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5 Ways to Prevent Operational Errors

Investors and regulators aren't the only ones wanting to know about how an investment fund will avoid

operational mistakes, in keep track of transactions and accounts.

So are fund boards.

Under the Investment Company Act of 1940 and state laws, fund boards are obligated to ensure that

investors are protected from the mistakes made by fund managers and other service providers.

Here are five ways they can protect their customers and their funds.

Check Out the Credentials of Every Service Provider

Fund boards will want to know the pedigree of the service provider. Having a brand name certainly helps but

wont be enough to quelch any concerns that the service provider might go out of business or not have

sufficient experience in a particular investment strategy or financial contract.

After understanding the investment discipline and process, fund boards want to analyze service providers

carefully to ensure they have the correct infrastructure, scalability and strong financials, said Tom OBrien,

president and chief executive officer of State Bank, who serves as an independent board member to thePrudential Annuity Funds. We dont want to find ourselves surprised by the failure of key procedures after

the engagement of a fund manager or any service provider.

Fund boards, said OBrien, might insist on periodic onsite visits to subadvisors and key service providers to

get a first hand look at all of the facilities, staffing, systems and procedures used.

Avoid Simple Mistakes.

Fund boards dont believe in blind faith. They want customized reports from the fund manager and its

service provider outlining what checks and balances the fund manager and its service provider are taking to

avoid human errors, software glitches, and the loss of confidential data on transactions and customers, said

Darlene DeRemer, managing director at Grail Partners, a Boston-based investment bank specializing in

investment managers. Those customized reports are presented during quarterly meetings attended by the

fund manager and the chief compliance or risk officer of the service provider.

Scrutinize Middle- and Back-Office Procedures.

Fund boards love the arcane nitty-gritty details. Jim Volk, chief compliance officer for SEI Investment

Manager Services came up with the following questions: how do you monitor counterparty exposure; how do

you price and record non-exchange traded contracts; how are newly traded financial instruments will be

accounted for and processed; how the service provider will reconcile positions with multiple counterparties.

Such reconciliation should be done daily, when possible, in the case of collateralized transactions such as

swap contracts. Counterparty risk is also mitigated more if margin postings and collateral movements are

done daily.

Take Nothing for Granted Overseas.

Investing in new markets can also turn out to be a tricky proposition particularly if the overseas countries

dont follow the same regulations as the U.S. when it comes to how their securities depositories, transfer

agents and subcustodians record ownership of shares and assume liability in the event of a computer glitch

or theft. While fund managers might be able to hedge against currency fluctuations there is little they can do

if foreign regulations dont allow for foreign depositories and local service providers to compensate investors

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from any operational errors or even wrongdoing. Case in point, said Volk: some funds have opted not to

invest directly in Russia because of the potential for financial loss due to poor recordkeeping practices.

Instead, the funds will invest in the American Depositary Receipts of Russian companies so the ownership

and settlement of shares is recorded on the books of Depository Trust Company in New York.

Learn from Others Errors.

Fund boards can be reactive. Although they may spend days crafting the questions they want to ask service

providers news and headlines on operational mistakes made by other funds could easily prompt an

additional set of questions. Fund boards take a systematic view to focusing on how fund managers and their

service providers could mitigate the risk arising from human error but idiosyncratic events can play a huge

role in the questions asked during an impromptu meeting, said Timothy Levin, a partner in the investment

management practice of Morgan Lewis & Bockius in Philadelphia.

One recent case: AXA Rosenburg Investment Managements $25 million fine in February by the Securities and

Exchange Commission for failing to notify senior management and investors about coding errors in its quant

models causing a financial loss. Fund boards immediately started asking fund managers how they were

mitigating the risk of coding errors to their quant models.

Yet another: widely publicized lawsuits filed by pension plans against some large custodian banks for an

alleged breach in their fiduciary duties in executing foreign exchange transactions. Fund boards are meetingwith custodian banks to go over the operational procedures used to ensure their foreign exchange orders are

executed at the best price possible for the fund, said Levin.