Fund Accounting

ORIGINAL POST DESCRIPTION: Never thought I’d make a second video.  But I also never thought I’d be on a Moroccan holiday adventure and need a reason to ditch my awful family for an hour.  

Quick explanation on why I ended the piece so abruptly:  

1) I was so absorbed in the Chuck-Norris-level action movie that is fund accounting that I missed a turn or two and honestly got lost in the heart of Chefchaouen… on my first day in the city.  

And worse:

2) Being that loud, ugly (sweaty) American talking into their iPhone as they walk through the quieter residential areas of the city draws the worst kind of attention: that of small, curious children who— en masse— stopped playing street ball and started to follow me.  

The worst part is that they weren’t even trying to get into the shot.  They were super polite, staying quiet and listening.  

Punks!

I should have robbed them. 

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Ok… so why am I posting this second video?

The first one was about how every engineer needs to deepen their business knowledge.  If you missed it, I wrote “Watch it to understand what you need to learn… how deep you need to go… to become a better engineer, a better partner…  an honest-to-god business contributor.”

This second video is to encourage you to be borderless in how you define your business and the associated learning you need to do.  

Think end-to-end!  Learn end-to-end!

If you’re in custody, slowly broaden that business lens to include fund accounting, transfer agency, fund administration, tax, etc… *ALL* the processes (and businesses) upstream and downstream from your bordered world.

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Don’t aspire to be the CIO.  

Aspire to be their boss. 

#HappyNewYear!

Hi. When I shot the Custody in an Hour video, I never thought there would be a second video. I shot it because I wanted to signal to my engineers– you– that you need to understand the businesses that you support– deeply… all the boring details– Because as I’ve always said: knowing the business better than your business partners is the only path to providing business value and the most powerful path for engineers to the c-suite; to become a CIO or to start your own company.

I still believe that. But I’m making this second video because I don’t want any of my engineers– you– to think narrowly about the business function you support. Just so I’m being super clear, if you’re an engineer, you have to understand the details of the businesses and business processes that are upstream and downstream to the one that you support. You are not some API that’s agnostic to the inputs you get from the engineers upstream and agnostic to the outputs you give from the engineers downstream.

Your path to engineering mastery isn’t just about being full-stack. You have to have an encyclopedic understanding of the end-to-end business process: to be able to walk from that external client– or even that client’s client– every step of the value chain… end-to-end… through every business and business function… whether it happens in your company or not… all the way back to that client… the one who’s paying your mortgage.

Ok. Enough preaching.

I shoot these videos during my lunch walks and I usually sweat a lot. But today, I’m doing it while on vacation here in the deserts of Morocco… so if you don't want to see me sweating bucketfuls, just focus on the audio.

On today's walk I’m probably going to suffer from heat stroke AND I'm going to try to explain fund accounting… business value that’s downstream from custody but deeply reliant on it. I'll probably touch very briefly on a business function called Transfer Agency... but that business really needs its own delirious walk.

Before I get to the main course (the accounting part of fund accounting) let's ground ourselves in the fund part. Let's answer "what is a mutual fund" by pretending like we're going to start our own.

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A mutual fund is a type of investment that pools money from many investors to purchase securities. If you don’t know what securities are, watch the first video. These investors– that buy into a fund– may be individuals, businesses, or other organizations.

Mutual funds offer investors three distinct advantages: 1) professional management, 2) diversification, and 3) economies of scale.

THE BENEFIT OF PROFESSIONAL MANAGEMENT is:

When you invest in a mutual fund, you are giving your money to professionals who will manage it for you. The people behind the fund have years of experience in the financial world and know how to invest money in a way that will give you a higher probability of making a profit (at least when compared to the average person dabbling in investing). In addition, the people behind the fund will also be responsible for creating all of the necessary paperwork (a business called Fund Administration) and paying all of the associated fees, which we'll hit on shortly... that make it difficult for small investors-- you and me-- to get started in this market.

That’s professional mgmt. THE BENEFIT OF DIVERSIFICATION means:

... that your money is spread out among many different investments (stocks, bonds, options, and futures), which reduces the risk that you will lose a lot of money if one of those investments fails. Diversification helps manage risk. If you only own 2 stocks, that eliminates 46% of the non-market risk of owning just 1 stock. If you own 4 stocks, that risk is reduced by 81%. Your personal ability to reduce risk after that requires you to do a ton of work-- which most people don't have the time or training to do. With 16 stocks, you're at 93% and with 32, non-market risk is reduced by 96%. After that you have to jump to 500 stocks to achieve 99% non-market risk reduction. And who has the time for that? You know that one uncle who keeps telling you to buy Google (which isn't called Google anymore). Well, ask him for another 15 good picks. Watch his eyes light up because he probably can. Then, ask him for an additional 485 and tell him to google non-market risk reduction.

Only other point on diversification: traditional mutual funds don't hold alternative investments like real estate, precious metals, Hedge funds, Private equity (and if you're Blackrock-- "infrastructure"). If you need that level of diversification, you probably shouldn't be watching a video about fund accounting. Just know that that is called an alternative mutual fund and it gives you even more diversification and higher fees (because they're harder to manage).

So... we covered professional management and diversification... the other BENEFIT:ECONOMIES OF SCALE

You buy into a mutual fund because WHEN so many people invest in them, the costs of running the fund are spread out among those people. This makes it cheaper for each individual investor, and it also means that the fund is more likely to make a profit or higher profit.

The industry's better stock pickers become the best mutual fund managers because they have a lot of experience and know how to choose good investments. They're not the best of the best.... because if they were... they'd probably start their own hedge funds. But that's besides the point. Fund managers have more knowledge about the stock market than you-- or me-- and that helps them make smarter decisions about where to put your money.

So... let's pretend that we're going to start a mutual fund ourselves, in the States. To start one, we will need to file documents with the Securities and Exchange Commission (SEC). These documents include the fund's prospectus and registration statement. The prospectus provides information about the fund, including its investment objectives and strategies. The registration statement includes information about the fund's management and financial statements.

We will also need to establish a bank account for the mutual fund and hire a transfer agent to handle shareholder transactions. The transfer agent will maintain records of ownership and distribute dividends and other payments to shareholders.

We'll need an investment strategy. Just for fun, let's make our strategy to copy the stock buys and stock sells of members of the US House of Representatives and the US Senate. Why? Because members of Congress have a legal but wildly unethical opportunity to use their access to privileged information to help them make smarter decisions about where to put their money. That needs to end. They can also influence the stock market by drafting legislation or blocking legislation or even by making statements about certain stocks or industries. This gives them an unfair advantage over regular investors, who don't have access to the same information or the same power.

So that'll be our investing strategy: we'll choose the stocks they're putting their money on. And our fund’s investment objective will be to have Congress serve the lowly investor-- even if they're doing it unintentionally and unethically.

The three most common stock picking strategies include 1) value investing, 2) growth investing, and 2) momentum investing.

Value investors look for stocks that are undervalued by the market. These stocks may be out of favor or have fallen in price due to negative news or poor performance. Value investors believe that eventually the market will recognize the true value of these stocks and prices will rebound. Warren Buffet. Value investor.

Growth investors focus on companies that are experiencing rapid growth in revenue and earnings. They believe that these companies will be able to grow their profits at a faster rate than the overall market, providing investors with above-average returns. Peter Lynch. Growth investor.

Momentum investors look for stocks that have been rising in price recently. They believe that these stocks are more likely to continue to rise in price, providing capital gains for investors. There are no famous momentum investors… which probably says something about momentum investing.

We’re dodging all that with our Congressional strategy and relying instead on how Congress hurts democracy and free markets.

As we're starting a fund, we'll also need to create a prospectus-- as I mentioned before– and that is a document that provides more detailed information about our fund, including its risks and investment strategies. What would the risks of our fund be: members of congress picking up some kind of moral conscience. Never happen.

The prohibitive costs of starting a mutual fund can be a deterrent for many investors. All of this bureaucracy and need for documentation can be expensive and time-consuming to create. In addition, we will need to pay various fees in order to launch our fund, including an initial registration fee, a management fee, and a 12b-1 distribution fee- a type of fee that helps to pay for the costs of marketing and selling the fund.

All these fees can add up quickly-- into a couple hundred thousand dollars US. So... not for the faint of heart.

But let's say we do all that paperwork-- which varies from state to state-- and we pay for it all.

Our customers can now buy our fund directly from us-- the fund company-- or through a financial advisor, or on an exchange.

Couple other structural considerations. Let's make our mutual fund an open-ended investment fund -- a type of mutual fund that doesn't have a set number of shares that can be issued. New shares can be created and sold to investors as demand dictates. Open Ended. This makes ours different from closed-end investment funds, which have a fixed number of shares that are issued at launch and those funds don't issue new shares.

Let's also make it a daily dealing fund. That means our customers can put their money in or take their money out of the fund on a day-by-day basis. There are funds that are not daily dealing... that only allow getting in-and-out on a weekly, monthly, or quarterly basis. But let's set up ours as daily. It's more convenient for a potential customer when they can invest their cash today and withdraw any day after. That's not putting down our weekly/monthly/quarterly competitors because honestly, most investors put their money into a fund for years. Many until they retire.

The reason we're choosing to make it daily for this walk is to drive home the value of fund accounting. Because if a customer invests a dollar in our fund today, they might want to know how their dollar is doing tomorrow, the day after or the day after that. And while most customers keep their money in mutual funds for long periods of time, there will be customers-- every day-- that need to cash out... for whatever good reason they have. Another reason why fund accounting matters.

The next structural consideration will determine how we get from the total fund value to one customer’s share of the fund. Let's structure our fund as a partnership-- which means our accounting will allocate gains and losses to our customers’ accounts. And on any day– the value of their assets– the “net asset value” of their accounts can be figured out.

By the way… What's the alternative to a partnership? Well, we could structure the fund as a company or as a trust. That would make our offering unitized-- which means that investors would be given units or shares in the fund at the time they invest. These shares would have a value... some specific value per share which would change over time. In this structure, the value per share at the time of our customers' investment determines how many shares they're allotted. And obviously, the value per share at the time that they withdraw their cash determines how much they get paid.

So, we're building a daily dealing fund that is a partnership.

With those decisions made, let's shame Congress and make our customers love us. Let’s bring real customers into the picture-- who want to buy and sell our fund-- any day of the week (minus holidays).

We're now ready to take cash from our customers-- which they're investing into our fund. Our fund will issue shares to those investors and use their funds to make investments in various financial instruments – specifically Congress’s picks. That allows the fund to earn income and incur expenses. And the real-world value of our fund will be determined by whether we buy-and-sell the right securities at the right time (or congress-people do).... and how efficiently we manage all associated expenses.

We're now at the point where we're going to *need* fund accounting.

Long way to go... but...

The point of fund accounting is to 1) track the individual investments in our fund, 2) track how much money each investor has put into the fund, and 3) track how much money the fund has made overall. This information is used daily to calculate the fund's net asset value (or NAV).

The definition of NAV: is the total value of a mutual fund's assets minus its liabilities. What's in the black minus what's in the red. Basic accounting. The NAV is calculated each day and published in newspapers and other financial information sources. It is important to investors because it is a measure of how well the fund-- and therefore their money-- is performing.

The assets in a fund are broken down into two categories: 1) primary investments and 2) secondary investments. The primary investments are the most important part of the NAV, as they make up the majority of the fund's value. The secondary investments– as you can guess– are less important, but still play a role in the overall NAV.

Primary Investments

- Equity investments: These are stocks and shares in companies. The value of equity investments goes up and down with the market, so their value can change rapidly.

- Fixed income investments: These are investments that give a set amount of money back every month or year, regardless of what the market does. Think bonds.

- Cash equivalents: These are investments that can be turned into cash quickly, such as short-term certificates of deposit (CDs-- like the kind Grandma used to give you for your birthday... if you're a certain age... like if your baby pictures are in black-and-white).

Secondary Investments

- Derivatives: These are contracts between two or more parties that derive their value from an underlying asset or group of assets. Please don’t expect me to make derivatives make sense. They’re almost intentionally complex. Easy one would be like a futures contract– that’s a kind of derivative– that agrees to buy a set amount of a commodity (like oil) at a set price on a set date in the future. Derivatives need a lifetime of walks like this.

- Other securities that are secondary investments: Think– types of investments that don't fit into one of the other categories like… real estate or mutual funds themselves… because a fund can buy a fund— a fund of funds.

As you can imagine, while the US markets are open-- think 9:30am EST until about 4pm EST-- all the prices of all the stocks in our fund will be changing. Fund Accounting helps us tell one of our customers how their investment is doing at 1pm... or helps us know how much to charge for our fund at 1:30... or helps us figure out how much to pay out for a customer who wants to cash out at 2pm... this is where fund accounting becomes indispensable.

Why? Because the easy answer to all of those customer questions and requests is to use yesterday's performance, yesterday's pricing summaries. And that requires that you close out all your funds numbers every day.

Which is why every business day, right after the markets close, the field of fund accounting has the most stressful hour of their lives. It's called the golden hour-- and it's during that time that navs are "struck" or calculated. Why? Easy answer: that's when all of the prices have stabilized… and we’ll get into what that means.

So... the golden hour of NAV production is the time after the market closes when mutual fund companies calculate their net asset values (NAVs) and it's called the "golden hour" (I'd say sarcastically) because it's when fund companies have their most accurate information about their funds' holdings.

The calculation of a single NAV is hard enough-- but fund accountants are never employed to calculate just one nav for just one fund. Imagine the market just closed-- and you and your team have thousands of funds that you need to cut a NAV for. This process AT SCALE can be incredibly complex and time-consuming... especially since the ambition of you, your clients and their clients, is to produce an accurate NAV-- 100% error-free-- daily-- during this tiny window of time.

But that's why they invented computers, no? It's not that simple. Because every transaction for every fund can come with multiple versions of the truth. The fund manager might think that they sold their Apple stock for $100 but their counterparty might think that they sold it for $98. A ton of reconciliation needs to happen in near-real-time. One kind of recon would be between the internal records of the mutual fund and the records of the stock exchange where the stock was sold. Another would be between the mutual fund's records and the records of its custodian or trustee. There might be reconciliations between different mutual funds that hold the same stock.

As a tech optimist, the key here is that technology is great when every system uses the same golden sources of data but the financial services industry has a long way to go before we get there.

And that's just the complexity on the assets side.

Two quick notes about jargon.

Accountants use the term "capital activity" for what we discussed-- its an industry specific term for the movement of money into and out of a mutual fund-- the buying and selling of assets.... the receipt and distribution of dividends and other payments. The term "capital activity" can also include the issuing or redemption of shares.

Accountants also use the words "portfolio activity"-- which refers to the buying and selling of securities by a mutual fund. This can include purchasing new securities– like… what did that shameless congressperson buy yesterday?– selling existing securities– what did that congressperson dump?-- or exchanging one security for another.

That said... you also have to incorporate potential liabilities when calculating net asset value:

1) outstanding shares

2) redemption requests

3) fees and expenses

4) dividends and interest payments (also called interest income)

1) Outstanding shares are the total number of shares that have been authorized by a mutual fund's board of directors but have not been purchased by investors.

2) Redemption requests are investors' demands to redeem their shares and receive the underlying assets back. That’s fancy talk for: the customer wants to cash out. Mutual fund managers must liquidate some or all of the underlying securities in order to meet redemption requests, which can actually affect the prices of the securities.

3) Fees and expenses include a variety of costs incurred by mutual funds, including management fees, distribution fees, and other operating expenses. In our example of using congressional buys-and-sells… we might need to pay a small army to keep checking congressional buy-and-sell disclosures. That’s an expense for our fund. All these costs reduce the net asset value of a fund and can have a significant impact on an investor's total return.

4) Dividends are payments made by a fund to its shareholders out of its profits. These payments may be in the form of cash, shares, or other assets. And interest payments are payments made by a lender to a borrower in exchange for the use of money. These payments typically occur on a periodic basis, such as monthly or quarterly.

How do you bring that all together? Well, it's hard to explain accounting without a white board where you can show your math... but let's try.

The most high level equation is:

a NAV = total net assets over number of shares outstanding.

That might be too high-level. Let's get a little deeper:

So the numerator of a NAV-- the top of the fraction-- what I just called total net assets = Total Assets minus Total Liability.

In terms of assets, a fund accountant has to account daily for any income-- think dividends and interest. They have to account for any trades that the fund manager made that day. They have to account for any related corporate actions (the process I described on my last video-- Custody Banking in an Hour).

Quick note here is that… as the accountant figures out the asset story, they have to reconcile cash and stock with custody. That means they have to ensure that they have an accurate count of the cash and stock that they are holding. They do this by working with a custodian (see that last video), who helps to manage and track the assets of the mutual fund. This also ensures that the mutual fund is able to stay in compliance with regulations.

That was the assets portion of the numerator. But remember, it was Total Assets minus Total Liabilities. When it comes to liabilities, there's two big ones. The fund accountant has to account for any outgoing payables and expenses accruals-- the process of recognizing any expenses as they are incurred, rather than waiting for when the payments are actually made. This helps to ensure that the mutual fund's financial statements are accurate and timely.

So that was all just the numerator. In our case, the total dollar value of all of our Congressional fund’s stocks, bonds, and any other investments – minus the total dollar value of all liabilities.

Now we need to compute the denominator-- the bottom of the fraction-- which is the number of shares outstanding. The number of shares of our Congressional Mirror Fund.

For this, the fund accountant needs to account for subscriptions and redemptions... fancy industry jargon for who's most recently bought into and sold out of your fund. That factors into the bottom of the fraction.

Once you have an accurate numerator and denominator – easier said than done – cutting the NAV is easy math.

There’s one other complexity that I need to mention when it comes to the numerator. When we talk about Total Assets - which again is the total dollar value of all of the fund’s investments – we need to know two things. The quantity of each security the fund owns times the price of that security at the end of the trading day.

That sounds fairly straightforward, but the pricing of securities is actually a lot more complex than you’d think.

There's a tool in every financial services company called a security master. It's a database that stores information about all the securities traded on every exchange. This includes the name of the security, its ticker symbol, the number of shares outstanding, and other important details. Having a rich, flexible, up-to-date security master is critical for pricing funds.

Companies use a security master to store accurate information regarding fundamental, transactional, and pricing data. Given the complexity in global markets, there might be multiple IBMs (as a security), multiple prices for that same security, and multiple pricing data providers (ICE, Bloomberg). And every fund and every fund board (the people who govern the fund) has their specific needs and preferences around how to price. And that’s built into their contracts with their fund accountants.

For instance, there's something called Fair Value Pricing... which prices a security by looking at how much money you would get if you sold the security right now... as opposed to when it actually sold 2 minutes ago. It’s a way of protecting against investors trying to game market volatility.

So pricing matters. A good security master definitely matters. If it's designed well, it can be easily accessed by users (and systems) across a large enterprise. If it was designed well, multiple types of asset classes can be mastered with it: equities, derivatives, bonds, currencies, interest rates, equity options, mutual funds, indices, and credit securities. You get the point.

It's especially important to master this kind of data to improve operational processes, optimize company’s resources, and reduce overall costs.

Why? Because without a security master, you're more at risk of having inconsistent information across multiple systems and processes... you're more at risk of storing duplicate data all over the place... you're more at risk of needing to reconcile-reconcile-reconcile your OWN data... all of which inevitably leads to large operational expenses.

Getting pricing right is about getting risk management right. Businesses need to reduce operational risks. They need to assess and address potential process breaks.

Getting pricing right is about great trade execution. Meaning companies can reduce execution costs, trade failures, and manage capital expenditures efficiently.

And getting pricing right leads to a positive client experience. Happy customers internally and externally. And-- because its financial services-- happy regulators.

Those are all key parts of your company's profitability. So using and maintaining a good security master (a solid pricing master) leads to more accurate NAVs and better end-to-end decision making. That's my little plug for investing in reference data.

AND as with my video walk for Custody, I forgot to mention taxes.

As with everything money-related, taxes are important because they can have a significant impact on an investor's profits. For example, if a fund sells some of its holdings for a profit, that profit will be subject to capital gains taxes. The amount of those taxes will depend on how long the fund has owned the shares, as well as the tax rate applicable to the investor.

If nothing else-- if we're going to start or run a mutual fund... or serve that fund with accurate accounting, we need to be deeply familiar with tax implications.

Anywho.... that is a lot of complexity for something as humbly titled as fund accounting.

As a technologist, I mourn for fund accountants. I feel their pain... concentrated as it is during the golden hour. In the short run, the best you can do is workflow, workflow, workflow.... Robotic process automation (RPA) where possible... and most importantly, fix your data supply chain as upstream as you possibly can.... in your client's shops if need be.

In the longer term, as an industry, we need to fix the root cause behind why there's so much confusion and need for reconciliation at an industry-wide level... Speaking just technically, the reason starts with the fact that every player has their own data and database. That's why the blockchain-- not crypto currencies-- provide such a compelling vision for the future. In theory, they become the foundation for a single industry-wide golden source repository.

Hope you learned something.

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Normally I'd end here but I haven't reached my home yet. So... I have a couple of minutes.... let's talk about fund administration.

Fund administration refers to the back-office responsibilities that are typically outsourced to whoever does your fund accounting. Instead of accounting though, fund administration focuses on tasks like 1) maintaining shareholder records, 2) calculating and paying out dividends, and 3) preparing financial statements.

1) maintaining shareholder records... Shareholder records are typically maintained through a shareholder registry. This is a centralized database where all shareholders are listed and their ownership percentage is tracked. The registry also maintains contact information for shareholders, as well as records of any transfers of ownership.

2) Dividends are typically calculated and paid out in two ways: either through a distribution waterfall or through a unitized system.

With a distribution waterfall, dividends are paid out to shareholders based on their ownership percentage. For example, if Company A has a 30% ownership stake in Company B, then they would be entitled to 30% of the dividends that Company B pays out. This type of system is common among publicly-traded companies.

With a unitized system, dividends are paid out to shareholders based on the number of units they own. For example, if Company A has 1,000 units of Company B and Company C has 2,000 units of Company B, then Company A would be entitled to 50% of the dividends that Company B pays out. This type of system is common among private companies.

3) Mutual funds and fund administration are both regulated by the SEC. Financial statements must be prepared in accordance with Generally Accepted Accounting Principles (GAAP). In particular, a mutual fund's financial statement must show how the fund's net asset value (NAV) has changed over time.

This is a space where you work with companies like MorningStar, Broadridge, FundQuest.... not to mention the usual suspects in securities servicing: State Street, JP Morgan, BNY Mellon, Northern, etc. These kinds of companies offer a wide range of services, including shareholder record-keeping, fund accounting, and transfer agency.

Alright... I'm home.

Hope you learned something.