody and documentation, 63
management company, 55 fund board, 63
separation of custody and sponsoring independent directors, 150
undertaking, 55 investment adviser, 150
voluntary standards, xvii investment advisory contract, 150
SFA, 170 safe harbor, 62, 63
Shareholder Fees. see Fees SEC, 63
Shareholders and supervision, 186 supervisory authority, 63
Sharpe, 91 Solvency, 21
Sharpe ratio, 138, 140 Solvency margin, 115
Short selling, 79, 98 Special Funds, 40, 190
Shortfall line, 117, 118, 119 Statement of Investment Policy. see SIP
Shortfall risk. see Downside risk, shortfall Statement of Investment Principles. see
risk SIP
Single European Currency. see European Statements of Principle for APER, 175
Economic and Monetary Union criteria for compliant/non-compliant
Single European passport, 24, 57, 166 conduct, 176
Single index model, 93 examples of non-compliant conduct,
Single issuer limit 176, 177
ERISA, 111 Strategic asset allocation, 124
ESOP, 111 analytical approach, 126
index funds, 108 benchmark selection, 98
pension funds, 108 definition, 126
sponsoring undertaking, 108 fiduciary duty, 126
UCITS, 108 Pensionskassen (German staff pension
Single market for financial services, 24, 26 schemes), 40
SIP, 123 SIP, 128
and active portfolio management, 98, Special Funds, 40
99 Stratification, 98
control, 130 Style management, 103
core contents (EU), 128 large/small cap. see Large/small cap
core contents (USA), 128 sectors, 103
ERISA, 128 style benchmarks, 104
failure to observe, 184 topics, 103
fund board, xvii, 129, 130, 148 value/growth. see Value/growth
pension funds, 128, 135 Style rotation, 103
PPS, 129 Subsidiarity, 36
preparing, 130 Supervision
prudential principles, 128 affiliated securities transactions, 150
Rebuilding Pensions, 128 aims in the EU, 168
strategic asset allocation, 128 a-posteriori control. see A-posteriori
updating, 130 control
290
INDEX
a-priori control. see A-priori control ERISA, 166

as regulatory areas, 3 sanctions, 169
assignment of rules, 3 powers of sanction, 182
audit committee, 181 prospectus, 133
authorisation v. disclosure, 169 responsibility in the EU, 165
bank-related mutual funds, 65, 166 responsibility in the USA, 182
Chinese walls, 73 sanctions, 169
compliance, 180 SEC, 166
custodian, 67 soft dollars, 63
disclosure v. authorisation, 169 USA, 166
fees & expenses, 154 Supplementary Pensions in the Single
functional supervision in holding Market. see Pensions green paper
company structure, 65 Support ratio, 7, 9, 10, 11, 12
German Insurance Supervision Act, 21 Swiss Performance Presentation
government, 37 Standards, 137
home country principle. see Home Switching, 39, 163
country principle SYSC, 178
Investment Company Act, 42 Allocation requirement, 180
investment rules, quantitative, 79 Apportionment requirement, 179, 180
other bodies and institutions. see Other compliance, 179
parties involved in supervision guidance, 179
personal investing, 59 objectives, 178
poor, 183 regulatory principles, 179
portfolio optimisation, 80 rules, 179
quantitative investment rules, 86 rules in detail, 180
SEC, 51 Systems and controls. see Systems and
shareholders, 186 controls
systems and controls. see Systems and Systems and controls
controls audit committee, 181
UCITS, 37 business continuity, 181
uniform, 181 business strategy, 181
voluntary standards, xvii, xviii Chinese walls, 180
Supervisory authority, 165 compliance, 180
and actuary, 188 delegation, 180
and auditors, 187 principles, 179
and custodian, 189 remuneration policies, 181
and fund board, 57, 169 risk assessment, 180
and management company, 167 rules, 180
and shareholders, 186, 187 storage, 181
annual and half-yearly reports, 135 suitability, 181
collaboration in the EU, 165, 168 supply of information, 181
compliance, 183 Tactical asset allocation
ERISA, 166 Special Funds, 41
EU, 165 Tactical asset allocation and asset
FSA. see FSA allocation in the broader sense, 124
fund board Tails of distribution, 121
lawsuit, 187 Target benefit plans, 15
government guarantee, 37 Tax allowances
instruments of incorporation, 167 ESOP, 111
intervention, 169 pension reform, 18
penalties, 169 Taxation
pension funds advance, 22
disclosure, 135, 136
291
INDEX
deferred. see Exempt-Exempt-Taxed derivatives, 81

(EET) derivatives funds, 38
Taxes Directive, 37
prospectus, 133 reform, 38
Taxes and returns. see Effects of taxes on disclosure duties, 37
returns diversification, 109
Technical reserves, 115 expenses, 134
Three-pillar pension system, 1, 13, 15, 18, fees, 134
22, 24 fiduciary duty, 48
TIAA-CREF, 74 funds of funds, 38
Time diversification, 82 harmonisation, 26
Time premium. see Liquidity premium index funds, 38
Total shareholder costs investment rules, quantitative, 79
and expense ratio, 156 money market funds, 38
definition, 158 permitted activities, 67
development, 158 products, xvi
Rule 12b-1, 156, 158 prospectus, 133
sales load, 158 recognition, mutual, 37
Tracking error, 94, 99 securities lending, 38, 81
definition, 139 single issuer limit, 108
Trading strategies, 107 single market, 24
Transaction costs, 98, 100 supervision, 37
active portfolio management, 96 valuation of fund assets, 77
bid/offer spread, 102 Underfunding. see Dynamic Minimum
components, 102 Funding Requirement
derivatives, 107 Undertakings for collective investment in
fees & expenses, 102 transferable securities. see UCITS
foreign currency investments, 114 Unemployment, 7, 8, 17
market impact. see Market impact Unit-holders. see also Shareholders
opportunity costs, 102 Unterstützungskasse (benefit funds), 40
Transactional efficiency, 114 US retirement assets
Transactions involving conflicts of mutual fund share, 32
interest total volume 1999, 31
in the EU, 64 volume, 32
personal investing, 58 Valuation committee, 77
Transactions involving conflicts of Valuation of fund assets, 77
interest in the USA, 58 compliance, 184
Transfer agent, 42, 43 custodian, 189
Treynor ratio, 140 Value added, 98, 99, 100, 102, 107
UCITS, 37 Value at risk, 82, 139
amended investment rules, 80 PPS, 138
and shareholders, 186 Value/growth strategy, 103, 104
annual and half-yearly reports, 134, Versicherungsaufsichtsgesetz. see
135 German Insurance Supervision Act
authorisation, 37, 166 Vesting, 16, 135
authorisation conditions, 167 Volatility, 139
bank deposit funds, 38 Volatility clustering, 100, 101
compliance, 183 Worker mobility, 26, 41
cross-border sale, 37 Working life, 6
custodian, 66, 67, 169, 188 Writing options, 107
definition, 37
292

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Asset Management

Otto Loistl and Robert Petrag

OTTO LOISTL AND ROBERT PETRAG

Vienna, March 2002

Preface to the First English Edition v

Executive Summary xvii

Chapter 1 Setting the Scene 1

Chapter 2 The Scenario Today 5

Chapter 3 A Description of the Structural Components of the

Chapter 4 The Regulation of Management Risk 58

Chapter 5 The Regulation of Investment Risk 79

5.1.6 Quantitative restrictions 108

Chapter 6 Control and Enforcement of Rules and Regulations 145

Chapter 7 Summary of Findings 191

Annex A Replacement Migration 195

Annex B FSA Handbook Timetable 199

Figure 19: Risk/return of five differently structured portfolios for

Figure 45: Sales-weighted total shareholder cost ratio for equity

Table 6: The “three pillar model” – sources of retirement income

THE MARKET OPPORTUNITY

opportunity for establishing asset management standards, particularly because

THE USA AS PIONEER AND COMPETITOR

CURRENT AND PLANNED LEGISLATION IN THE EU

PROPOSALS FOR STANDARDS

x Transparency about transaction and management costs, soft dollar rules

Setting the Scene

primarily on funded pension schemes. The description of the situation in

1.2 THE PROBLEMS

1.3 STRUCTURE OF THE STUDY

present successful international examples of supplementary funded pension

management and investment risk. Each section then concludes with

The Scenario Today

2.1 STRUCTURAL CHANGE IN THE ASSET

2.1.1 Inherent weakness in pay-as-you-go state pension

Overview of the problems

Country or Region 1950– 1965– 1995– 2020– 2045–

Country or Region 1950– 1965– 1995– 2020– 2045–

Adhering to the principles of the pay-as-you-go model essentially means

Estimated demographic trends in Germany

Figure 1: Age structure 1992 Figure 2: Age structure 2040 (worst-case

Population Population Proportion 65 Increase in

as a consequence of net immigration of around 700 million people

Figure 4: Proportion of migrants 45 to total population in 1990, and projected to

x A potential alternative to high levels of immigration is an increase in the

Country or Region Retirement age (years)

Funded pension systems to supplement the pay-as-you-go system

Pillar Type of pension and financing

In addition, past experience shows that the effective return on securities

Year Effective return on Growth in real gross earned income

1994 level 1998 level Target level for 2020

Country Share (%) Country Share (%)

The pillar 2 supplementary61 pension systems are generally financed by

defined contribution (DC)64 schemes:65 only in the latter case do pension

Germany’s latest pensions reform

x Introduction of a needs-driven basic provision.84

Monthly pensiongross = Personal earnings points · Pension type factor · Current

In view of the by now very commonplace gaps in working life, the

Figure 5: State support under the German Old-Age Provision Act97

These payments are reduced if a defined percentage (rising from 1% in

State allowance State top-up ratio