Used to be you had little idea that that 100,000 shares of Exxon-Mobil you bought for your global growth fund put you over the top for your firm-wide exposure to the fate of a single issuer.

No more.

If your mutual fund is not managing itself with a close eye and auditable trail to how it fulfills its investment mandate, then you're on thin ice. You can fall afoul of your responsibilities to investors under the Investment Company Act of 1940. And, more critically, you may find it hard to attract big money from pension funds and other clients for one, more or all of the funds in your complex.

But automation is starting to solve a good part of that. Using natural language statements, algebraic-like if-then statements and, in some cases, tagging of complex formulas, software is now routinely taking on the task of enforcing the strictures of a mutual fund or exchange-traded fund family's investment policies.

"The diversity of assets [held by funds] is increasing. The number of [investment] policies increasing. No one thinks it's going to go the other way," said Matt Grinnell, buy-side compliance officer at Fidessa Group.

Meaning: It's much more challenging to uphold your firm's or your fund's policies on what it will or won't invest in, without converting those policies into rules that can be watched and enforced, through software.

The trick is making it easy to convert into mathematical form all types of investment policies such as what percentage of a fund's holdings should be in stocks or bonds, how those percentages should change as the size of the fund grows, what percentage of a fund's holdings can be in a single stock or securities from a single issuer, or whether any investments at all can be bought on margin or sold short.

At Charles River Development, this process is handled for the most part in words, not math. Its investment management software lets business executives express their policies in sentences that seem natural. Then, the words in the natural language sentences are parsed and turned into rules for enforcing investment policies.

Take just this one statement: "I must place at least 60% of this fund's funds in U.S. fixed income products."

Digitally, this gets parsed into three key statements:

 

1. I must invest in fixed-income products (aka, bonds).

2. These must be issued in the United States.

3. At least 60% of total holdings must meet these two criteria.

 

There are other ways to create complex rules out of simple mechanisms, as Tom Driscoll, Charles River's managing director of global development, notes. Drop-down menus with pre-established statements that allow a manager to set what percentage of a fund's holdings can be in any single issuer's stock is one, for instance. Storing of re-usable (and modifiable) statements in a rules library is another.

What gets complicated though is the many ways that rules get stacked on rules.

In the case of almost any sizable fund complex, it's not enough-by a long shot-to be able to create a set of rules that for a single fund. That, if need be, could be handled by a spreadsheet or even a manager with a steel-trap memory.

What's required now, as investments get more complex, as the countries of their origin expand, as regulations increase, as the importance of knowing who your counterparty really is becomes paramount, the challenge is to aggregate. To know what's in every fund and roll it up to provide one view of "complex-wide" holdings, as Driscoll calls it. And how that squares with fundamental rules set for an entire fund complex.

This usually boils down, in Driscoll's estimate, to the quality of data being maintained by a given complex. For each security, the fund has to be able to keep track not just of each instrument being held, but the issuer and the controlling entity. Is that capability widespread?

"In most cases, the answer is ... not really," Driscoll said.

The "real trick" for most complexes is to be able to "run calculations across the whole institution,'' he maintains. That is, to figure out what a firm's overall exposure is to certain kinds of derivative securities or the concentration of holdings across all funds in instruments from one issuer or dependent on the economic health of a particular region of the world.

It's not enough, though, to just calculate such exposures. Now, with a flood of new regulatory requirements about to influence investment policies the world over, and clients becoming increasingly concerned that investment policies they're banking on are actually getting followed, a clear audit trail of what's going on inside a fund is critical, said Jordan Schwartz, vice president at HedgeOp Compliance.

Part of this is to prove that a broker serving a fund is not front-running a fund customer. But, more simply, it's re-assurance that the money is being put in and handled by safe hands.

It's no longer enough to rely on what Schwartz calls an "honor system."

Interestingly, the challenge of finding ways to embody investment policies in digital code can be an opportunity. A marketing opportunity.

If your systems are working right, they can largely be run in the background, said Roger Kahlon, head of buy-side business development at Fidessa. Violations of policies can be funneled into a queue for a manager to deal with during or after a trading session.

And the ways in which code automates the execution of investment policies can be used to convince clients to increase the assets they place in a fund. These can be run in the background while managers make active, real-time decisions on violations of policies that emerge during or after each trading day.

Now, in effect, a client can be shown not just what the policy is, but the exact formula that is used to carry out its enforcement.

"When it works well, it becomes a marketing tool,'' Kahlon said. "It attracts money."

Used to be you had little idea that that 100,000 shares of Exxon-Mobil you bought for your global growth fund put you over the top for your firm-wide exposure to the fate of a single issuer.

No more.

If your mutual fund is not managing itself with a close eye and auditable trail to how it fulfills its investment mandate, then you're on thin ice. You can fall afoul of your responsibilities to investors under the Investment Company Act of 1940. And, more critically, you may find it hard to attract big money from pension funds and other clients for one, more or all of the funds in your complex.

But automation is starting to solve a good part of that. Using natural language statements, algebraic-like if-then statements and, in some cases, tagging of complex formulas, software is now routinely taking on the task of enforcing the strictures of a mutual fund or exchange-traded fund family's investment policies.

"The diversity of assets [held by funds] is increasing. The number of [investment] policies increasing. No one thinks it's going to go the other way," said Matt Grinnell, buy-side compliance officer at Fidessa Group.

Meaning: It's much more challenging to uphold your firm's or your fund's policies on what it will or won't invest in, without converting those policies into rules that can be watched and enforced, through software.

The trick is making it easy to convert into mathematical form all types of investment policies such as what percentage of a fund's holdings should be in stocks or bonds, how those percentages should change as the size of the fund grows, what percentage of a fund's holdings can be in a single stock or securities from a single issuer, or whether any investments at all can be bought on margin or sold short.

At Charles River Development, the rule setup process in its compliance software is handled for the most part in words, not through programming. Its investment management software lets business managers express their policies in sentences that seem natural. Then, the words in the natural language sentences are parsed and turned into rules for enforcing investment policies.

Take just this one statement: "The fund must invest at least 60% of total assets in U.S. fixed income products."

This gets parsed into three statements:

1.Fixed-income securities

2.Issued in the United States

3.Not less than 60 percent of total assets

In each case, definitions inform the rules. For instance, in the first statement, a fund can create a universe of what securities it will accept as "fixed-income securities" and it can define how it calculates total assets, net assets or other denominator it wants to use in the third statement.

There are other ways to create complex rules out of simple mechanisms, as Tom Driscoll, Charles River's managing director of global development, notes.

Drop-down menus with pre-established statements prompt the user in the rule-building process to set out what percentage of a fund's holdings can be placed in securities from any single issuer, for example. Storing of re-usable (and modifiable) compliance rules in library is another.

What gets complicated though is the many ways that rules get stacked on rules.

In the case of almost any sizable fund complex, it's not enough-by a long shot-to be able to create a set of rules that for a single fund. That, if need be, could be handled by a spreadsheet or even a manager with a steel-trap memory.

What's required now, as investments get more complex, as the countries of their origin expand, as regulations increase, as the importance of knowing who your counterparty really is becomes paramount, is the ability to aggregate. To know what's in every fund and roll it up to provide one view of "complex-wide" holdings, as Driscoll calls it. And how that squares with fundamental rules set for an entire fund complex.

This usually boils down, in Driscoll's estimate, to the quality of data being maintained by a given complex. For each security, the fund has to be able to keep track not just of each instrument being held, but the issuer and the controlling entity. Is that capability complex-wide?

"In most cases, the answer is ... not really," Driscoll said.

The "real trick" for most complexes is to be able to "run calculations across the whole institution,'' he maintains. That is, to figure out what a firm's overall exposure is to certain kinds of derivative securities or the concentration of holdings across all funds in instruments from one issuer or dependent on the economic health of a particular region of the world.

It's not enough, though, to just calculate such exposures.

Now, with a flood of new regulatory requirements about to influence investment policies the world over, and clients becoming increasingly concerned that investment policies they're banking on are actually getting followed, a clear audit trail of what's going on inside a fund is critical, said Jordan Schwartz, vice president at HedgeOp Compliance.

Part of this is to prove that a broker serving a fund is not front-running a fund customer. But, more simply, it's re-assurance that the money is being put in and handled by safe hands.

It's no longer enough to rely on what Schwartz calls an "honor system."

Interestingly, the challenge of finding ways to embody investment policies in digital code can be an opportunity. A marketing opportunity.

If your systems are working right, they can largely be run in the background, said Roger Kahlon, head of buy-side business development at Fidessa. Potential violations of policy are identified, and routed into a queue to be dealt with by the appropriate manager. Other trades continue uninterrupted.

The ways in which code automates the execution of investment policies can be used to convince clients to increase the assets they place in a fund. Asset management firms that can visually show how the policies are enforced. The demonstration of tight controls can lure in more business.

Now, in effect, a client can be shown not just what the policy is, but the exact formula that is used to carry out its enforcement. Furthermore, the system can show testing results from each trading day, to illustrate the guidelines are actively being monitored

"When it works well, it becomes a marketing tool,'' Kahlon said. "It attracts money."MME

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.