Since the global financial crisis, regulators have given increased attention to the responsibilities of fund management companies* in overseeing their delegated functions. The US Investment Company Act of 1940, and AIFMD and UCITS in Europe, are clear that – while the valuation function may be outsourced – the overall responsibility for the accuracy of the net asset valuation (NAV) lies with the fund management company. The maxim is that: while you can delegate the duties, you cannot delegate the responsibility.
A combination of industry trends – including mounting regulatory pressure, the growing popularity of passive investment strategies and the rise of ETFs, fee pressures and reduced margins – have presented managers with the challenge of having to fulfil their fiduciary duties in a cost efficient manner. Added to this is the pressure to ensure NAV timeliness. With strict publication deadlines, it becomes particularly challenging to ensure NAV accuracy and timeliness across a wide range of funds. Processes therefore need to ensure operational efficiency, as well as a demonstrable level of control.
When things go wrong…
As a number of recent cases have highlighted, the cost of NAV errors can be significant. Firstly, with an obligation to report such errors to regulators and shareholders, miscalculations can be embarrassing and – more importantly – may damage the trust and respect of investors.
Secondly, there is the issue of compensation. Investors who have bought or sold shares in the fund at an incorrect price need to be compensated accordingly. If the NAV price is overstated, then those who purchased shares will need to be compensated. However, it does not follow that those who sold shares will be expected to reimburse the fund for the amount from which they benefitted. Therefore, in practice, the loss is often compounded.
But the cost of compensation is just one aspect to consider. Fixing a NAV error takes time away from precious resources. Significant work is needed to investigate the error, plan a resolution, report to the regulators, involve the fund’s auditors, notify and reimburse the affected investors, and to ensure the ongoing reporting of controls. This all comes at a cost that far exceeds that of ensuring things are right in the first place.
Prevention is easier and cheaper than remediation. NAV errors are costly, timely and carry reputational risk. To mitigate these risks and fulfil their obligations to investors, fund management companies should ensure that appropriate and transparent controls are in place within the valuation function.
The importance of pricing controls
When exercising their statutory obligation to oversee the valuation of the fund, the fund management company must pay particular attention to ensuring that the valuation policy and procedures contain the appropriate pricing methodologies for the various asset classes of the fund’s investments (for example, the source, timing and type of quote used). In addition, detailed methodologies must be evident for fair value pricing, valuation of illiquid instruments and OTC derivatives. These must reflect the valuation rules as set out in the fund’s Prospectus.
Best practice dictates that there must be sufficient controls in place over the valuation function to ensure adherence to the valuation policy. The exercise of these controls must be transparent to the fund management company for it to fulfil its duty in overseeing the valuation function. Reporting of key metrics such as exceptions to the pricing rules, manual overrides, pricing errors, number and duration of stale prices, number of broker quotes, illiquid securities and fair value adjustments are invaluable tools that aid in achieving transparency in pricing the assets of the fund.
So what are some of the key controls that can be deployed in pricing and what real world value do they bring? The following are some examples of pricing controls that form industry best practice:
1. Price variation check
Perhaps the most basic and commonly used check, the price variation check verifies if the daily percentage price movement is within a pre-defined tolerance.
Care should be taken to ensure that the tolerance level applied is appropriate to the volatility of its asset class. If the tolerance level is too low, the result will be an unnecessarily high number of exceptions. This must of course be balanced with ensuring that errors are identified early. Other factors affecting volatility, such as the price size (“penny stocks”), should also be considered when defining tolerance levels.
2. Vendor cross check
Regulations commonly require the fund management company to ensure the reliability of pricing sources. With increasing regulatory scrutiny, it’s feasible that reliance upon a single pricing source for valuing the fund’s assets may soon become unacceptable.
Seeking market consensus for a price enables fund managers to verify the reliability of the primary source, as well as challenge occurrences of missing or stale data.
3. Index check
Checking price movement against that of a relevant index can be useful in determining whether a large price move can be explained by volatility in the market. Care should be taken to ensure the reference index closely reflects the attributes of the instrument, whether that be sector, market capitalisation or volatility.
4. Stale price check
Stale prices receive much attention with good reason. If an asset is not valued at the latest realisable price, there may be concerns that this presents an arbitrage opportunity for short-term investors, which would be to the detriment of long-term investors. Notwithstanding, it’s important that stale prices are identified, challenged and, where appropriate, priced at fair value.
5. Quotation type check
These checks ensure that prices sourced from a vendor are of the correct quotation type (eg – bid, last traded, mid etc.). This check is necessary to ensure adherence to the methodology of the valuation policy.
Selecting a pricing master that you can depend on
While the trend is for firms to rely less on manual processes, reliance on spreadsheets and macros for price control processes is still common practice at many organisations. This approach introduces a number of risks – manual errors, key person dependencies, incomprehensible or unstable code and lack of scalability.
Given the risks introduced by manual processes and macros, as well as the regulatory and fee pressures firms currently face, it is now more imperative than ever to have a pricing master application that you can depend on.
When deciding which system to implement, there are a number of important factors to consider. Consideration factors include the range of pricing vendors that the system supports, the set of out-of-the-box validation rules available, as well as connectivity to downstream systems.
One should also consider to what degree – and how easily – these business processes and rules can be customised to meet the specificities of the business systems and processes. For example, how easy is it to implement new validation rules to meet the fund’s valuation policy? And can these customisations be performed at the business user level, or do they require the intervention of specialist IT resources?
As well as satisfying these requirements, a good pricing master should also deliver the process efficiency and scalability needed to fulfil regulatory and fiduciary obligations in a cost effective manner.
The regulatory landscape of the fund management industry continues to change at pace, with an ever greater focus on the oversight of the delegated valuation function. Fund management companies must be confident that their valuation policy is fit for purpose, addresses the valuation risks that pose a threat to shareholder interests, and is adhered to in the valuation of the fund. Good data management is critical to achieving this.
Pricing controls form a key role in ensuring that the valuation of the fund’s assets is correct and in line with the methodologies detailed in the valuation policy. Care should be taken in selecting a pricing master application that delivers the control, transparency and efficiency that’s required in today’s operating environment and that provides the flexibility and scalability to fit with firms’ current and future data governance requirements.