With the twin challenges of March’s significant market volatility combined with remote working still fresh in the memory, it’s a good time to take stock of how operating models performed. In this article, we focus on the challenges fund managers faced while overseeing their net asset value (NAV) production, and draw out lessons learned for the future.

A large percentage of fund managers rely on some form of proxy to validate the NAV calculated by their fund accountant(s). These proxies are usually based on the index that each fund tracks for performance purposes. The heart of our question then is how did this process perform when put under unprecedented stress?

Our data indicates that many of these index-based processes lacked the accuracy to keep pace with market volatility, leading them to highlight possible NAV errors that subsequently turn out to be correct. This introduced significant uncertainty and manual work at a time when efficiency and accuracy were at a premium. Put simply, when these processes were most needed, they often fell short of their aims, and in some respects may have been counterproductive.

Remote working is still a fact of life for much of the industry and may remain so for some time.  Market volatility can return at any moment and is potentially more likely in the context of the ongoing pandemic and its consequences. We can offer an alternative process for accurately and efficiently validating NAVs that specifically addresses the challenges we encountered in our research.

Background

Fund managers can outsource the generation of a NAV, but remain ultimately responsible for its accuracy and timeliness. Regulators are making these responsibilities more explicit than ever, with guidelines targeting the oversight obligations of fund managers and fund boards. The quick fix for many fund managers has been to develop processes using a fund’s index or other ‘reasonability’ checks as a validation mechanism. These are often technically implemented using Excel macros and other semi-automated tools. The benefits of this approach are that it is cheap to implement, and it is relatively accurate in benign market conditions.

As the pandemic unfolded, fund managers started to institute work-from-home practices and other BCP arrangements. At the same time, they also sought to ensure continuity in trading, operations, and client support. The early days were marked by enormous trading volume, massive stock price swings, and exchanges triggering circuit breakers — events that would be difficult to handle even if the industry were not adjusting to working remotely.

The high cost of low accuracy

The importance of accuracy and efficiency in NAV oversight during this period is best illustrated with a case study. We analyzed NAVs of a large complex fund manager and compared them to two NAV validation processes; the first is the commonplace index comparison used by many fund managers, the second is InfoNAV®, a BBH developed solution that recalculates a secondary NAV using many of the same inputs as the primary NAV. The difference in accuracy between these two validation methodologies yielded dramatically different results.

Our fund manager received 4,114 NAVs over the three-week period of maximum market volatility1, all of which were calculated correctly by the fund administrator. However, a validation process based on index methodology highlighted 71% of these calculations as suspect and potentially erroneous using a standard +/-10 basis points (bps) variation tolerance. In other words, during just three weeks, 2,920 NAVs required additional research because the validation mechanism highlighted a potential NAV error. This happened when teams were working from home without the same level of robust infrastructure available to them in the office. There could hardly have been a worse time to ‘cry wolf’ quite so often. Using the same +/-10 bps tolerances, the more accurate calculation methodology of BBH’s InfoNAV flagged just 5% of the fund manager’s NAVs2, delivering a dramatically reduced workload.

The above results are based upon a globally invested range of funds that include a wide variety of instrument types, including OTC derivatives. For less complex managers the results are no less dramatic. The index-based methodology flagged potential errors in 53% and 73% of NAVs in two other case studies we analyzed over the same period, while InfoNAV highlighted just 1.5% in both.

In a previous article “Administrator Oversight: It’s More than BCP,” we suggested that fund managers’ BCP procedures should incorporate a secondary NAV calculation that is independent of the fund administrator. We suggested that a “DIY”, in-house NAV oversight approach, including the use of macros, industry benchmarking, or even more high-level ‘reasonability’ checks, could prove unreliable and may potentially be inferior as a BCP solution. In other words, we highlighted the importance of independent calculation and accuracy, because, at that time, several BCP events highlighted that was an area of potential need. While that is certainly still true, what we did not foresee is that even if a fund accountant successfully and accurately delivers NAVs, there can still be a high cost to pay for having an inaccurate secondary NAV methodology.

Bottom line

Now that the industry is operating in a more business as usual (BAU) environment, managers and fund boards are looking to implement the lessons learned from this unusual and unique period. One of the most important lessons has been that when dealing with a crisis, it is essential to make decisions on the best quality information available and to introduce the least number of unnecessary distractions. Oversight obligations on fund managers and fund boards are becoming increasingly stringent, adding to the need for accuracy and efficiency. The events of March 2020 demonstrated that ‘good enough on a good day’ was not good enough in a crisis when it was needed the most and more accurate solutions proved their worth.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally.  This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. Pursuant to information regarding the provision of applicable services or products by BBH, please note the following:Brown Brothers Harriman Fund Administration Services (Ireland) Limited and Brown Brothers Harriman Trustee Services (Ireland) Limited are regulated by the Central Bank of Ireland,Brown Brothers Harriman Investor Services Limited is authorised and regulated by the Financial Conduct Authority, Brown Brothers Harriman (Luxembourg) S.C.A is regulated by the Commission de Surveillance du Secteur Financier All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved. IS-06261-2020-06-04

1 March 9 - March 27, 2020
2 InfoNAV methodology includes position valuation inclusive of daily trading activity, capstock activity, corporate actions, and accruals / expenses