New SEC Reporting Forces Big Analytic Leap for Funds

Duration, options delta, gamma, vega. total monthly return and payoff profile.

These are just a handful of the data points which mutual fund companies will be required to provide the US Securities and Exchange Commission if the regulatory agency finally adopts its new reporting rules for registered investment companies.

For the SEC, the new data requirements represent what it calls a “modernization” of how it oversees the registered investment fund market. It wants to know whether there is any potential systemic risk arising from widespread investor redemptions. That concern also prompted the regulatory agency to propose other rules on how registered investment fund managers should curtail their use of derivatives and manage their liquidity risk.

However for fund companies, the finding, accumulating and presentation of all of the new data could feel something like undergoing a crash course in ancient Greek. Even the most technologically sophisticated firms might not mastered all the analytics involved. If they have, they certainly didn’t disclose them to the public. In requiring the information to be revealed to the SEC and partly disclosed to the public on a delayed basis, the SEC is holding fund companies to a far higher standard of accuracy. The price for inaccuracy could range from a letter of deficiency all the way to a financial penalty.

The SEC issued its proposals on the new reporting requirements last year and completed the comment period. Hence, the new rules have yet to be adopted. Still, regulatory reporting and risk consultants are warning fund companies to start preparing for the inevitable now. Reporting could start as early as 2018 for the largest fund management complexes or as late as 2019 for smaller shops. “Funds can’t wait until a month or two before reporting begins. It could take most funds a minimum of six months to adequately prepare,” explains Samuel Won, managing director of Global Risk Management Advisors (GRMA), a New York-based risk management consultancy.

SEC Ready and Waiting

Those who believe they have nothing to worry about because the SEC won’t be able to analyze the hoards of information it will receive through the new reporting forms had better think again. The agency has made no secret of its desire to improve its capabilities to acquire, store and analyze data. It recently formed the Office of Risk and Strategy to lead a risk-based, data-driven approach to protecting investors. In its 2017 budget request to Congress, the SEC asked for funding to expand data analytic tools that assist in the interpretation and analysis of huge volumes of market data. The agency specifically said it would create three new positions to conduct ongoing data analysis.

“The SEC will indeed be able to collect, compile, aggregate and analyze the massive amount of information on Form N-PORT by the time it is first filed,” says Paul Soltis, global market manager at Confluence, a Pittsburgh-based regulatory reporting software firm.  He recommends that to prepare for regulatory exams mutual funds try to mimic the analysis the SEC will do when viewing the same data.

A new monthly Form N-PORT would replace the current Form N-Q which is now used to report portfolio holdings at the end of the first and third quarters. For larger mutual fund complexes — those with over US$1 billion in assets under management — Form N-PORT won’t be required to be filed until 18 months after the effective date. For any fund under that size, it would be 30 months later.

Form N-PORT is intended to give the SEC sufficient information to analyze market, credit, liquidity and other risks on a fund level across specific types of funds and industry-wide. In a nutshell, here is what the new form requires: general information about the fund including assets and liabilities, portfolio-level metrics including complex risk metrics, information on securities lending transactions and counterparties involved; cash flow data; information on monthly returns, and information on specific derivative contracts such as the characteristics, terms and conditions of each contract. The additional metrics of duration and spread duration, most relevant to bond investments, are designed to measure a fund’s sensitivity to changing market conditions such as changes in asset prices, interest rates or credit spreads. Information on liquidity pricing and fund flows would also be included as would total returns for each of the previous three months. “The SEC has indicated that this information could reveal performance outliers or performance that appears to be inconsistent with a fund’s investment strategy or other benchmarks that may trigger further inquiries from the agency,” says Won.

A new form N-CEN of census-type information, which replaces form N-SAR, would be required to be filed annually about 18 months after the effective date of the new rule. Much of the information on form N-CEN is the same as that on N-SAR. The key difference: additional information on whether open-ended funds have to adjust payments to shareholders or reprocess accounts due to a mistake when calculating the net asset value. The new Form N-CEN also requires data on whether borrowers defaulted on securities loans and the fee structure of the deals.

Of the two forms, form N-PORT is considered the more difficult one to fill out. Of the 124 questions, six involve risk management calculations. Mutual funds might already measure their risk but not at the rigorous level the SEC will now require. “Investment funds will obviously need to familiarize themselves with the information the SEC wants and having financial accounting expertise won’t be sufficient when it comes to risk calculations,” says Won. ” It’s not about calculating profit and loss. It is about measuring the potential for financial loss under different market circumstances.” The SEC has not specified a required methodology for making the risk calculations, but that doesn’t mean funds should take their work as lightly as filling in the box. If they do, they run the risk of triggering red flags and prompting further review of their firms by the SEC, cautions Won.

As if making the risk calculations weren’t hard enough, the SEC wants financial firms to disclose a lot more information about their derivative contracts, such as counterparty data, reference data and all of the economic details. That information might not be located in their existing order management and trade execution platforms.  “Fund firms may need to update any front-end trade systems and booking practices to be far more comprehensive in their data capture,” says Brian Cosgrove, senior manager in the asset management practice of global consultancy Accenture in New York. Likewise, it is unlikely that these same applications would store all of the data on securities lending transactions required by Form N-PORT. Data on the type and amount of collateral used as well as any reinvested collateral would have to be sourced from separate collateral management systems.

With data located in multiple locations — trade management systems, fund accounting, securities lending and finance, and security masterfiles. the chances of errors are high. Firms will be forced to reconcile any discrepancies or fill any missing information before any reports are filed. “Traditionally firms could afford to manually look at each data point in a filing with the SEC, but given the amount of data and the reporting frequency the top-to-bottom approach won’t be possible with Form N-PORT,” cautions Cosgrove. “Therefore, the final controls process would need to take place on an exception-basis only through the regulatory reporting processes and system monitored at the back office.” Such a scenario means that the regulatory reporting systems developed to address the new Form N-PORT would need to include automated data validation and highlight any occurrences of missing or inconsistent data. This would allow regulatory reporting teams to focus their scarce resources investigating potential glitches.”

Shouldering the Workload

Just who will do all the work to comply with the new reporting requirements? It will have to be a combination of front, middle and back office operations, technology and compliance experts. Front and middle-office staff would likely be involved with data collection and calculations of risk metrics while back-office staff could do the reformatting into the XML schema. Technology experts would implement either internal applications or third-party systems while compliance directors would need to draft a specific program outlining the respective roles of each department and any testing procedures.

Also important is deciding who will sign off on the reports before they are submitted to the SEC. Ideally, they should be reviewed by multiple C-level executives including the chief risk officer, chief compliance officer and chief financial officer, according to Won. “At the end of the day to get the reporting right, it comes down to having proper people, process, controls and governance in place,” he says.

Some fund complexes might also decide to turn to their fund administrators for help with the daunting reporting task, given that the service providers already possess some of the data elements. However, they might not have all of the data required or be able to make risk calculations or even have the data reformatting abilities. Operations managers at two fund complexes say that given their poor experiences with fund administrators in filing Form PF, documentation required for private fund advisors, relying on fund administrators may not be the best choice. Likewise, not all fund administrators contacted by FinOps Report were confident of their skills. Two out of three say they will not be able to leverage the experience of their alternative fund teams in preparing Form PF because mutual funds are serviced by separate units which might not communicate with each other.

For funds wanting to better control and monitor the reporting process, hiring a risk management firm such as Won’s to set up the necessary process controls and governance mechanisms might just do the trick. GRMA will also assist with producing the risk metrics. Firms such as Confluence specialize in data aggregation, non-risk based calculations, populating regulatory forms and producing the necessary XML files.

Operations managers at US mutual fund complexes tell FinOps that they are still in the early stages of preparing for the new reporting requirements by analyzing where the data is located and how the new risk metrics will be calculated. “We are speaking with compliance and IT folks about what collecting the new data entails and who will be responsible for what,” says one operations manager. “We’re waiting for the SEC’s final rules to be released before doing any more work.”

Compliance managers and reporting teams will likely share most of the workload during the first months of complying with the new SEC reporting rules, predicts Cosgrove. “They will have to ensure the proper systems, procedures and control points are in place to handle the initial filings,” he says. “However, once that takes place, back-office reporting teams will carry the weight of monthly reporting going forward.”