For asset managers and third-party administrators (TPAs), the daily valuation of securities can represent a daunting task. As a basis for multiple net asset value (NAV) calculations, TPAs and fund managers have a window of under two hours to price tens of thousands of instruments across multiple asset classes for hundreds of funds.
In Europe, and now increasingly in the US, the pressure is on to complete this process not just once a day, but throughout the day. Multiple valuation points are standard for European firms, with some pricing on the hour and up to 15 times daily. In a live, fast-moving trading market, where prices change constantly, multiple intra-day valuations can place major demands on a financial institution’s resources and operations. As the fuel of those operations, and effective fund management, there is an urgent need for a more efficient approach to pricing.
Risks and costs for the pricing process
As Europe’s asset managers and TPAs look to expand their customer base and achieve growth, the need to carry out multiple intra-day valuations in tighter time-frames creates risk for the pricing process. This risk only increases when firms rely on manual input and spreadsheets to manage their pricing data.
What is more, many asset managers and TPAs rely on just one source of data to price instruments. With no back-up sources to validate prices, this approach not only increases the risk of inaccurate valuations but also of no pricing updates at all, should a data vendor’s system fail for any significantlength of time. Corporate actions can add another layer of complexity to the pricing process, and their impact on prices must be closely monitored and reported on. Again, purchasing just one feed for corporate actions data makes this impact hard to validate, increasing the risk of errors.
All the while, the investment world is itself becoming more complex. To differentiate themselves in a highly competitive market, traditional, “long-only” asset management firms are increasingly adopting hedge-fund-style strategies and trading alternative over-the-counter (OTC) instruments. Although regulation now decrees that most standard OTC products must be cleared by central counterparties, a large number of exotic instruments are still not traded at an exchange. Electronic pricing data is therefore not available on these often illiquid products. To value them, firms instead rely to a far greater degree on human calculations and input – running a greater risk of human error.
Beyond introducing significant risk and potential for error, a largely manual approach to pricing is costly for asset managers and TPAs. Typically firms have responded to growing pressures on pricing processes by hiring more staff. For organisations looking to achieve scale, this will prove an unsustainable solution as intra-day valuations and NAV calculations become more common and onerous.
Taking a wrong turn: the impact of inaccuracy
In the first instance, inaccurate prices will inevitably lead to inaccurate NAV calculations. As well as having a negative impact on anyone transacting with the fund, this can potentially dilute the fund itself or reduce its value for remaining shareholders. Incorrect valuations can also have a knock-on effect on performance presentations and, if they are based on performance, the calculation of fees. Perhaps most importantly, a fund’s reputation can suffer. Recent years have seen a number of high-profile court cases and news stories related to the incorrect valuation of instruments. Whether undervaluing by mistake, or fixing prices by design, institutions are more and more likely to misprice securities when manual processes are involved: spreadsheets can be malleable; numbers may be dropped; human errors could creep in.
The road to compliance
In the wake of well-publicised incidents of mispricing, where portfolio managers have had a little too much control over the prices of certain instruments, regulators around the world are paying new attention to valuation practices.
Although no specific regulatory guidelines on valuation have been issued as yet by, for example, the US Securities and Exchange Commission or the European Securities and Markets Authority, the need for checks and balances across pricing processes is growing. This is particularly the case when no current market value is available. With funds having to use a certain amount of discretion to determine fair value, rigorous controls must be in place to underpin their judgements.
Steering the way forward
Now that oversight is the watchword of valuation processes, the role of the chief compliance officer (CCO) is gaining importance. As the eyes and ears of the board in terms of compliance issues, CCOs are driving a new emphasis on internal valuation control – and the previously undervalued pricing function as a whole. As a result, a cultural shift is taking place. For oversight and due diligence, asset managers are generally increasing their awareness of, and proactive involvement in, the details of the pricing process.
Policies and procedures
Ultimately, the new, more rigorous approach to pricing is leading funds to more clearly define policies and procedures for the valuation of instruments. Making sure these mandates are both created andare carried out is becoming the cornerstone of robust, compliant pricing.
An internal pricing mandate could be as simple as always using a primary data source feed and a secondary pricing feed to compare it with, and – if these don’t match – a named third source to validate one or the other. For non-standard OTC instruments, with no electronic feeds to help price them, the procedure may not be as straightforward; the main objective, for compliance and control, is to have a procedure in place to start with.
Full speed ahead but in control: new ways to drive down costs and risk
Intent on retaining control over their mandates, while reducing the costs and risks of in-house pricing, asset managers and TPAs are increasingly looking to outsource pricing validation processes to external service providers. An outsourced model will adhere to the firm’s own policies and procedures for pricing and corporate actions, thereby keeping ultimate control of the function in-house. At the same time, it can introduce a range of new benefits for the outsourcing firm.
Automation is key to the pricing services provider, instantly reducing the risk of human error and significantly speeding up the pricing process. The validation component of calculating an NAV can take up to 90 minutes; an automated solution, hosted on the provider’s own powerful infrastructure, can scrub and validate prices in 15 minutes. It will compare feeds as dictated by a firm’s mandate, and automatically generate easily digestible reports on the results.
High levels of automation can even be applied, not only to validating prices and corporate actions for traditional instruments, but also to the core processes of pricing illiquid OTC products. Working with the customer’s brokers, the provider will apply tolerance tests and other checks to the prices provided, using artificial intelligence to transfer details from faxes or emails into the automated system. Any manual data input along the way, for example of a price given over the phone, will be subject to a four-eyes approval process. Here, the data is collected and entered independently by two different pricing services team members.
Independent validation and audit trails
In itself, an outsourced pricing service is an automatic guarantee of independently validated, and therefore highly trustworthy, prices: critical for peace of mind in the new age of compliance. For OTC valuations in particular, it also automates the generation of an audit trail – demonstrating that pricing policies and procedures have been followed, and any inaccuracies are not the fault of the asset manager or TPA concerned.
Economies of scale
When pricing is carried out in-house, increased demands on valuation processes inevitably result in higher staff and infrastructure costs. A large pricing services provider may value hundreds of thousands of instruments on a daily basis and, by automating price validation for many customers, can offer unrivalled economies of scale as well as scalable infrastructure.
Focusing on strengths
As well as helping reduce the cost of additional resources, an outsourced pricing service will ultimately help get more value from existing staff. By taking on the most time-consuming yet least skilled aspect of NAV calculations, the service provider allows in-house teams to concentrate on the part of the process where they can add critical value, which is in an oversight capacity.
By adopting an automated price validation process, asset managers and TPAs are better poised to accommodate a broader range of flexible investment solutions, inclusive of larger volumes of more complex instruments, to meet their clients’ demands. Ultimately, the focus is on retaining existing clients and winning new business.
Conclusion: power effective fund management with efficient pricing
Price validation is rarely a core competency for asset managers and TPAs, nor should it become one. In the front office, fund managers’ talents lie in stock picking, fund allocation and marketing; in the back office, the focus should be on managing complex discrepancies in pricing data.
That said, pricing validation is also a critical part of fund management activity, not least when it comes to achieving compliance and building a reliable reputation. If fund managers are fast, expensive cars, with the sleek brand identities and gleaming chassis they need to market themselves to investors, then pricing data is their fuel. Every vehicle, however sophisticated, needs good fuel to perform well and go far. Without accurate, reliable, independently validated prices, fund managers cannot operate at the peak of their powers.
SunGard is a software and technology services company that serves approximately 25,000 customers in more than 70 countries and has approximately 17,000 employees. SunGard provides software and processing solutions for financial services, education and the public sector.