The Investment Management Back Offi ce 119 These interactions are facilitated by different clearance and settlement agents, depending on the type of security being traded. The time between trade and settlement also varies—in the United States some securities, such as Treasury notes and commercial paper, settle on trade date; outside the United States, some settlement cycles remain weeks in length. In all cases, however, the pro- cess ends with the transfer of ownership and movement of money.
The trade operations group makes sure trades are processed to completion successfully. They obtain records of trades that have been executed by the front offi ce, and compare them to the notifi cations that come in from the bro- ker and clearing organization. They confi rm the trades with the brokers, and affi rm the trades through DTC. If one of the parties involved in the settlement sends a non-recognition notice (called a DK, for “don’t know”), they research and resolve the problem so that the trade can settle properly. Most often, DKs result from one of the parties—investment manager or broker—not including enough information on the record it creates of a trade, rendering it impossible for the trade to be recognized.
Having a discrepancy cause a trade to fail—that is, to be invalidated and have to be redone—can cost money for the investment manager. For example, consider the case in which the advisor sells a security, the security’s price on the market falls signifi cantly, and then the trade fails. If the advisor has to make the sale again at the new, lower price, someone has lost money. If this happens, the regulations make it clear that the investment advisor, not the fund, is on the hook for the losses. The SEC interprets Section 206 of the 1940 Act, the anti-fraud provisions, to mean that advisors are expected to insulate clients from trading losses.3 The SEC has made it clear that an advisor cannot use soft dollar arrangements to absorb any loss for which it is responsible;
it has to come out of the advisor’s pockets. Needless to say, the back offi ce works hard to ensure that trades do not fail. When a trade failure does occur, the trade operations group must determine who is at fault (e.g., advisor, bro- ker, counter-party), and the amount of loss that must be made up to the fund.
When Compliance Monitoring Fails
Portfolio compliance monitoring seeks to prevent rules violations that may be unlikely to occur, but which have serious consequences when they do occur. The case of PaineWebber’s Short Term U. S. Government Income Fund illustrates just how serious those consequences can be.
In the early 1990s, PaineWebber brokers sold this fund to their clients as an alternative to money-market funds or CDs, an alternative that would provide a higher yield at only a slightly higher risk. (Some brokers started calling it the “CD buster.”)5 The fund’s prospectus stated that it sought the highest level of income consistent with preservation of capital and low volatility of NAV. Further, an appendix to the prospectus disclosed that the fund would avoid certain types of securities, including specifi c types of interest only and principal only stripped mortgage-backed securities. This approach to pursuing this objective proved successful. By 1993, the fund had gathered $1.3 billion in assets.
Unfortunately, however, the portfolio manager for the fund started violating these rules in pursuit of better performance. He bought some of the explicitly forbidden securities—“inappropriate IO and PO securities,” as the SEC termed them in its enforcement procedure fi ndings.6 No compliance monitoring detected or fl agged these acquisitions. No one suspected any problem at all, as long as interest rates remained low.
When interest rates increased sharply in the fi rst half of 1994, however, the response of these securities—a steep drop in price—illustrated precisely why they shouldn’t have been in the portfolio in the fi rst place. To compound the problems, the portfolio manager disguised this price drop—he overrode the prices they were getting each day from the custodian with prices he derived himself, prices that averaged about 27 percent higher.7 No compliance monitoring procedures caught this, either.
Finally, in early May, cash fl ow needs forced the fund to sell some of these securities—
at prices much lower than the manager had been using—and the cat was out of the bag. On May 6, the fund was revalued using the custodian’s prices for the securities, and the NAV dropped 4 percent in one day. Brokers and shareholders screamed, senior management began investigating, and the SEC took notice. Over the next few months, the entire story came out. The results were catastrophic.
• PaineWebber ended up paying $283 million to fi x the problem—$250 millionto buy the questionable securities from the fund, and $33 million to settle shareholder lawsuits.
• The SEC fi ned PaineWebber $500,000 for failing to adhere to the prospectus in managing the fund.
• People lost their jobs: the portfolio manager, and both the chief investment offi cer and the president at Mitchell Hutchins, the PaineWebber subsidiary actually managing the fund.
• Shareholders bailed out, reducing the fund’s assets from $1.3 billion to $600 million within a year.
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• In an attempt to regain credibility, PaineWebber engaged a third party subadvisor, PIMCO, to manage the fund, at a cost to PaineWebber of about $1.5 million per year.
• Both the portfolio manager and the chief investment offi cer were sanctioned by the SEC.
From the SEC’s point of view, it was a clear-cut case of failure to monitor compliance.
Said Colleen Mahoney, SEC deputy director: “the case is a reminder to fi rms to pay attention to what their portfolio managers are doing. This fund was recklessly invested and PaineWebber wasn’t monitoring their manager properly. Well, if the fund companies don’t, we will.”8
directors engage the manager, the custodian, or another entity to carry out the operational steps involved in compliance monitoring, while they retain ultimate responsibility.
Different fund groups organize the compliance monitoring function differently, and many aspects of compliance are not related to the portfolio composition. These other aspects of compliance—dealing with such issues as distribution and regulatory reporting—are discussed in the next chapter.
Portfolio compliance and risk monitoring are sometimes termed investment management “middle offi ce” functions. Since they focus primarily on the trades and securities holdings of the fund, they resemble back offi ce functions and are discussed here. Portfolio compliance monitoring falls into two broad categories: pre-trade compliance and post-trade compliance.
All fund groups perform post-trade compliance monitoring in one way or another. The compliance group examines records of the fund’s portfolio holdings at periodic intervals, usually quarterly or monthly, looking for cases in which a rule has been broken. This monitoring is typically evidenced by checklists that are completed and signed by a compliance offi cer. For many fund companies, this activity remains manual—compliance offi cers pore over reports of fund holdings, ticking off their fi ndings on paper checklists. Others have automated at least part of it, having computer programs compare records of fund holdings with the rules, and highlighting exceptions.
Unfortunately, periodic post-trade monitoring leaves open the possibility that a problem trade could go undetected for a considerable time, with the potential risk of signifi cant cost involved in unwinding it. For example, con- sider the case in which the advisor violates the industry concentration rule by taking a position in a certain security, but doesn’t discover the fact until three weeks later, by which time the value of the position has declined by $100,000.
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From the fund director’s point of view, this is simply a condition that the advi- sor must fi x. Regulations make it clear that the advisor, not the fund, is liable for any resulting loss. The advisor must “make the fund whole.”
Pre-trade compliance monitoring helps the investment advisor avoid this problem in the fi rst place. Advisors that have had costly compliance viola- tions typically become very interested in implementing pre-trade compliance procedures. Pre-trade compliance checking is implemented via a computer- ized trade order management system. First, the compliance staff articulates the rules in a way that they can be input into the system. Then, as each trade order is entered, the system checks it against the rules. For example, when the portfolio manager enters an order to buy Intel, the system goes through a hierarchy of checks: Is this a forbidden issue? If not, does it violate the rule on how much of a single stock we can own? If not, does it drive us over the limits for the industry? The list can go on. If there is an apparent violation, the sys- tem signals an exception. Investment management staff check to see whether the violation is real, in which case the trade cannot proceed.
Pre-trade compliance checking does not eliminate the need for post-trade or back-end compliance monitoring. Market action may bring a fund’s position out of compliance with a regulation even if no trades have been made. For example, a fund that had a prospectus limit of 15 percent for any individual sector could fi nd that rising prices had raised the market value of its holdings in one sector to the point that it violated the 15 percent rule. These types of violations are caught by periodic monitoring of the fund positions against the rules.
Even if a fund’s investment advisor follows every regulation, prospec- tus requirement, and management company policy perfectly, that does not eliminate risk for the fund. For example, a fund holding a perfectly acceptable (from the compliance standpoint) portfolio of bonds could incur signifi cant losses if interest rates shift signifi cantly in the wrong direction, or a major issuer defaults. Risk management involves analyzing these and other types of bad things that might happen to the fund, and determining what should be done to reduce their potential impact. The function is harder to describe than other investment functions, since the discipline is only a few years old, and no two fi rms approach it in the same manner. Some observers argue that asset managers such as mutual funds are only just beginning to apply risk manage- ment techniques.9
Risk monitoring can be as simple as measuring certain attributes of the fund’s portfolio (duration, credit rating profi le, country exposure, etc.) and comparing them to targets or benchmarks. Portfolio managers do this sort of monitoring in the normal course of running the fund. In other cases, risk management may involve running computer models that project what would
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Compliance versus Risk: The Piper Jaffray Affair
A fund’s manager can operate in complete compliance with the regulations and the language in the fund’s prospectus, but still subject the fund to unacceptable levels of risk for its shareholders. The incident of the Piper Jaffray Institutional Government Income Fund illustrates the difference between compliance and risk monitoring.
This fund was aimed at institutions and high net worth individuals that wanted to earn better than deposit account rates on their excess cash. In the early 1990s, the fund gave them exactly what they sought, and by 1993 had attracted $800 million from investors the likes of the Minnesota Orchestra and the towns of Maple Grove, and Mound, Minnesota. Portfolio manager Worth Bruntjen’s investing strategy had made the fund the best performing of short-term government funds in 1993, and the money poured in.10 To accomplish this, however, he had to take some considerable risks. In early 1993, Bruntjen had nearly 60 percent of the fund’s assets invested in three types of mortgage-backed derivative securities:11
• Principal Only Strips—securities that do not bear interest, and entitle the holder to receive only the principal component of the payments made on the underlying mortgages;
• Inverse Interest Only Strips—securities that pay the investor in inverse proportion to the interest payments being made on underlying securities; and
• Inverse Floaters—securities that pay the holder an interest rate that adjusts periodically in the opposite direction of a specifi c index.
happen under various circumstances (interest rates change, foreign exchange rates change, etc.). Value at risk (VaR) modeling attempts to express the amount of risk inherent in a fund’s portfolio of securities at any given time by explicitly calculating how much money the fund could lose under speci- fi ed circumstances. The model repeatedly simulates the portfolio’s behavior as it changes underlying assumptions, and develops a profi le of the resulting outcomes. Doing VaR calculations requires specialized computer systems and staff dedicated to using them.
However a fund’s management handles risk monitoring, it remains a combination of art and science, with much of the art lying in human judg- ments about the validity and applicability of the quantitative results. A VaR model may show that the fund could lose $10 million tomorrow if German interest rates fall, but will those rates fall? And even if we believe that they will, what’s the best action to take? The best that directors and shareholders can ask for today is that fund management monitor risk using some systematic technique, and act upon the results it receives.
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