Form N-PORT: Managers Report Big Stress

Update 12/12/2017: Fund managers shouldn’t feel too relieved by the US Securities and Exchange Commission’s delay on when they must submit Form N-PORT. On December 8, the SEC said that fund managers can wait until April 2019 at the earliest to transmit their completed Form N-PORT to the regulatory agency’s Edgar system. However, fund managers must still hold all of the required data internally and provide it to the SEC upon request.

Published 10/27/2017: Middle-office operations managers, compliance managers, and technologists preparing for the US Securities and Exchange Commission’s new reporting rules for registered funds are still having trouble figuring out to complete the new more detailed Form N-PORT.

Annoyance, anxiety and outright anger are some of what they are feeling, they tell FinOps Report. Their antidote: keep plugging along and hope they are ready by June 2018. Topping the list of pain points: how to translate information located in multiple applications into the machine-readable structured XML format the SEC wants so it can make comparisons between funds. Also providing plenty of angst is how to classify assets into four categories of liquidity: very liquid, moderately liquid, less liquid and illiquid.

Regulatory reporting is one of the most challenging tasks faced by operations and compliance managers. They have to ensure that the information they provide the SEC is accurate. Penalties for inaccurate data range from a warning or audit all the way to a fine. The N-PORT filing must also follow the SEC’s schema, which was released earlier this month. Otherwise, it won’t be accepted and won’t be considered filed. That is where technologists fit into the reporting equation. They act as translators of sorts to convert the information the SEC wants into the right electronic format.

The new monthly Form N-PORT would replace current Form N-Q now used to report portfolio holdings at the end of the first and third quarters. Form N-PORT, part of the SEC’s reporting modernization plan for managers of mutual fund complexes and exchange-traded funds, is intended to give the  regulatory agency sufficient information to analyze market, credit, liquidity and other risks on the fund level, across specific types of funds and industry wide.

Stress Factors

All 20 operations, compliance and IT managers at US mutual funds and ETFs contacted by FinOps expressed concerns about meeting the requirements. “We are not accustomed to some of the questions,” says the compliance manager at one US mutual fund complex. “We’re worried about being prepared for the data schema,” says the technology director at another US mutual fund complex.

The SEC’s new reporting rules are intertwined with their new liquidity rules. The regulatory agency wants to make sure that fund managers have sufficient liquid assets on hand to handle a rush of redemptions. Until now, all fund managers had to be worried about is honoring redemption requests within seven days.

The new liquidity rule Rule 22e4 requiring fund managers to categorize the liquidity of assetsis part of broader requirements on liquidity management. Although the new rule won’t be effective until December 2018 for funds with over US$1 billion in assets under management, those funds  will have to submit more extensive details of their holdings — and liquidity classifications — to the SEC in Form N-PORT as of June 2018.

Form N-PORT requires reporting of assets and liabilities, portfolio-level risk metrics, information on securities lending transactions and counterparties involved, cash flow data, monthly returns, and details of derivative contracts such as the characteristics, terms and conditions. The additional metrics of duration and spread duration, most relevant to bond investments, are designed to indicatea fund’s sensitivity to market movements such as changing 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.

Finding the needed data, calculating the metrics and successfully delivering the report in required XML format to the SEC presents challenges at every step. Much of the information required for Form N-PORT will be stored in multiple applications. Once extracted, it is likely to exist in a variety of data formats, from XML to PDFs which must all be normalized to XML. Information on collateral used for OTC derivatives or securities lending agreements are sometimes in PDF format.

Whatever fund managers knew about submitting other forms to the SEC goes out the window, because the Form N-PORT schema is entirely different. Therefore, technology departments must start from scratch. The SEC will offer fund managers the ability to test their data transmittals until December 2017 and from March to May 2018 using the XML. The testing also includes the validation that will be performed by the SEC to make sure that some data issues, such as incorrectly formatted dates, don’t sneak into Form N-PORT.

Meanwhile, compliance managers are struggling with the SEC’s guidance of how to classify their assets into four liquidity buckets. The SEC says that firms can consider the existence of an active market for the asset, frequency of trades or quotes for the asset, average daily trading volume of the asset, volatility of trading prices, bid-ask spreads and the size of the fund’s position in the asset relative to the asset’s average daily trading volume.

The guidance sounds detailed enough, but it may not be practical. “In today’s highly correlated environment, most assets are not classified on an individual basis in line with the four buckets found in the SEC’s methodology,” explains Joanna Fields, principal of Aplomb Strategies, a New York-based consultancy specializing in regulatory compliance. Therefore, even if compliance and operations managers were to ask traders and risk managers for help, they might not have the correct answers, she cautions. “Historically, risk is generally managed on a portfolio basis through a systematcially developed framework that weighs a number of factors, including liquidity, market risk, credit risk and liquidity,” she says.

Exchange-traded funds and mutual funds relying on hedging strategies using over-the-counter derivatives cannot predict how long it will take to novate — or unwind — a contract in order to liquidate a position following a redemption request. Exchange-traded funds, which are required to honor redemptions in one day, have no experience with determining liquidity — or the potential for assets to be sold — beyond the one day timeframe.

Fund managers who invest in syndicated loans will likely be compelled to categorize those assets as illiquid only because of the lengthy settlement cycle– far beyond the current two days for equities. Even if the assets really aren’t illiquid, compliance managers tell FinOps that they are worried there could easily be a mismatch between the time it takes to receive cash from the settlement of a syndicated loan transaction to the time it takes to pay an investor seeking a redemption.

Outsourcing the process of asset classification might sound like a great idea for operations managers, but compliance managers might not buy it. “We would either have to ask an external provider to use our methodology or we would have to accept theirs,” says one compliance director at a US mutual fund complex. “Then the question becomes whether we use the same methology for each fund or a different methodology.”

What about outsourcing the entire Form N-PORT reporting process to fund administrators? Again, compliance managers of fund management firms are playing it cautious. Of 20 mutual fund management firms contacted by FinOps, only five say they will do so. “We’re worried about mistakes in risk calculations,”says one compliance manager. “We will also want to do the asset classifications ourselves as they wouldn’t b able to come up with the answers because we have the data.”

Sleeves Don’t Match

Mutual funds that are managed by more than one fund manager in a multi-sleeve approach say they are feeling the most pain. It is unclear whether they will report on each sleeve– which partions a portfolio by investor class– individually — or roll up all of the information into a single report. “It is still a grey area and we don’t know which approach we will take,” says one compliance manager. “Doing the data aggregation and any risk calculations on an aggregated approach for multi-manager funds is far harder than for single-manager funds. We can’t just add up any numbers or consolidate information to come up with total results.” Case in point: an equity-focused fund could have a credit-based sleeve. On its own the credit sleeve could have a very illiquid asset composition while the overall fund does not.

Given that there could be inconsistency involved in completing Form N-PORT can the SEC really make apples-to-apples comparisons of funds? Compliance and risk managers are doubtful, but the SEC is willing to take what it can. “We do not believe that data based on estimations of market conditions on a fund-by-fund basis is uninformative or of limited utility, because of the information’s sometimes fund-specific subjective nature,” says the SEC in a footnote to its adopting release on reporting modernization. “Rather, we believe that even with the potential variances in determinations, the liquidity informtion reported will be informative to the Commission.”

The SEC also appears to understand that it is stretching the limitations of fund managers. To that end, it won’t make the first six months of information on Form N-PORT public. “The delay will allow the commission to make adjustments to fine-tune the technical specifications and data validation process,” says the SEC in its adopting release on reporting modernization. “We believe that this process can ultimately improve the data that is reported to the Commission and as required reported to the public.”

But how accepting the regulatory agency will be of mistakes in answering its lengthy list of questions is anyone’s guess. As is typically the case with any compliance challenge, documenting policy and procedures is crucial to fending off any criticisms. “Fund managers will need to come up with auditable information and clear explanations of the methodologies used to clasify each asset class,” says Fields. “They also must implement a process to review the portfolio classifications at least monthly and have the flexibility to account for relevant changes to market, trading and other investment considerations that may materially impact the funds investment classifications.”

The SEC will be looking far more closely at the robustness of a fund manager’s policies and procedures as well as the consistency of the methodologies used to classify assets rather than the answers generated, predicts Fields.