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How regulation creates risk in managing investment

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Regulation is seen by fund managers as the chief buy-side risk, a new study suggests. That's bizarre, since rules are meant to lower the financial danger in investment management. Well written regulation, and self-regulation as well, should ensure that asset managers have the required skills, capital, infrastructure and time to be opportunistic and prudent in equal measure.

Responders to the PRIMA/Sunguard research do have a substantial point, though. Regulation – from Dodd Frank to Solvency II and all stops in between – has a downside. The dangers are that rules will be misunderstood and/or misapplied. The cost of compliance can harm wealth and wealth creation. Regulation can also obscure the ultimate goals of investment: the efficient allocation of capital and the effective pursuit of financial security.

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The risks are different for the portfolio managers and for the owners of capital invested. Regulators can catch out incompetent and negligent investment managers – which is, for them, a palpable danger.

While sound policing helps economies and owners of invested wealth, wrong-headed regulation can also be an investment risk in itself. The popularity of high-grade sovereign bonds may well be a salutary case in point. Regulation – no doubt written in good faith – has triggered a shift in asset allocation among pension funds, in the U.K. and elsewhere. Badly burned by their over-exposure to equities in 2000-01, pension funds moved into bonds. Corporate sponsors of pension schemes also realized that their obligation – to regulators and shareholders – was to cover liabilities and reduce the risk of seeing value destroyed. Bonds, not equities, suited.

Those regulatory imperatives, however, raised investment risks now seen in the value of high-grade sovereign bonds. Though wider economic and financial circumstances cannot be ignored, regulation has pushed yields on triple-A government debt to record lows. Forward-looking asset managers are getting smarter and the best of them appreciate the risk that regulation will make investors suffer if, or when, the bond bubble bursts. At times, managers may have to challenge or work around regulatory strictures if they are to run truly balanced investment risks.

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