Over the past year, the SEC and Financial Industry Regulatory Authority (FINRA) have begun broadly examining funds, advisers and broker-dealers by using complex analytics techniques. While analytics are not new to buy-side organizations, incorporating improved technologies and processes into regulator focus areas does provide new opportunities to improve operations and better target compliance requirements. Customized analytics may be developed using advanced methods that address these areas and bring multiple benefits to buy-side firms.
Last November, the SEC released "Forensic Measures for Funds and Advisers" to guide firms on the types of analytic tests that funds and advisers could include as part of their compliance program. With the increased regulatory scrutiny on trading practices, firms must look beyond assessing controls to analyzing voluminous and often complex data. Sometimes referred to as forensic testing, an integrated analytics approach to compliance programs has become a necessity.
The Five Focus Areas
One of the challenges in developing effective and meaningful compliance and fraud tests is that most asset management organizations require a level of customization not available through packaged solutions. Using techniques that embrace newly developed visualization capabilities that give insight into business activity evidenced in the data can provide greater value in compliance and operational improvement. Areas that should be considered include:
Portfolio management and trade allocation. Focusing on hedge funds and mutual funds business, the most important tests in this area must ensure that the firm complies with fund rules and prospectuses. Analytics can also examine performance disparities across clients, funds and managers, and can test for noncompliant activities. The goal of these tests is to find hidden patterns or relationships that traditional spot checks or threshold testing would miss.
Broker arrangement and execution. With the implementation of Reg NMS, intended to provide transparency into whether customers are receiving best prices for their trades, broker favoritism and best execution have become serious buy-side concerns. The most important tests analyze commissions and look for correlations among sales and trades, soft dollars, and management overrides.
Financial reporting and fund accounting. The accounting integrity of positions flowing through to financial statements poses a significant area of risk to controllers' departments. The most important functions in this area now focus on ensuring the integrity of reference data (i.e., security master files) across disparate order management and account systems, as well as reconciliations with third-party vendors that manage different aspects of the business (e.g., custodians). Financial statement analytics focus on identifying fraud in journal entries, particularly cash-based transactions.
Gifts and entertainment. Firms making investment decisions now have a responsibility to closely analyze employees' expense behaviors and patterns. The most important tests include comparing sales and trading activities to trader and portfolio manager expenses. More-basic tests include keyword searches, statistical analysis by expense type, and levels and variance testing.
Personal trading. Inappropriate personal trading risk may result in compliance issues and elicit questions about a buy-side firm's professionalism. Firms often lack all the data needed to identify cases of insider trading that may go across multiple firms and parties. However, they do have the ability to compare their investment stakeholders' trades to major events on the Street and within their firms, and to view disparities between individual accounts and client performance. At a foundational level, firms should analyze their restricted securities master for integrity and accuracy.
While not comprehensive, these items cover target areas that can guide buy-side firms to direct their compliance thinking toward analytics. Many of them are traditionally tested through process controls, but employees may find new ways around these areas that analytics can help identify. This testing helps to strengthen controls and identifies new controls to put in place.