Principal Funds, a group of 112 mutual funds, had a problem with post-trade compliance: It wanted some way to confirm that all its transactions stayed within investment trading rules, and to confirm that every day.
The problem? The sheer volume of testing compliance every day would require a staffer to work all day at the task to get through just a fraction of Principal’s funds. It simply couldn’t be done—at least not economically, explains Layne Rasmussen, Principal Funds’ controller and CFO.
“We recognized there was some risk of not detecting an investment-restriction breach sooner than later by not having a daily process,” Rasmussen says. By the middle of the 2000s, “It was time to tighten up our process, and we wanted to do that without adding to staff.”
Principal Funds is part of the Principal Financial Group, which manages $280 billion in assets. And like all other mutual funds laboring under the Investment Company Act of 1940, it must be able to prove that each fund and portfolio stays within the bounds of what it promises to investors. For example, if you call a fund “The China Fund” or “U.S. Government Short-Term Treasurys Fund,” you must invest at least 80 percent of that fund’s holdings in China or in U.S. short-term treasurys.
The industry has two compliance regimes to help funds follow those restrictions. Pre-trade compliance alerts fund managers when they’re about to make an investment that’s out of step; post-trade compliance flags problems that emerge only after the trading day is done. (For example, if certain stocks soar or plunge during the day, that might push a fund’s asset allocation ratios beyond what the prospectus promises investors.)
Reece
As of 2006, data for post-trade compliance at Principal Funds was coming from the funds’ accounting department. Those reports had been designed for fund accounting—not compliance. The financial-compliance team needed a system that could refresh data more often, and provide more flexible reporting, says Sara Reece, Principal Funds’ assistant controller. As a result, her group was trapped with a decidedly manual system: pulling data off Bloomberg terminals and scribbling exception notes on pieces of paper.
But while Principal Funds knew it wanted automation, Reece and Rasmussen did not want the complexity of an entire new database just to manage compliance.
“There are plenty of compliance vendors,” Reece says. “But we didn’t want to have yet another system to have holdings data; having to put it in and scrub it and maintain it seemed awfully redundant.”
Principal then turned to Confluence Technologies, a vendor Principal already used to track other types of fund information, through Confluence’s Unity database platform. At first, Reece says, the idea was simply to feed Bloomberg data into the Unity platform and create customized reports about funds’ holdings that the compliance department could use.
But, Reece admits, “That was a short-sighted view of how effective we could make the process. It took care of the stale data issue, but it didn’t get us very far toward exception-based reporting. It focused on exception detection rather than reconciling the exceptions we found.” Conversations with Confluence led to something more ambitious: a new Unity module that Principal would help develop, called Unity Post-Trade Compliance.
How It Got Done
The project ran through much of 2007. Confluence analysts worked with the Principal Funds team to review workflows and discuss features of the prospective software, and then did software development in Pittsburgh. Principal dedicated the part-time efforts of four employees during development, working with beta versions and providing feedback. When version 1.0 of the application arrived, three Principal employees wrote tests, made sure data feeds were properly set up, and performed application testing, Reece says.
Confluence delivered the final product in October 2007, and Principal launched it in January 2008, comparing a bevy of investment restrictions to 112 mutual funds with 614 share classes. The transition went smoothly because so many members of the financial-compliance team participated in developing the software, Reece says. The application was also intuitive, allowing a staffer to read which data a test was pulling, what the test was supposed to do, and what the results should look like, she adds.
“Automating post-trade compliance should be viewed as an opportunity to not only introduce greater efficiency to a key task, but also as an opportunity to enhance and tighten controls to minimize risk.”
—Layne Rasmussen,
CEO, Controller,
Principal Funds
“We were running zero tests on a daily basis, and now we run nearly 1,800 tests on a daily basis,” Reece says. “That really shows that we’re performing the due diligence that we’re required to provide.”
Testing now takes one employee only half a day, Reece says. Although largely an intellectual exercise, daily testing would have never happened without automation, she says. Principal estimates doing the same process manually would cost more than $435,000 in labor a year. While Principal hasn’t disclosed the cost of the system, “we feel like we got a great value for the cost incurred,” she says.
The system also ended the monotonous paper shuffling necessary for Principal’s prior, spreadsheet-based system, which made the task of post-trade compliance more interesting to higher-level staff. “Now it’s about looking at exceptions and tracking down those exceptions,” Reece says.
Having a compliance-specific window into fund data has yielded a few other unexpected benefits. Principal Funds employs outside advisers to manage mutual fund assets; the new post-trade compliance system gives Principal better insights into those advisers’ investment styles.
“If they’re constantly pushing the limits, maybe this person’s someone we need to look at,” Reese says. “This addresses a business risk, not just compliance risk.”
Rasmussen
The new system has also been a help when merging Principal funds, Rasmussen says. “We have been able to use Unity Post-Trade Compliance to compare the investment holdings of the acquired fund against the investment restrictions of the acquiring fund,” he says. “We didn’t contemplate using Unity for this purpose, but it has made that part of the reorganization analysis simpler.”
The new system’s flexibility and scalability lets Principal add or alter tests based on regulatory changes as well as new needs from business users, Reece says.
A key lesson, Reece says, is that having multiple applications on one central database can pay off, and would encourage those considering yet another system for post-trade compliance to think about adding it to an existing platform.
“Automating post-trade compliance should be viewed as an opportunity to not only introduce greater efficiency to a key task, but also as an opportunity to enhance and tighten controls to minimize risk,” Rasmussen adds.
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