Investors and regulators aren't the only ones wanting to know how a fund will mitigate its operational risk.

Mutual fund boards are taking a closer look at who the fund manager uses as its service providers and what procedures are used to reduce the potential for error, according to panelists and executives attending a regional conference hosted by the National Investment Company Services Association (NICSA) in New York.

"Operational risk has become a lot more im portant to fund boards in the wake of the financial crisis, the bankruptcy of Lehman Brothers, the market-timing crisis and the Reserve Fund's breaking the buck," said Darlene DeRemer, director of Grail Partners, a Boston investment banking firm specializing in investment managers. "At issue is understanding how the investment fund and its service providers prevent errors involved as simple as data rekeying to as complex as data recovery and even fraud."

The main job of a fund manager is to increase alpha-the return to investors. But even the best strategies won't help if mistakes in valuing and pricing over-the-counter derivatives, onboarding customer accounts, settling transactions, and managing collateral eat away at the bottom line.

Not only do funds risk having to compensate investors for any accidental losses, but they may have to pay regulators. That doesn't even include the administrative cost of fixing the errors.

Fund boards may not be as adept as dedicated chief risk officers in understanding operational risk but that doesn't stop them from trying. They will often include an executive with some risk experience and do study up on just where the fund manager and its service provider could trip up.

Rightly so. "They don't want to be a rubber stamp for the fund manager," DeRemer said.

Under the Investment Company Act of 1940 and state laws, fund boards are obligated to ensure that investors are protected from the mistakes made by fund managers and other service providers.

Fund managers often outsource their middle- and back-office operations to banks or other third-party firms. These functions can include accounting, managing the portfolio valuation process, pricing non-exchange traded securities, reconciling with the books of counterparties and other agents, collateral management and processing of over-the-counter financial contracts.

"After understanding the investment discipline and process, fund boards want to analyze service providers carefully to ensure they have the correct infrastructure, scalability and strong financials," said Tom O'Brien, president and chief executive officer of State Bank, who serves as an independent board member to the Prudential Annuity Funds. "We don't want to find ourselves surprised by the failure of key procedures after the engagement of a fund manager or any service provider."

To that end, O'Brien said, fund boards might insist on periodic onsite visits to sub-advisors and key service providers to get a first hand look at all the facilities, staffing, systems and procedures used.

Boards are also asking for customized reports from the fund manager and its service provider outlining what checks and balances the fund manager and its service provider are taking to avoid human errors, software glitches, and the loss of confidential data on transactions and customers, DeRemer said. Those customized reports are presented during quarterly meetings attended by the fund manager and the chief compliance or risk officer of the service provider.

Among the questions that fund boards will ask fund managers and their service providers are: how counterparty exposure is monitored; how non-exchange traded contracts are priced and recorded; how newly traded financial instruments will be accounted for and processed; and how the service provider will reconcile positions with multiple counterparties, said Jim Volk, chief compliance officer for SEI Investment Manager Services. Such reconciliation should be done daily, when possible, in the case of collateralized transactions such as swap contracts. Counterparty risk is also mitigated more if margin postings and collateral movements are done daily.

"Fund boards may question how fund managers reduce counterparty exposure and often prefer that exposure be measured based on the notional value of the applicable derivative contracts," said Volk, whose firm offers middle- and back-office services to fund managers and plan sponsors. "They also want to know that fund managers will use independent sources of valuations as much as possible and not rely too heavily on broker-dealer quotes which might be suspect."

Investing in new markets can also turn out to be a tricky proposition particularly if the overseas countries don't follow the same regulations as the U.S. when it comes to how their securities depositories, transfer agents and sub-custodians record ownership of shares and assume liability in the event of a computer glitch or theft.

While fund managers might be able to hedge against currency fluctuations there is little they can do if foreign regulations don't allow for foreign depositories and local service providers to compensate investors from any operational errors or wrongdoing that occurs.

Fund boards can also be reactive. "Fund boards take a systematic view to focusing on how fund managers and their service providers could mitigate the risk arising from human error but idiosyncratic events can play a huge role in the questions asked during an impromptu meeting," said Timothy Levin, a partner in the investment management practice of Morgan Lewis & Bockius in Philadelphia.

One recent case: AXA Rosenburg Investment Management's $25 million civil fine in February by the Securities and Exchange Commission for failing to notify senior management and investors about coding errors in its quant models, causing a financial loss.

Fund boards immediately started asking fund managers how they were mitigating the risk of coding errors to their quant models.

Yet another: widely publicized lawsuits filed by pension plans against some large custodian banks for an alleged breach in their fiduciary duties in executing foreign exchange transactions. "Fund boards are meeting with custodian banks to go over the operational procedures used to ensure their foreign exchange orders are executed at the best price possible for the fund," Levin said.

The worst mistake a fund manager or its service provider can make: not telling a board about any errors made and addressing what steps will be taken to prevent them from occurring in the future.

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