CAIA L2 - 8.4 - Operational Due Diligence Flashcards
Define
Rogue Trader risk
Reading 8.4: Operational Due Diligence
when an opportunistic employee
deliberately ignores the investment mandate
to generate additional revenue
or
recover previous prior losses,
thereby exposing all the investors
to significant risk of loss
Agency conflict example - source of operational risk of a fund.
Although the rogue trader behavior may appear to be fraudulent, it is not necessarily fraudulent because the actions are not meant to harm or deceive the investor. The intention is for the trader to benefit alongside the investor.
Reading 8.4: Operational Due Diligence
List and explain
4 main functions
of noninvestment operational activities
(trading)
Reading 8.4: Operational Due Diligence
- Allocation. Distributing new positions amongst funds. Recommended to have allocation policies that are predetermined and allow for no favoritism of one fund/account to the detriment of another. Ex: Pro rata allocation distributes purchased securities based on a predetermined metric, such as assets under management or target allocation size. Preventing conflict of interest scenarios, such as managers allocating lucrative IPO trades to higher fee-paying client accounts, requires funds to have written policies that can be enforced.
-
Execution. Completing a trade, with staff relaying the trades to the main trading desk—though some smaller funds have trading staff directly executing trades. A best practice is to segregate a firm’s trading functions from its investment functions to reduce possible conflicts of interest.
Most firms have an order management system (OMS) or other electronic transmission system that helps a fund manager manage their trading cycle and maintain a trade blotter— which tracks filled and unfilled orders. Once a trade order is received, it can be executed by a broker or counterparty, either electronically or over the phone. Electronic orders can use various technologies, including the Financial Information eXchange (FIX) protocol.
It usually involves built-in risk management - Posting and settlement. Internal logging of trades ande completion of trade confirmations in an order management or accounting system. Internal settlement is the matching of third-party trade confirmations for completed trades to the firm’s trade blotters and internal systems, plus the transferring of the securities and cash to settle the trade. Settlement could occur in real time or could take a few days, depending on the security traded.
-
Reconciliation. Internal review that confirms that the fund’s trade details match those of the counterparty.
* Two-way reconciliation = fund – prime broker refers to the matching of the fund’s data to the prime broker’s data. FA best practice is for a fund to use a third-party administrator and perform a three-way reconciliation = fund – counterparties – third party adm (triangular reconciliation) to the match the fund’s data against the data of both the counterparties and the third-party administrator as an additional confirmation.** An expected trade that did not execute is referred to as a trade break.**
* A fund may perform daily or longer reconciliations, depending on the security types traded. Many liquid securities trade on a T + 1 basis, which involves settling one day (+1) after the trade date (T) and allowing for daily reconciliation. More illiquid security types may reconcile less frequently due to the additional administrative tasks involved and the fees charged by third-party administrators. However, longer settlement and reconciliation periods may increase trading cost errors because the errors will not be detected quickly, and there may be larger unfavorable price changes in the meantime.
Reading 8.4.2: Operational Due Diligence
List
4 primary categories
of
fund cash
Reading 8.4: Operational Due Diligence
- Cash for fund expenses - rent, salaries, audit, and legal (best practices: management fees for first 2 / investor cover last 2). Segregate who is responsible for invoice accounting and invoice payment. Also require multiple and/or more senior approvals for certain expenses. The fund administrator oversees and approves cash payments made by a fund.
- Cash for trading. decide whether it will keep a positive cash balance with a counterparty or sweep the cash back into its own account to reduce its counterparty risk and earn interest.
- Cash flow from and to investors Internal fund reviews and administrator checks are critical to:
– confirm that subscriptions are put in the right funds;
– ensure that payments go to the right people and in the right amount;
– assess timing of redemptions and subscriptions for compliance with the fund’s terms and guidelines; and
– audit subscription and redemption documents for compliance with accredited investor and anti–money laundering regulations, amongst others. - Unencumbered cash - any purpose - invested in liquid securities
Reading 8.4.3: Operational Due Diligence
Define
Asset verification
and
Position verification
(in a ODD)
Reading 8.4: Operational Due Diligence
Asset verification
is an independent confirmation of
the amount of a
fund manager’s assets held with external entities,
including banks, prime brokers, and administrators.
‘–
Position verification
is the process of confirming the actual positions
with those external entities.
‘–
Verifications should be done before investing in the fund
and on an ongoing process after investing.
Reading 8.4: Operational Due Diligence
List
Common compliance restrictions
regarding
personal trading
Reading 8.4: Operational Due Diligence
- preclearance (approval) - of trades (can be matched with postclearance)
- restricted list - list of securities not allowed to be traded. (ex: meterial nonpublic information, ESG)
- minimum holding periods
- maximum number of trades
- blackout period - time period relative to fund trades
- hardship exemption procedure - ex: exorbitant loss in personal account
Reading 8.4: Operational Due Diligence
List
8 ways
compliance departments
mitigate the risks of
expert networks
Reading 8.4: Operational Due Diligence
- analyzing the MNPI policies of expert networks to make sure they do not violate the fund’s policies and applicable laws;
- adding to or customizing the experts’ policies for the fund’s specific needs;
- requiring employees to obtain preapproval before participating in expert networks;
- requiring the reading of a preapproved script at the start of each call (e.g. objective, information to be discussed);
- involving compliance staff in the monitoring of phone conversations with expert networks;
- implementing a cooling off period for consultants/experts who terminated employment where they would have been in possession of MNPI
- setting quarterly limits on the frequency of contract with a specific expert; and
- analyzing trading activity for any irregularities after participating in expert network discussions.
Reading 8.4: Operational Due Diligence
List
4 tasks
third-party consultants
can reduce the onerous demands
of internal compliance
Reading 8.4: Operational Due Diligence
- Audit simulation - Conducting simulation regulatory audits
- Revising procedures - Revising compliance procedures and policies to meet regulation changes
- Conducting compliance testing
- Providing compliance services to branch offices with no compliance staff
Reading 8.4: Operational Due Diligence
List
8 steps
of the
ODD process
for alternative investments
Reading 8.4: Operational Due Diligence
1-3 => Before visiting, analize documentation
4-5 => then you investigate service providers and management
6-7 => then you decide after process all info
8 => if invested, monitore it!
- document collection,
- document analysis,
- on-site visit,
- service provider reviews and confirmations,
- investigative due diligence,
- process documentation,
- operational decision (low risk = invest / medium risk = lower allocation / high risk = not invested), and
- ongoing monitoring (if proceed with investment).
Reading 8.4: Operational Due Diligence
List
5 reasons
that explain the
expansion scope of ODD
Reading 8.4: Operational Due Diligence
ODD has recently expanded in scope for the following reasons:
- More regulations
- More due diligence guidance available
- Consistent stream of fraud and operational failures
- Greater sophistication of operations and automation of processes
- Increased reliance on trading models and risk management systems
Reading 8.4: Operational Due Diligence
List
9 warning signals
of operational risk
(in a fund, when performing ODD)
Reading 8.4: Operational Due Diligence
Nine warning signals of operational risk are as follows:
- Unqualified administrator - No qualified external administrator
- Unknown auditor
- Changing service providers - Frequent changes in third-party service providers
- Red flag financial statements - Red flags noted in the audited financial statements
- Red flag key employees - Red flags in the background checks of key employees
- Existence of undisclosed conflicts of interest
- Weak infra - Weak operating infrastructure and compliance systems
- Weak valuation process
- No transparency
Reading 8.4: Operational Due Diligence
Define
meta risk
Reading 8.4: Operational Due Diligence
qualitative risk (not financial risk)
that is not captured by specific, measurable financial risks.
In the context of funds, it could include:
* organizational and human behavior,
* moral hazards,
* the improper use and excessive dependence on quantitative methods,
* market interaction, and
* extreme events in capital markets.
’–
None of those items fit into another specific operational risk category, so meta risk is used as a general term. The extent to which an investor will assign values to meta risks will vary by investor due to their inevitable subjectivity.
Reading 8.4: Operational Due Diligence
Define
Emerging managers
and
factors that disqulify them
(from being invested)
Reading 8.4: Operational Due Diligence
- track record < 3y
- AUM < $250 m
Due diligence experts were asked which factors disqualify funds from investment, and they categorized them as follows:
Top factors = RRRCE
* returns
* risk
* risk operational
* compliance
* experience
Middle factors
* staffing
* philosophy
* style drift
Bottom factors
* AUM of the manager
* fund terms
* fees
Reading 8.4: Operational Due Diligence
Identify
4 approaches
to resource allocation
for operational due diligence
Reading 8.4: Operational Due Diligence
-
Dedicated
A dedicated operational due diligence approach has at least one full-time staff member analyzing the fund managers’ operational risks. -
Shared
The shared operational due diligence approach is the same as the dedicated approach, except there are multiple part-time staff members. -
Modular
Each specialist review part of ODD + 1 generalist - The modular operational due diligence approach splits up the review into functional parts, each with specialists possessing knowledge specific to their assigned function. There is an operational generalist who gathers all the information together from the functional reviews performed by the specialists to reach a conclusion about the operational risk of the fund manager under review. -
Hybrid
Mix of previous 3 - The hybrid operational due diligence approach is any combination of the dedicated, shared, and modular approaches.
Reading 8.4: Operational Due Diligence
Areas where operational risk of a fund may arise from and methods asset managers should use to manage operational risk
- Operational errors
- Agency Conflicts
- Operational fraud
Asset managers should manage operational risk through
prevention (include internal controls with robust policies and procedures),
detection (properly functioning internal controls and mitigation), and
mitigation (diversifying the portfolio, performing ODD examinations, and examining fund operational risk in a thorough manner).
LO 8.4.1
Three models used for investigative due diligence
- Equity ownership model
- Investment decision-making authority model
- risk control model
LO 8.4.4
