The Importance of Automating Investment Policy Compliance

By: Tyler Hogge, Clearwater Analytics 


This article was originally published in gtnews on March 24, 2014

Yield has not been a top priority for many corporate in the current era of low investment returns, but this situation is changing. As companies gradually recover a risk appetite to achieve better returns, automating investment policy compliance enables them not only to mitigate portfolio risk but also to gain transparency, eliminate manual effort and explore new investment types.

According to the Association for Financial Professional’s (AFP) 2013 Liquidity Survey (http://www.afponline.org/liquidity/) preservation of capital still ranks as the most common investing objective for cash and investment management. While many companies are now more likely than in previous years to emphasise liquidity to support larger corporate objectives, yield remains a distant third.

The reasons for such a lack of interest in yield are clear. Only scant returns are available on most traditional investments and the returns on many government bonds are particularly poor. With rates as low as they’ve been - and for as long as they’ve been - it’s no wonder that corporations have made yield such a low priority.

Subtle market shifts, however, are causing some corporate treasury departments to consider higher-yield or non-traditional investment types. As Clearwater Analytics provides investment accounting and reporting for thousands of corporations, the group has seen many corporate clients migrate toward separately-managed accounts, while some also begin to explore more complex bonds such as collateralised mortgage obligations (CMO), asset-backed securities (ABS) and mortgage-backed securities (MBS).

Even new lower-yield vehicles are garnering attention. Floating-rate notes (FRNs), the first new US government security type in nearly 17 years, provide investors with a nearly risk-free way to earn interest on cash that’s not needed immediately. While the yield potential is low, that didn’t stop money market fund (MMFs) and separately managed account investors from snapping FRNs up when the US Treasury Department auctioned them off in January 2014.

The Effect of New Investment Types on Compliance Policies

All of this new exploratory activity creates important new questions: How does this appetite for new investment types affect corporations’ investment policies? Can corporations explore new investment types if they’re not explicitly permitted to do so in a written investment policy? Or, are they unknowingly violating their investment policies? How closely can corporations monitor their own policy compliance? How often are they tracking compliance? Is it only monthly, when ideally it should be daily? Do they have a compliance monitoring process that can adjust to ever-changing markets? Does the compliance monitoring process require manual upkeep of spreadsheets, or is it automated? Many companies are asking themselves these questions today and are looking for solutions.

While a vast majority of corporates (nearly three in four, according to AFP) maintain a written investment policy that specifies maximum maturity and minimum credit ratings, establishes minimum and maximum concentration levels per specific investment types, or even stipulates which investment types are permitted, it’s unclear how effectively they are able to monitor compliance. This is a concern when inhouse or external managers begin investing in new security types, and is especially worrisome when companies only review their policies twice a year.

As treasurers explore the idea of expanding their investment playbooks to seek higher yields, they must always be aware of how their investment decisions might – or conversely might not - comply with their investment policies. In addition, they must have mechanisms in place to not only change investment policies, but to enforce them as well.

If an organisation is not flexible enough to accommodate these changes, or if it doesn’t have the proper investment policy compliance processes and systems in place, it runs the risk of major compliance complications and exposing the organisation to undue risk.

Compliance Policies - only as Good as Your Ability to Monitor and Enforce Them

Investment policies are only as good as their compliance enforcement mechanisms. That’s why it’s so important that an organisation’s treasury team possess a high-functioning infrastructure that supports their capacity to not only effectively manage multiple internal and external portfolios and understand the risk across them, but also to assess compliance in regards to formal investment policies.

Given the market’s volatility, tracking compliance is more critical than ever. Evaluating counterparty risk is especially difficult when using multiple asset managers. As a result, investment policies may be out of compliance. Investors need to be able to easily answer the question: “Who is the ultimate obligor, and does this affect my exposure to risk?”

The right system gives investors visibility into all relevant compliance issues, including violations at the individual security level - even broken out by tax lot - on a daily basis, instead of monthly or quarterly. The ideal compliance solution is web-based, checks policy compliance automatically, and sends violation notifications, allowing treasurers to set accounting-based rules to assess risk (for example, maximum realised gains and losses). It also provides visibility into investment activity across an entire portfolio, no matter how assets are managed. Best practices dictate that investors never rely on an external asset manager alone to manage compliance policies - independent verification is vital. Lastly, the right system allows an investor to update policy limits, add notes and resolutions to violations, and audit any changes made to the policy automatically - without the use of external spreadsheets.

Investment policies are critical tools that corporate treasuries need to protect their organisations from risk. With the right investment policy compliance monitoring system, corporate treasuries can explore the use of more complex investment types, and keep senior management apprised of their portfolio while mitigating exposure to risk. And without a robust investment policy compliance solution, and the critical visibility and transparency it provides, corporates might not be investing in opportunities they may be allowed to invest in - and may be leaving money on the table.

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