Automated compliance management software in the specialised world of fixed income holds the key for asset managers to control their financial risk, maintain client relationships and win new business in these turbulent times, says Adrian Pay, of LatentZero. Below, he tells GC.com readers why it makes sense to invest in compliance technology.
This year has been a nervous one for investors. The collapse of blue-chip names like Enron, Adelphia and WorldCom into a morass of debt has left people anxiously wondering who will be the next big company to admit to accounting irregularities or fraud charges or is about to hit the brick wall of financial reality.
Times have changed. Not long ago fixed income investment was the sleepy side of asset management, all about yield curves, currency and duration, while managers were filling their portfolios with high quality telecom debt. But now even companies like BT, Deutsche Telecom, France Telecom, KPN and Ericsson are no longer seen as being as reliable as they once were.
Yesterday’s nice safe investment could be tomorrow’s victim of yet another profit warning or credit downgrade. Portfolio managers are now busy picking companies that look like they are long-term survivors, not short-term winners.
But while the tea leaves of the investment world are currently almost impossible to read, investors are still demanding portfolio performance, while managers have to remain within the investment restriction limits set by their investment management agreement. These restrictions are becoming harder to monitor, with pension consultants recommending ever more complicated restrictions and debt re-ratings cropping up every day. As a result portfolio managers are caught between complex investment restrictions that cannot be easily checked on the one hand and the daily shuffling of credit ratings in their accounts on the other.
Ordinary credit rating restrictions are hard to monitor. For example, if one rule limits any investment to just A-graded securities, that means that every day the portfolio manager has to check that none of the hundred or more issues held has been downgraded. Plus if the manager has ten portfolios then the monitoring is ten times harder, making life very complicated.
Another problem comes when dealing with rules based on a percentage of the portfolio in a credit band, for example saying that not more than 20% of the portfolio can be in securities rated between AA/Aa and BBB/Baa. Very few people have the time to manually add up all the securities in this band, and split credit ratings only complicate the calculation.
But the toughest credit rating restrictions include those based on a benchmark or an average credit rating or which have any combination of permitted/prohibited ratings. Some examples of these rules say that the average credit level of the portfolio should remain above AA, or that you cannot invest in securities rated below A unless the asset manager believes it to be of at least A grade quality. Restrictions like these win gold medals for complexity but every asset manager will have something similar in their mandates.
Just to add to the burden for the asset manager, institutional investors would like all their compliance checks to be run pre-trade as well as overnight. Institutional investors and their consultants know that credit risk has gone up sharply since the bursting of the TMT bubble and are focusing on how their managers can monitor restrictions and manage potential breaches. The way that they keep an eye on events and deal with any problems will help to keep clients happy, and could even attract new investors.
Using compliance systems, such as LatentZero’s Sentinel, asset managers can demonstrate to their clients that they can monitor and manage the toughest restrictions thrown at them, and even check these pre-trade as well as post-trade.
Bringing in compliance technology can therefore free up the portfolio manager to focus on investment decisions themselves – which is what investors are paying them for. This should give stronger performance and also reassures clients that the asset manager will stay within the rails of investment rules. It also reduces the risk of any straying, even accidentally, from the straight and narrow. Basically it’s a win-win situation for everyone – which is good news in these volatile times.