Portfolio compliance experts at fund management firms may not like to talk about their accidental breaches of investment guidelines, but they are quickly waking up to their need to do something about them.
There is simply too much at stake. Portfolio compliance is a fundamental competence investors and regulators assume they’re getting. Admitting to even a few breaches doesn’t inspire confidence, even if the missteps are corrected as soon as they’re discovered and investors made whole.
Errors can easily happen when external events, such as a significant market shift triggers a need to divest or replace securities. No surprise there. What is more noteworthy are other ways they can occur due to shortcomings in technological, data, and operational oversight. Front-office systems might only catch breaches after they happen, data management might not be optimized for investment compliance monitoring, and governance might not be sufficiently focused on finding solutions.
Common accidental breaches include trading in the wrong assets or with the wrong counterparties, or allocating investments to the wrong underlying account. Considering the complexity of operations, technology and data involved it may not be possible to entirely eliminate breaches. But the number can certainly be reduced, says global consultancy Deloitte in a recent survey evaluating just how well fund managers are faring.
Among the recommendations offered: find root causes to resolve issues that contribute to breaches occurring, conduct forensics to identify patterns in breaches, and identify the causes of recurring false alerts. However, it’s even better if these potential breaches are identified before they have to be cleaned up — just before a trade is about to be executed.
Measuring the Problem
Just how prevalent are these accidental breaches? About 36 percent of the twenty six investment management firms surveyed by Deloitte for its analysis say they violate their investment restrictions anywhere from 16 times to 50 times a year. More than 20 percent had over 50 breaches, and of these, the overwhelming majority had more than 75 a year.
Fund managers contacted by FinOps Report wouldn’t quantify how the breaches compare to the total number of trades executed. Deloitte’s survey likewise doesn’t offer any numerical context for the reported breaches. However, as Miguel Miranda, a director with Deloitte’s investment management practice notes, even one mistake can be expensive. While two-thirds of respondents estimated that their breach costs at less than $10,000 apiece, at the high end 17 percent of the respondents saw costs of US$500,000.
Those are just the explicit costs of making the fund — and its investors — whole by either selling out or replacing a position. They don’t include the operational burdens of tracking down the causes and correcting portfolio accounting, recordkeeping and reporting systems, not to mention the ever-present risk of market volatility affecting prices and ultimate costs. Three operations specialists at US fund management firms tell FinOps that, based on the size of a trade and market conditions, correcting a single error could consume US$1 million. That would mean fund managers are really forking over multimillions of dollars annually to fix investment breaches, which hurtst their bottom lines.
Let’s not forget reputational and legal costs. Investors aren’t keen on such operational mistakes, and neither are regulators which can fine firms for breaching fiduciary duties. The US Department of Labor, for one, has strict guidelines on what pension plans following guidelines imposed by the Employee Retirement Income Security Act (ERISA) can and cannot invest in. The US Securities and Exchange Commission might be understanding if a fund manager makes an unintentional error, but is unforgiving if it doesn’t make investors immediately whole as evidenced in a case involving Western Asset Management Company (WAMCO) highlighted in an article appearing on FinOps on February 5.
Ounce of Prevention
Optimally, fund managers should prevent investment breaches from occurring in the first place, and one of the ways is to confirm that front-office systems are doing what they are supposed to — preventing prohibited trades from going through. Surprisingly, they might not. “While trade order management systems (OMS) are generally well-linked with an organization’s investment compliance monitoring system, the lack of connectivity between investment compliance systems and execution management systems (EMS) can generate issues,” explains Miranda.
One possible result: the use of prohibited counterparties, particularly when it comes to derivative trades. The execution with a restricted counterparty may not be detected until the trade is completed and subsequently screened by the investment compliance (ICM) system during post-trade routing. Of the two-thirds of survey participants who use trade execution platforms, 50 percent have a compliance check for approved brokers after the trade is executed, but before it is allocated and sent to the portfolio accounting department. Another 36 percent check in a different timeframe and 14 percent don’t check at all.
Deloitte’s recommendation: investment managers should evaluate whether they can monitor investment management guidelines throughout the trading life cycle, because EMS platforms often do not feature or enable the same level of connectivity to an ICM as an OMS. Ideally, fund managers should enhance their EMS to allow prohibitions to be entered on each trade during the execution phase to prevent the use of prohibited counterparties. Yet another option, not cited by Deloitte, but offered by one US fund manager contacted by FinOps: using a blended platform known as OEMS which incorporates both investment compliance, order management and trade execution functions.
Definition Discrepancies
As is the case with all compliance tools, ICM engines run on rules and data. Discrepancies in terms related to investment restrictions and contracts can lead to misinterpretation, causing inadvertent breaches or preferential treatment of some portfolios, another regulatory no-no.
Effective management of interpretative issues calls for a consistent approach to identification, investigation, resolution and corrective action, says Deloitte. Yet about 68 percent of participants in its survey did not have a standardized approach to addressing enterprise-wide interpretative matters. Here is just one example of what can go wrong, say fund management operations specialists: a fund manager classifies preferred stock as a debt instrument for the security masterfiles and other recordkeeping systems, but the investor considers it as an equity. Without a reconciliation of definitions, a trade might go through in preferred stock which shouldn’t have.
If the investment management contract does not define a term — such as preferred stock — then its up to the fund manager to be consistent in its definition for all of its accounts. Such definitions need to be made by a cross-functional committee or working group, which should include representatives from portfolio management, compliance, sales, operations and legal departments, according to Miranda and other US fund management operations specialists contacted by FinOps. Of course, when in doubt, consulting with the client is always the best modus operandi.
Also increasing the potential for error: the lack of accurate and sufficient data on hand necessary to meet investment compliance guidelines. Because ICM systems are highly dependent on data quality and availability, fund management firms should conduct periodic assessments to determine whether the necessary data is complete and accurate. Additional data feeds may needed to enable systematic compliance monitoring. Otherwise manual monitoring is required, which is often inefficient and costly, says Deloitte’s survey. Forty six percent of fund manager respondents report that half of their manual rules were due to data limitations.
The necessary data and/or rules might be related to the underlying constituents of an industry benchmark which fund managers must meet — such as the credit ratings on a particular bond or the duration. “Obtaining that data on a consistent automated basis through vendor datafeeds could be costly and if the fund management firm doesn’t want that expense, the firm’s operations department could end up having to look it up and manually input it into the rules-based investment compliance system,” explains Matt Grinnell, compliance officer for the buy-side front-office solutions provider Fidessa in Boston. Such a hybrid approach to data management could easily generate errors.
“Ample data can generate efficiencies in rule monitoring by reducing the number of manual monitoring procedures performed and providing or enhancing the ability to perform forensic trend analysis,” notes Deloitte’s survey.
What to Do
Clearly, system performance is a critical factor. “There should be a periodic assessment of the systems as well as the investment compliance rules developed in the system to reasonably ensure the system and the rules are working as intended,” recommends Miranda.
In a worse-case scenario, having a solid communications gameplan is also critical to proving to regulators, clients and investors that the fund management firm has gone the extra mile to mitigate any potential damage. Once investment compliance departments become aware of a breach, so must the portfolio management unit — and fast. As a rule of thumb, the quicker the breach is rectified, the lower the impact to investors and the lower the cost for the fund manager to fix. Of course, it goes without saying that the fund’s board; the governance committees of the fund manager and C-level executives must also be notified. So should institutional investors when separately managed accounts are affected, says Miranda.
Just how far along are fund managers to meeting the best practices recommended by Deloitte and other experts? Deloitte’s survey did not include participants’ future plans, but one operations specialist at a US East Coast fund management firm tells FinOps that the firm is evaluating all of the front-end systems used by trading desk to decide whether to reduce the number of OMS and EMS platforms used.
“Consolidation is one way fund managers are tackling the matter,” acknowledges Grinnell. Too many overlapping platforms can be duplicative and costly to maintain. Even worse, errors might be caught far after the trade is executed, because even the best systems don’t talk to each other.
Another operations specialist at a US East Coast fund management firm tells FinOps that his firm is focusing on more frequent testing of its investment compliance system — quarterly, instead of only annually. In addition, an external auditor is reviewing the test results, along with the internal investment compliance, portfolio management, trading and operations departments with C-level executives and boards of directors receiving quarterly updates. “It’s come down to more of a clearly defined and documented science,” he says. “We’re leaving nothing to chance.”
Excellent article!