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Reconciliations, Risk, and Reporting - The Three “R’s” of CoLIM’S Fund Accounting Department,
and How our Work Impacts and Benefits our Clients
by Ted Sevick
The Fund Accounting Department of City of London Investment Management Company Ltd (CoLIM) has three main objectives:
1) Provide For Management, Oversight of the Custodian and Record-Keeper of our Clients’ Assets
2) Act as an Internal Risk Control to Other Departments within CoLIM
3) Provide Internal Reports to Other Departments within CoLIM
We complete these main objectives through maintaining an internal set of books and records for the assets that we are entrusted to manage on behalf of our clients
as their Investment Manager. While this article will focus primarily on the first objective and the direct impact on our clients, we will first mention a couple of points
regarding the second and third objectives.
From an internal risk control perspective, the CoLIM Fund Accounting Department is separate from the Fund Managers at CoLIM, both in location and within
the firm’s infrastructure. This separation provides internal controls related to various activities on our clients’ accounts. For example, the Fund Managers enter trades
into a front-end trade order management system (Charles River Investment Management System) for matching with brokers. Once trade details are matched with
brokers, these trades are authorized for delivery to the custodian for matching in the market by our Fund Accounting team. The custodians cannot accept instructions
directly from Fund Managers, as all authorized signatories are either Directors of City of London Investment Group (CLIG) or Managers within Fund Accounting.
From an internal reporting perspective, reports based on data from the Fund Accounting database are a primary source of information across the firm. Information,
such as holdings, accruals, country weights, Compliance reporting, Net Asset Values, and cash balances, is generated at the end of each business day based on Fund
Accounting data. This allows for performance measurement and attribution for the prior day to be calculated in our Singapore office at the beginning of the next
24-hour trading day.
With regard to the first objective, the oversight of clients’ assets, there are regulatory reasons we maintain an internal set of books and records. As CoLIM’s head
office is domiciled in London, the Financial Services Authority (FSA) is CoLIM’s lead regulator. By maintaining our own books and records, CoLIM is adhering
to the FSA Rule COLL 6.3.6.2(2)(J), which states “An authorised fund manager needs to be able to demonstrate that it has effective controls over its calculations
of unit prices. Controls include that the fund manager regularly reviews the portfolio valuation for accuracy.” In addition, where the unit pricing of the fund is
delegated to a third party, COLL 6.6.15 states that “the authorised fund manager must ensure that it can monitor effectively the relevant activities of any person
so retained”.
While an internal set of books and records is maintained within CoLIM, we are neither the custodian nor the official record-keeper of any of our clients’ assets.
Rather, we mirror the custodian and official record-keeper’s activities and reconcile their information to our internal books and records. This reconciliation process
is an additional service provided by CoLIM on behalf of our clients, as part of the “Investment Management Services” referenced in Figure 1 below:
Figure 1:
Custody & Valuation Services
Investment Management Services
Client
Contract
Contract
Trading Details
Custodian/
Record Keeper
CoLIM
Valuation Data & Reporting
We complete this mirroring process through a series of reconciliations throughout the day, including holdings, cash, dividends, and for a subset of our accounts,
overall Net Asset Values and Net Asset Values per Share. We mirror our custodians for two primary reasons:
1) To review the processing completed by the official custodians and record-keepers of our clients’ accounts to ensure they have completed this work correctly, and
2) To ensure our internal books and records are accurate, as our internal data is used by the CoLIM Fund Management Team to make investment decisions
effectively in real-time.
The impact of this reconciliation process is different depending on the type of client/account. Generally speaking, we manage two different types of accounts:
1) Commingled products, usually with monthly liquidity, and
2) Segregated accounts, where there is only one client in the account
For the commingled products, which are “daily valued” accounts (even if liquidity is monthly), the recordkeeping function is usually reconciled daily to the custody
system internally at the Custodian, and discrepancies are researched and resolved as a high priority. There are rarely any significant discrepancies at the official monthend valuation point, because these issues are resolved throughout the month.
For segregated accounts, the clients traditionally only receive a report from their record-keeper that includes the market value on a monthly basis, which is usually
sent between 5 and 20 business days after the month-end. This means the record-keeper does not have to reconcile to custody daily, but can instead post certain
transactions at different points during the month, or even after the month-end. This also allows for certain discrepancies to build up over the month, and these are
not always resolved by the client’s stated deadline. These discrepancies, if not reported and reviewed, sometimes influence decision making by our clients on the
basis of inaccurate information.
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How our Reconciliation Work Impacts our Clients
As referenced above, one of the primary reasons we complete the daily reconciliations to our clients’ custodians/record-keepers is to review those service
providers and assist them in providing an accurate valuation to our joint clients.
The CoLIM investment universe contains primarily closed-end funds that invest
in Emerging Markets equities, which historically have caused challenges for the
custodian/record-keepers. We will also invest in common stocks, ETFs, and
foreign or domestic domiciled commingled investment vehicles. In addition,
corporate governance events impact a significant part of the closed-end fund
universe, which means corporate actions like tender offers, share buy-backs, or
large dividend payments will occur.
Additionally, we have found that when dealing with large custodian banks,
there is significant staff turnover at the junior level amongst employees that are
responsible for the daily processing on our clients’ accounts. This contrasts
significantly with the low turnover in our Fund Accounting department at
CoLIM, where 5 of the 8 team members have over 4 years experience, and two
of the team members have been in the department for over 10 years. The average tenure of staff in the department is just under 5 years at CoLIM. As a result
of this frequent turnover of staff at the custodians, we have to often “train”
new employees at the custodian banks how to handle the different securities
and transactions referenced earlier which they are not accustomed to processing.
Focusing on just the reconciliations with the record-keepers, as they are
responsible for providing our clients with their market values on a monthly
basis, we find that discrepancies fall generally under five categories:
• Dividends Due & Accrued Discrepancies: These discrepancies can be
quite large. For example, in last September, there was a $9.282 dividend
that went “ex” on LAQ US (Aberdeen Latin America Equity), causing the
price to drop significantly. Certain custodians did not reflect this dividend
in their valuations, causing the value of the position overall to drop
significantly. Other quite standard discrepancies are caused by custodians
only reporting part of the dividends (for example, the income portion but
not the capital gains portions), or tax withholding rate discrepancies.
• Erroneous Pricing: In certain instances record-keepers have valued a
closed–end fund at the publically stated Net Asset Value instead of the
quoted price.
• Tender Offers: Certain closed-end funds will allow shareholders to “tender”
their shares, which will allow the shareholder to receive either cash or
underlying securities at a set discount to NAV. Record-keepers will often
struggle with accounting for these transactions, as they can be complex
and need input/direction from multiple departments within the bank. We
will often work with the custodian/record-keeper by providing guidance
and forwarding any publically available information.
• Cash and Holdings Discrepancies: These are very rare, and if they occur,
usually will not be a significant issue due to CoLIM’s daily cash and
holdings reconciliations, and our procedures to address such discrepancies
immediately.
• Discrepancies due to Stale Pricing: These discrepancies are frequent,
and can usually be associated with the holdings in foreign or domestic
domiciled commingled investment vehicles. These investments are often
not priced daily by their record-keeper, but instead, are valued weekly or
monthly, and usually at a lag. As such, the price is not always available for
the record-keeper to source in time for the valuation, and they will often
“stale price” the holding, regardless of the moves of global markets. This
is not an issue with the custody function of the bank, as they have a record
of the holding (predominantly via their sub-custody network), but
instead, the pricing of the holding.
On the right is a table showing a representative sample of segregated accounts
that we manage, the custodian and record-keeper of those respective accounts,
CoLIM’s and the record-keeper’s market values (in base currency of the
account), and the difference between the two figures, in both overall market
value amounts and as a percentage. While the data below reflects September
2010 Month-End figures, it is indicative of a “normal” month-end reconciliation, in terms of the distribution and levels of differences.
Figure 2:
Segregated
Custodian/
City of London
Custodian
Difference
Difference
Account
Record-Keeper Market Value Market Value (Market Value) (Percentage)
Account #1
Custodian A
19,280,997.07
19,311,960.88
30,963.81
Account #2
Custodian A
48,106,691.20
48,170,306.98
63,615.78
0.13%
Account #3
Custodian C
256,680,296.38 256,558,768.06
(121,528.32)
-0.05%
Account #4
Custodian B
59,468,609.11
59,426,506.24
(42,102.87)
-0.07%
Account #5
Custodian B
94,276,107.24
94,198,497.97
(77,609.27)
-0.08%
Account #6
Custodian D
338,856,810.37 338,230,185.47
(626,624.90)
-0.18%
Account #7
Custodian D
Account #8
Custodian E
Account #9
Custodian B
Account #10 Custodian D
0.16%
56,548,621.46
56,322,885.30
(225,736.16)
-0.40%
88,911,994.11
88,427,716.98
(484,277.13)
-0.54%
203,938,892.80 202,326,627.98 (1,612,264.82)
86,808,732.91
86,076,643.36
(732,089.55)
-0.79%
-0.84%
Source: City of London Investment Management, Client-Specific Custodians
As shown in the above table, focusing on “Account #10”, any reporting from
their custodian/record-keeper to our joint client showed an ending Market
Value that was 84 basis points lower than our internal valuation. While this
difference was due to the custodian/record-keeper not reflecting the aforementioned LAQ US dividend on the books of the account (despite it being a
valid dividend), the client would only see a report that understated CoLIM’s
performance.
How the External Custodian/Record-Keeper’s Valuation Process
Can Be Improved
At the end of the day, knowledge is power, and we want our clients to have a
robust relationship with their custodians and record-keepers. We also want to
ensure the service providers are doing their job and providing accurate valuations to our joint clients. However, the record-keeper does not have any duty
or responsibility to the Investment Manager, so we are limited in how much
we can pressure them to “get it right”. Below are a few suggestions that our
segregated account clients can potentially discuss with their record-keeper in
order to get the most accurate valuation and reporting:
1) Allow, or empower, the record-keeper to re-open the books if CoLIM
brings a significant discrepancy to their attention.
2) Remind the record-keeper that corporate actions need extra attention,
and that if a security goes ex-dividend, a dividend accrual needs to be
placed on the account due to the resulting price drop.
3) Reiterate with the official record-keeper that stale pricing of securities
is unacceptable. If global markets are rising (or falling) dramatically, it is
not reasonable to value a security on a lag.
4) Request that more items be posted intra-month, instead of waiting for
the month-end to close. Also, request that the record-keeper and custodian
reconcile to each other’s books more frequently during the month so
that the end of the month posting process is smoother.
It is critical that our clients are aware of areas where their record-keepers are
not providing the most accurate valuation of their assets. In order to facilitate
this process, in the first quarter of 2011, CoLIM plans to begin sending our
segregated account clients a review of their specific reconciliation each
month, highlighting any major discrepancies between CoLIM’s internal
records and the official set of records that is being sent to each client by
their respective record-keeper. As shown in Figure 1, this review will augment
the reporting provided by the record-keeper via the official valuation.
Our goal in this article was to give our clients a measure of additional comfort
around the valuation of their assets that we are entrusted to manage, even
though we are not responsible for the custody or recordkeeping of those assets.
We take this aspect of our relationship with our clients very seriously and there
is an entire department of professionals working diligently to assist our clients’
custodians and record-keepers to provide the best service possible.
We welcome “Operational Due Diligence” visits from our clients and/or their
consultants. Additionally, if any client would like to have a deeper discussion
about any of the topics discussed in this article or otherwise, we welcome such
an opportunity.