Validating NAVs: An Ounce of Prevention Saves a Lot of Grief

Net asset value, or NAV for short: it’s a basic calculation which hundreds of mutual and other investment fund managers have to make each day to allow investors to know just how much they will pay to buy and sell shares or units.

While the timetable for when the figure must be struck might differ, fund managers are starting to quickly realize they have to rely on automated software to do the job for a multitude of reasons. The need for NAV validation always existed but the stakes are higher than ever before. Budgetary constraints during tough economic times are dictating that fund managers reduce their back office-staff. Such a scenario ultimately leads to operational risk, which left undeterred can wreak havoc.

“When NAV errors occur they can cause both reputational damage and additional cost,” explains Paul Westgate, product manager for Linedata’s Navquest automated NAV validation tool in London. The error in NAV doesn’t need to be huge before it’s reported to regulators and in any event, any affected investors must be immediately made whole.

Operations specialists at three US fund management firms agree that the potential for error in striking NAVs is far too high to be ignored. “Should the number of NAV calculations we verify grow while staff is reduced, we could easily overlook a critical data point,” an operations manager at an East Coast fund management shop tells FinOps Report.

Regulators across the globe are also keeping a closer eye on the NAV validation process. Regardless of just who strikes the NAV — a fund manager or its administrator, the fund manager remains legally liable.

Regulatory Scrutiny

The US Investment Company Act of 1940 does suggest that fund managers are responsible for ensuring accurate NAVs, but offers little specific guidance. Still, fund managers know that the Securities and Exchange Commission won’t tolerate lax procedures if investors are hurt.

Foreign regulators appear to be far more outspoken in insisting that fund managers are particularly careful when it comes to outsourced valuations. The UK’s Financial Conduct Authority has put fund managers on alert they must more carefully oversee third-party service providers including those which calculate NAVs. Australia’s securities watchdog the Australian Prudential Regulation Authority (APRA) has also explicitly warned investment fund trustees they must verify the source and accuracy of data used by third-party providers in striking an NAV. APRA has even called fund managers the use of spreadsheets to do so an ineffective modus operandi.

With sophisticated third-party tools now coming to market, fund managers could find it a lot easier to embrace automation. Case in point: the US’ OppenheimerFunds has selected Milestone Group’s pControl NAV Oversight platform. “The solution aims to allow OppenheimerFunds to have a tailored view into the NAV calculation process without replicating their third-party service provider activities,” says a February statement issued by the Sydney, Australia headquartered Milestone which offers two products related to NAV validation. OppenheimerFunds declined to comment for this article but Milestone says it is one of three US fund managers using the NAV oversight tool; it wouldn’t identify the other two.

The pControl NAV Oversight tool, now used by a total of seven fund managers, including OppenheimerFunds, allows fund managers to review the accuracy of the NAV calculation of an external fund administrator; other customers of the two-year old software, include Schroders and Prudential in the UK as well as pension fund First State in Australia.

Milestone’s other legacy oversight tool pControl NAV Control is typically used either fund managers who strike their NAVs in house or by fund administrators doing the work for them; customers include Citi; BNP Paribas Securities Services as well as Canada’s BMO Asset Management Group.

Milestone’s main competitor is Linedata Services whose standalone NAV validation software Linedata Navquest also allows for oversight of NAVs struck by third-party service providers. A more comprehensive product called I-CIPS specializes in both striking and validating NAVs internally and according to Linedata can be used by fund managers wanting to strengthen their procedures for striking NAVs in-house or by third-party fund administrators who do the work for them. Linedata doesn’t disclose the number of customers for either product.

While the use of automation might sound like a given for fund managers it is a recent phenomenon. Apparently, far too many mutual and other traditional fund managers, says Hodge, had been taking the work done by their administrators for granted. Either that or they were using Excel spreadsheets or add-on proprietary software.

The result: an entire oversight back-office departments or multiple oversight departments are required in different geographic locations. Even so, without relying on an automated toolset, it’s easy to miss a discrepancy in a critical data set which could ultimately affect the NAV of an investment fund.

Sniff Test

If it sounds like mutual and other traditional fund managers are engaging in a process the hedge fund community has coined shadow accounting, they aren’t. They are relying at best on a high-level sniff test.

“Under shadow accounting, hedge fund managers are often mirroring the exact work of their fund administrators either in-house or using yet another third party to do so ,” says Geoff Hodge, chief executive of Milestone Group. “The goal might be the same, but the workload is far less in simply validating NAV calculations.”

The reason: fund managers could easily have several hundred NAVs to validate each day and under far tighter deadlines than their alternative fund manager peers. “They [fund managers] don’t have the time to do more with their current tools and resources as NAVs must be struck either at 4PM EST for US mutual funds or intraday for European investment funds,” explains Hodge. “That gives them anywhere from a few minutes to up to an hour or so to undertake all of the necessary validations.”

In some instances, European investment funds also have multiple share classes requiring several NAVs to be calculated each day for a single fund. Case in point: funds which fall under Europe’s UCITS legislation and provide multiple investment options with a range of share classes. Likewise, life company funds with between ten and twenty series could require individual prices to be struck for each series.

If fund managers can’t do a thorough validation of their NAV before it must be published, they could be left praying that either their internal staff or the third party administrator has done their job right. Fund managers will be forced to make some quick decisions about just how much data checking needs to be done and the best way to correct an erroneous NAV. The decision will depend on just how far astray the published NAV is from the accurate NAV and whether investors are affected.

Faced with limited internal resources, fund managers can’t possibly validate every data input which goes into the validation process, but they can still make a best effort, says Hodge. That typically translates into ensuring that at least two dozen validation points are accurate such as the daily cash flows in and out of the fund; income accruals; and tax accruals. The ultimate goal: for asset managers to be focused on comparing the NAV received to an expected NAV or tolerance level.

By contrast, fund administrators typically go through over 100 data checks and validations to ensure the accuracy of their NAV calculations. Those checks include comparing the market value of individual securities each day with the value the previous day as well as verifying changes to total, sector and security level indices; and foreign exchange rates. The reason: administrators also need reassure their fund manager clients that their NAV calculation is solid based on their data integrity.

Human Error

Even such rigorous work doesn’t entirely prevent human errors from occurring: data might have been rekeyed wrong into a particular application or not input at all. The most common data discrepancies involve data related to the terms of a derivative contract; a corporate action or a tax or fee accrual. Depending on the type of error and whether it is caught in time, it’s often a matter of luck as to whether the financial impact — or its effect on the NAV is significant or not.

Still, making the NAV validation process automated is far better for fund managers than printing out NAV reports emailed by fund administrators and verifying the data inputs based on the previous day’s results.

“Using an automated NAV validation process allows just those funds showing exceptions to be focused on instead of having to check each fund, the majority of which are likely to be correct on any given day,” says Westgate. “Typically checks would be focused on a comfort level — for example a movement in a security value relative to a tolerance — a greater than tolerance range movement signalling an exception.” That exception might indicate that a corporate action or an incorrect individual price of a security must be investigated further.

Hodge says that Milestone Group’s NAV oversight tool takes the validation process one step further than its competitors by creating an independent expected NAV that can incorporate data from third-party sources than relying on the administrator’s data.

As a result, fund managers can discover far more quickly whether or not their administrators are on the mark on a given day and even resolve errors in as close to real-time as possible so the wrong NAVs won’t be circulated.

Regardless of just how much work the fund manager puts into the NAV validation, one thing is certain. The days of Excel spreadsheets are over. Cost and risk make it impossible to continue using outdated methodology.
dated methodology.