In a relay race, individual runners may set blistering paces. But a team might still lose if one of its runners is either too slow or drops the baton.
"The same logic applies to investment funds when passing information between individuals, departments, and applications internally and externally," said Holly Miller, a founding member and partner at Stone House Consulting, a Thornton, Pa.-based operations consultancy specializing in providing advice to fund management firms. "Plenty of errors can happen when that data is delayed, wrong or lost in transit."
Investment funds are now taking action-and spending money-to reduce mistakes which can happen in the middle and back office, according to industry consultants and software vendors. Those errors involve anything from booking a trade incorrectly to failing to settle on time-and there is plenty of room for other glitches in-between. Among those are a late corporate action notification, an erroneous valuation of an over-the-counter derivatives product, and a mistaken margin call.
No one wants to say just how much operational mistakes cost fund managers so there are no official figures. But there is plenty of anecdotal evidence to suggest they can be expensive. "It could be anywhere from several thousand dollars a year to several million depending on the type of error and who is to blame," one operations director at a New York investment firm told Money Management Executive.
There are also no statistics on just how much fund managers are spending to reduce errors and the associated operational risks. However, a recent research report issued by TowerGroup in Needham, Mass., uncovered some correlation between what investment funds consider to be the riskiest middle- and back-office functions and how they allocate their technology budgets.
Mistakes in processing a corporate action, said TowerGroup Director of Securities and Investments Research Dayle Scher, were chosen by 43% of the investment fund respondents as posing the greatest operational risk. That is because some are sending notifications to investors on corporate action events or decisions on tender and exchange offers to custodian banks through either fax or email.
Sixty-six percent of the fund managers surveyed said they are implementing improvements; those involve using either using the network operated by the Society for Worldwide Interbank Financial Telecommunications (SWIFT) to communicate information on corporate actions in a standardized way and make decisions, or relying on some sort of data-scrubbing engine to ensure accurate information and workflow.
"Middle- and back-office executives were once the only ones concerned about whether or not the firm had correct corporate action information, but the front office and trading desk is now taking an interest," said Gerard Bermingham, vice president of business strategy at Information Mosaic, a New York-based corporate actions and custody platform provider.
Case in point: Let's say a fund manager owns 1,000 shares of stock priced at $50. The shares are thus worth $50,000. If there is a 2-for-1 stock split, the fund manager now owns 2,000 shares, and the price has dropped to $25 per share. If the portfolio manager or trader wants to eliminate the entire position in the stock and the stock split-the corporate action for which a notification is sent-has not been processed correctly, it is possible that only 1,000 shares will be sold. That will inadvertently leave a 1,000-share position in the portfolio.
Although poor reference data ranked fifth in terms of operational risk, it tied for second place along with client reporting as two key areas being tackled by investment managers. And with good reason. Errors in reference data can not only lead to failures to settle trades on time, but also reduce the ability of firms to measure their enterprise-wide risk. This will become critical as regulators on both sides of the Atlantic begin to monitor systemic risk-the potential for the financial failure of one institution to affect others.
"Efficient data management and governance has now become the cornerstone of efficient operations," said Elizabeth Schneider, a principal at Citisoft, a consultancy in Boston specializing in investment funds.
Among the possible improvements: Creating a single data repository which feeds downstream applications. But that might not be the most ideal solution because firms will need to spend lots of money figuring out just how to integrate-or move-that data quickly into different applications so it can also be accessed quickly by the business line executives who need it. And they have to hope that the data has the same format or naming convention.
Aite Group, a Boston-based research firm, estimates that midsize asset managers and larger hedge funds with between $30 billion and $120 billion in assets will spend between $3 million to $4 million on data integration while smaller asset and hedge fund managers with less than $30 billion in assets will spend up to $500,000. That integration involves a cumbersome process of hand-coding, replication or a process known as extract-transform and load.
But some quantitative fund managers, says Schneider, who are dependent on high volumes of data to make quick trading decisions are turning to an alternative means of data management known as data virtualization; it's a cloud-based approach to data management. That means the data does not have to reside in a business application but in a sort of "middleware" layer; its contents are defined by metadata-data about the data. Such a scenario allows business line managers to reduce the time it takes to move data from one application to another and allows them to quickly access data and deliver it anywhere in the organization.
Although timeliness of data access may not be as urgent for middle- and back-office professionals as it is for traders, accuracy remains paramount to client reporting and other middle-office functions such as reconciliation and exceptions processing. Mistakes can not only lead to reputational risk and potential litigation but also regulatory scrutiny if fraud or even poor recordkeeping is suspected.
Concerned with reducing operational risk while keeping costs at bay, fund managers are faced with a tough choice to make-either build technology, license it or outsource a process. Cost is only one factor. Control and time to market are others.
"Some firms don't want to build new applications from scratch due to maintenance, resource constraints and time," said Patrick Murray, president and chief executive officer of STP Investment Services, a financial services outsourcing firm in Exton, Pa. "Purchasing a vendor software system can also be a costly integration exercise so outsourcing enables the fund manager to focus on its core competencies."
STP Investment Services aggregates all position, trade, analytics, benchmarking, performance and attribution data for fund managers from external data vendors, fund administrators and custodian banks into its own data warehouse and reconciles any discrepancies to ensure accurate client reports, risk metric calculations and net asset valuations. To prevent potential settlement failures, the firm will also collect information from multiple custodian banks on the status of the trades and flag any transactions in which the cash or securities might not be delivered on time.
But even if fund managers outsource their middle- and back-office function, they still have the fiduciary responsibility to ensure that reconciliation and exceptions processing takes place on their end. "It is critical that this certification process be automated in order to achieve the greatest level of control and audit possible, and so that the process occurs as efficiently as possible," said Nolan Gesher, senior product manager for Fiserv, a global provider of financial services technology solutions in New York. The firm offers an account control module attached to the firm's reconciliation software which allows them to keep track of who has finished which exceptions processing task and which supervisor has agreed.
Celent, a New York-based research firm, predicts that asset managers will account for close to 40% of the $829 million to be spent on reconciliation and exceptions processing software in 2012. The impetus: diversifying from equities to fixed income products and over-the-counter derivatives and cross-border trading.
Still undetermined is how fund managers will react to new regulatory requirements-adopted in the U.S. and pending in Europe-to report many of their trades in OTC derivatives to a trade repository and clearing them through a central counterparty service. "In some cases, there could be a reduction in trading of OTC derivatives while in others fund managers will opt to spend more on reconciliation services, collateral management and valuation services," one operations executive at a New York fund management firm told Money Management Executive.
That could mean either outsourcing middle-office services or buying more software. But neither are panaceas. Outsourcing of operational work doesn't relieve the fund manager of its fiduciary and legal responsibilities to ensure accurate reporting. Too many diverse applications can increase the potential for error if they don't effectively communicate with teach other.
"Firms are currently reviewing just which third-party platforms have overlapping capabilities and in some cases are eliminating redundant software packages systems if one can perform multiple functions or has multi-asset class capabilities," said David Kubersky, New York-based managing director for SimCorp, which provides software to manage front-, middle- and back-office services.