Top Five Questions Fund CCOs Should Consider When Conducting Subadviser Due Diligence and Oversight
For many firms, transaction volumes have grown steadily over time. The manageability of their compliance rule libraries is reaching a critical point while the process and controls around them are failing. Although technology of compliance systems has improved, functionality and performance lag behind industry and regulatory changes. Securities have become more complex and violations are occurring because of incorrect coding - causing potential errors at the issuer level.
On the surface, the automated compliance library can appear to be smooth sailing. The reports look good and there are no major complaints from the front office or from clients — “everything looks cool.” However, compliance teams need to look beyond the surface; what lies beneath is often the cause of costly errors.
Uncontrolled library growth, inconsistent interpretation of mandates, rules that don’t match actual trading activity or regulations, false positives, excessive overrides and data issues are just a few of the reasons that investment managers miss violations and risk monetary and reputational loss. Without a rigorous, annual testing of the automated library and supporting data, the results portfolio managers and compliance teams rely upon are likely to harbor error rates of 25% or more but there are questions CCOs should ask subadvisers to mitigate mistakes.
Generally, the Fund CCO is associated with the adviser and may have oversight for the Fund’s compliance program, including some level of oversight of the compliance library. Here are the top five questions that Fund CCOs need to take into consideration when conducting subadviser due diligence and oversight.
1. Which compliance systems/service providers does the subadviser use to monitor compliance with the Investment Company Act?
a. How long has this system been in place?
b. How often are due diligence meetings held with the service provider?
c. How does the service provider notify its customer regarding system enhancements and upgrades?
d. Have any recent systems been replaced or upgrades been implemented?
e. Provide a sample of management/exception reports generated from the system.
f. Has the service provider been issued a SSAE16?
2. Does the subadviser have sufficient policies and procedures in place to comply with the requirements of 38a-1 of Investment Company Act?
a. How often are these policies and procedures reviewed and updated?
b. What are the policies for escalating material trading violations to compliance?
c. Does the subadviser have a compliance rules management program (i.e. a program implemented around detailed policies and procedures for compliance rule coding and maintenance) implemented at your company?
d. Are risk assessments performed?
3. Does the subadviser have sufficient staff/resources to support the compliance library?
a. How many employees have access to the compliance library and what is each person’s role?
b. What is the process for approving new rules added to the library?
c. What type of training is conducted with employees?
d. Has there been turnover? How is turnover handled?
e. Has there been a third-party review and/or audit of the compliance library?
4. Have there been any material violations due to systemic errors?
a. How often do false violations occur due to incorrect coding or rule set up or the rules are obsolete.
b. Has the principal adviser and/or subadviser identified any critical operational risks that would impact the management of the Fund and, if so, have they assessed how to eliminate or mitigate those risks?
c. How is missing data from the library handled that is required to test a condition? How is rectified and how long does it take?
5. What is the relationship between the trading desk and compliance?
a. Who supervises the trading desk?
b. How are violations escalated and reviewed?
c. How are false positives handled?
For more information on the requirements of Rule 38a-1, see Part 1 of this blog series authored by Gigi Szekely.