An introduction to unitised funds and unit pricing

Transcription

1 ACTUARIES An introduction to unitised funds and unit pricing ADVISORY

2 Synopsis and objective of paper Introduction This paper is an introduction to the management and unit pricing of non-listed unitised funds. It deals with considerations and issues ranging from product and fund design, practical operational management, control processes and finally what to do when things go wrong. The paper is written for those who are new to the industry as well as those with considerable unit fund management experience. As unit pricing requires reliable inputs from the main systems and processes of the funds manager, sound unit pricing is at the core of the overall financial management of a unitised fund. It is, therefore, the key focus of this paper. Nonetheless, the paper is not intended to provide an in depth review of the funds management markets in Australia, nor is it a technical paper covering detailed tax issues or legal obligations of trustees or managers of investment funds. Acknowledgement In preparing this paper the authors enjoyed considerable support from colleagues at KPMG including Greg Martin, Paul Reid, Jeremy Hirschhorn, Matthew Githens, Samantha Kim and Christine Evans, and from Ricky Notarangelo at BNP Paribas, who reviewed earlier versions of this paper and provided valuable feedback, comments and observations. The views expressed in this paper, however, remain those of the authors The authors would be very interested to receive any questions or comments on the paper. They can be contacted on the details below. Michael Dermody Martin Paino Director Senior Manager KPMG Actuaries KPMG Actuaries 10 Shelley Street 10 Shelley Street Sydney NSW 2000 Sydney NSW 2000 Australia Australia Tel: Tel: Fax: Fax: [email protected] [email protected]

3 Contents 1 Introduction 1 2 Unitised funds in Australia 3 3 Unitised fund principles 10 4 Product design and unit price methodology 14 5 Overall unitised fund framework 24 6 Asset valuation 33 7 Tax provisioning 36 8 Unit price error correction 45 9 Concluding remarks Bibliography 55 Appendices Appendix A - Unit pricing structures 57 Appendix B - System reconciliations and controls 61

4 2 An introduction to unitised funds and unit pricing 1 Introduction 1.1 Description of unitised funds A unitised fund is an investment vehicle whereby the contributions of a number of unitholders are pooled and the total amount is then used to purchase assets such as shares, bonds, property and cash. The basic principle of unitised funds is that the fund's underlying assets are notionally apportioned into units, such that the total face value of units (unit price multiplied by the number of units) equals the fund's net asset value. This equality between unit values and asset values is maintained via the creation/ cancellation of units at the prevailing unit price when unitholders apply/ withdraw funds, and by movements in the unit price when the market values of the underlying assets change. In this way the number of units held by a unitholder represents their share in the pool, while the unit price can simply be described as an index reflecting the return on the fund assets, net of an appropriate allowance for tax and relevant management expenses and charges. The unit pricing mechanism therefore achieves the simple and logical outcome of returning to unitholders the actual performance of their share of fund assets. 1.2 Structure of paper Although the underlying concept of unitised funds is simple, in practice their management involves addressing a large number of equity and operational issues. The purpose of this paper is to identify and discuss these issues. Chapter 2 provides a high-level overview of the products and the industry. Chapters 3 and 4 consider product design issues. Chapter 3 begins with an overview of unit pricing principles. Chapter 4 makes reference to these principles and considers specific aspects of the theoretical unit pricing methodology that fund managers face when establishing a new product. Chapters 5-7 consider the practical and operational issues faced by fund managers in implementing the chosen unit pricing methodology. This section includes a discussion of the control environment and the system and processing framework. Practical issues in determining appropriate asset values and tax provisions are also considered. The final chapter considers the steps required when these processes fail to operate effectively and the fund manager is required to implement unit price error corrections.

5 An introduction to unitised funds and unit pricing Scope of paper There are various types of unitised funds in Australia including Managed Investment Schemes as defined under the Corporations Act 2001, Superannuation Funds regulated under the Superannuation (Supervision) Act 1993 and investment-linked life insurance and friendly society business regulated under the Life Insurance Act Certain private unit trusts which are not regulated under the Corporations Act may also fit the broad description of a unitised fund set out above if unit transactions are based on a unit price, calculated using the net market value of trust assets. While much of this paper is relevant to the management of such private trusts, the main focus and discussion is on the management of publicly offered unitised funds. While there is limited analysis in this paper of overseas unitised fund products and regulation, the general operating issues are common across countries and therefore many of the conclusions on matters of principle and method would appear to have relevance for the management of unitised funds outside Australia. It is noted that within the general discussion of this paper references to 'fund manager' are intended as a reference to the collective parties responsible for the management of a unitised fund (e.g. trustee, responsible entity, and/or life office where appropriate).

6 4 An introduction to unitised funds and unit pricing 2 Unitised funds in Australia The unitised fund structure is ideally suited to pooled investment vehicles as it supports the principle of independence of unitholders (actions of any one unitholder have a minimal impact on other unitholders), while at the same time enabling many unitholders, and particularly small unitholders, to participate in a diversified, professionally managed investment portfolio at a reasonable cost. For these reasons, unitised funds have become the principal investment vehicle in Australia for retail and wholesale investors. In Australia, unitised products are offered under various legal structures. For publicly offered funds, the most common products are unit trusts, life policies and superannuation funds. Across these different products, regulation and tax treatments vary. In addition, certain products may be restricted to particular types of investor. For example, only superannuation money can be invested in superannuation funds. This chapter provides a high-level overview of the types of unitised products. It also provides details on the size of the unitised fund market in Australia and a brief introduction to the legislation and regulations applying to unitised funds. 2.1 Unitised products The following provides a brief review of the main unitised products available in Australia. Unit trusts A trust is a legal entity separate from both the manager and the beneficiaries. Each trust has a trustee that holds the trust assets on behalf of the beneficiaries and is responsible for administering the assets in the interests of the beneficiaries. A trust is legally constituted under a trust deed that sets out the roles and responsibilities of the trustee. It may also specify unit pricing requirements. A unit trust is a trust where the beneficial interest is represented by the number of units held. The units do not represent a direct interest in the underlying assets. Most unit trusts do not pay tax themselves, with tax obligations with respect to income and gains being passed through to unitholders in proportion to the number of units they hold. Such non-taxed unit trusts are often referred to as 'ordinary money' funds. There are four main types of trusts. Although they all have the same legal structure, they have certain product feature differences that are highlighted below.

7 An introduction to unitised funds and unit pricing 5 Unlisted public unit trusts (retail) Public unit trusts are often open to a wide variety of investors including investments from overseas. Typical modern products offer either a single contribution with the option to contribute further arbitrary amounts at any time, or a regular contribution where a fixed amount is contributed, usually on a monthly basis. Common ongoing management expense ratios (MERs) including manager fees, for these products are generally between 1.0 percent and 2.5 percent per annum of funds under management (FUM) and would normally vary for different managers and asset classes. However, there are indexed fund unit trusts available in Australia that tend to have lower fee rates. Management expenses include fund administration manager fees as well as the expenses of the fund (e.g. audit costs) and investment management expenses. Discounted manager fee rates are normally offered where the amount invested is large. Units of a listed unit trust are traded on the stock exchange in a similar way to shares. As listed public unit trusts do not require unit prices to be calculated they do not meet the definition of a unitised fund for the purposes of this paper. Wholesale unit trusts Wholesale unit trusts are similar to unlisted retail public unit trusts although they have a higher minimum investment so the main unitholders tend to be institutional investors and high-net-worth individuals. Although they can vary widely a typical minimum investment in a wholesale unit trust would be $250,000-$500,000. Unitholders are generally free to contribute additional amounts at any time. Wholesale unit trust MERs are generally significantly lower than for retail public unit trusts. For example, MERs generally vary between 0.2 percent and 1.0 percent per annum. As for retail public unit trusts, expense ratios would normally vary for different managers and asset classes. Discounts for large investments are also common. Cash management trusts Cash management trusts (CMTs) are public unit trusts that invest in short-term, fixedinterest securities. The unit price is commonly fixed at $1 and interest income is distributed to the unitholder at regular intervals or when they leave the fund. This is different from other unit trusts where the unit price is not fixed and will move in response to movements in the market value of the underlying assets of the trust.

8 6 An introduction to unitised funds and unit pricing Master trusts Master trust products provide the unitholder with some choice about how their funds will be invested. There are two main master trust structures. A discretionary trust structure, where the unitholder can choose to invest in one or more managed investment fund(s) from a panel of funds. A fund-of-fund structure, where the unitholder selects a risk profile (e.g. growth, capital stable). Each risk profile generally consists of a number of managed investment funds. The managed investment funds underlying the master trust are generally public unit trusts or wholesale unit trusts and may be managed by an external manager or by the manager of the master trust. Investors can also access unitised funds through a Wrap account. Wrap accounts are similar to a master trust in that they provide access to a panel of funds, but differ in that they typically also provide access to ASX listed shares, cash accounts and margin lending. Superannuation funds Superannuation funds are regulated under the Superannuation Industry (Supervision) Act 1993 (SIS). Funds that are deemed to comply with this legislation are subject to a concessional 15 percent tax rate on investment income and capital gains. This is unlike most ordinary money trusts which pass tax obligations with respect to income and gains to the unitholders. However, special tax arrangements apply to benefits when they are paid out of a superannuation fund. The following is a list of the main types of unitised superannuation funds available in Australia.

9 An introduction to unitised funds and unit pricing 7 Public offer superannuation fund Public offer superannuation funds (commonly referred to as retail superannuation funds) are open to the public and may take the form of a master trust or a traditional trust structure as described above. Pooled superannuation trust A pooled superannuation trust (PST) is a wholesale trust that is only open to other complying superannuation funds. Certain industry and corporate superannuation funds Industry superannuation funds are generally open to people who work in a specific industry, while corporate superannuation funds (also referred to as employer funds) are generally only open to people who work for the employer that sponsors the fund. Historically many of these funds have not operated under a unitised fund structure, instead providing benefits under a defined benefit and/or crediting rate structure. In recent years there have been moves to unitise some of these funds. Allocated pension An allocated pension is a product that can be purchased by retirees with superannuation benefits or other eligible amounts. The differentiating features of an allocated pension are as follows. The investor must draw an income stream from their investment, which must be within prescribed minimum and maximum amounts. Payments cease when the account reaches zero. There is generally no tax payable by the fund on the investment income of the underlying assets. However, a proportion of the income stream is included in the member's personal tax return. Life insurance products In Australia, unitised products are also commonly sold as life policies issued by life company statutory funds. In the life insurance industry, unitised products are commonly referred to as unit-linked or investment-linked products.

10 8 An introduction to unitised funds and unit pricing The unitised fund assets are owned by the company through the statutory funds and therefore do not have a legal existence separate from the company. Consequently, the regulation framework applying to life offices is different. This structure contrasts with that of unit trusts, where the assets are held in a separate legal vehicle from the manager. Life insurance companies and the statutory funds are regulated under the Life Insurance Act 1995 (LIA), which is considered further in the next chapter. Life insurance companies offer a range of unitised products that compete with trusts and superannuation funds. Non-superannuation policies are similar in terms of product features and fees to public unit trusts. However, in contrast to ordinary unit trusts, non-superannuation life products operate on a tax-paid basis (i.e. the life office pays the tax). Life superannuation policies include retail investment business, which is similar to public offer superannuation funds, as well as wholesale policies that compete with PSTs. Life policies that are allocated pensions are also sold. Friendly society life unitised products Friendly societies offer a similar range of retail unitised products to a life insurance company. 2.2 Unitised fund market There are various publicly available sources of data on investment products in Australia, although these generally are not related exclusively to unitised funds. The ABS undertakes a quarterly survey of the managed fund industry, which was estimated to be $814 billion at December We estimate that approximately 70 percent of the $814 billion would be through unitised funds. Managed Fund Assets, December 2004 Total Cross invested Consolidated Estimate of unitised funds Type of institution $ million $ million $ million $ million Life insurance corporations(a) 214,586 30, , ,000 Superannuation funds 501,840 88, , ,000 Public unit trusts 192,761 24, , ,000 Friendly societies 6,370 1,851 4,519 2,000 Common funds 10, ,740 0 Cash management trusts 34, ,349 34,000 Total 960, , , ,000 (a) Investments by pension funds which are held and administered by life insurance offices are included under life insurance offices. Source: ABS Managed Funds, Australia, Dec 2004 (5655.0).

11 An introduction to unitised funds and unit pricing 9 The above figures exclude funds of a speculative nature that do not offer redemption facilities (e.g. agricultural and film trusts). Common funds are similar to public unit trusts, however, they do not issue units. 2.3 Investment and Financial Services Association The Investment and Financial Services Association Limited (IFSA) is a national not-forprofit organisation representing the retail and wholesale funds management and life insurance industries. IFSA members manage approximately 97 percent of the industry's funds under management (based on statistics as at September 2003). While IFSA has many functions including the general promotion of the industry, it also has a role in developing industry consensus, standardising practices and procedures and ensuring proper disclosure with respect to unit funds management. In July 1999, IFSA published a code of ethics, as well as a range of standards and guidance notes, which guide the conduct of its member companies. Compliance with standards is compulsory for IFSA members; while compliance with guidance notes is voluntary. The standards and guidance notes relating to unit pricing are described briefly below. Relevant sections of the standards and guidance notes are referred to throughout this paper. IFSA Standard No Scheme Pricing This standard covers the principles to be adopted in the calculation of unit prices and provides guidance in relation to the application and interpretation of these principles. It also specifies the practices, procedures and terminology required by industry participants. IFSA Standard No Valuation of Scheme Assets and Liabilities This standard specifies the principles that should be adopted in the valuation of assets and liabilities for managed investments, and provides guidance in the interpretation and application of these principles. IFSA Guidance Note No Incorrect Pricing of Scheme Units - Correction and Compensation This guidance note specifies the guidelines that fund managers are expected to follow on occasions when incorrect pricing takes place and when compensation arising from incorrect pricing is required.

12 10 An introduction to unitised funds and unit pricing The Association of Superannuation Funds of Australia (ASFA) has also issued a discussion paper to provide information and best practice guidance about the valuation of superannuation fund assets and liabilities and the calculation of unit prices for unitised superannuation funds. 2.4 Legislation applying to unitised funds Unitised products written through Life Insurance Companies and Friendly Societies are principally regulated under LIA. Superannuation funds are regulated under the SIS, while most other unitised funds are principally regulated under the Corporations Act 2001 (Corps Act). The Australian Prudential Regulation Authority (APRA) and the Australia Securities and Investments Commission (ASIC) consultation paper titled Unit Pricing Guide to Good Practice provides a concise summary of the fiduciary requirements applying to each piece of legislation. Product Disclosure Statement Unitised products regulated under SIS, LIA and the Corps Act are all required to issue a Product Disclosure Statement (PDS) to retail clients. The PDS sets out the significant features of a financial product including the risks, benefits and costs. The PDS is also relevant to the unit pricing process as under IFSA standards, members are require to disclose in the PDS information relevant to the unit pricing calculations. For example, the following must be disclosed. The basis by which the assets and liabilities are valued. If transaction costs accrue to the manager, the amount retained by the manager. If a manager retains any rounding adjustment in the unit pricing calculation, the amount retained by the fund manager. The frequency that the unitholders can transact. For funds that do not have a transaction factor - the reason for its absence and the method for allowing for the costs of any transactions with the fund. For funds that have a transaction factor, the purpose and method of calculation. Information about fees, expenses and charges. Information about any commission or other similar payments.

13 An introduction to unitised funds and unit pricing 11 3 Unitised fund principles 3.1 Returns from pooled investment different from investing on a stand-alone basis The management of unitised funds is not a precise science. There is no single unit pricing methodology that adheres to a hard and fast formula deemed to be the correct or 'the best one'. Rather, in making decisions about any given type of fund there are likely to be a range of approaches that might be considered reasonable. Such decision making will be based on an assessment of the circumstances and objectives of the particular fund. The requirement to exercise such judgement often arises because, in addition to the practical issues of scale on costs, the overall returns on a pool are likely to be different from those that would be obtained if each unitholder invested their funds on a standalone basis. For example, the effect of pooling on tax and transactions costs often results in an improved overall return. In many cases it is not possible to define a single 'best' approach that attributes pooling benefits to individual unitholders. These cases call for an appraisal of the various approaches that could be taken and for decisions to be made on the approach considered most appropriate. Often a range of approaches might be considered reasonable. 3.2 Industry and regulator concepts of equity in unit pricing Unit pricing approaches or outcomes including the allocation of pooling benefits, are commonly described in terms of how 'equitable' they are. While there does not appear to be a clear common understanding of what equity in unit pricing means, there is a high awareness of the importance of determining appropriate unit prices for processing unitholder applications and redemptions. Unit pricing is about determining a fair value at which investors can enter and leave a pooled investment scheme. Worcester, Money Management, 3 October 2002 IFSA has also sought to guide appropriate practice in the management of unitised funds through the issue of its unit pricing and asset valuation standards. These standards and guidance notes make reference to issues of fairness and equity. IFSA Standard No 8.00 Scheme Pricing in particular covers the 'principles to be adopted in the calculation of unit prices, and provides guidance in relation to the application and interpretation of these principles'. In part it reads:

14 12 An introduction to unitised funds and unit pricing The process of determining scheme prices in relation to a scheme should meet the following criteria: it should be fair and equitable it should be coherent it should be transparent it should be consistent it should be accurate. Interests in a scheme should be transacted at scheme prices that reflect the following: the value of scheme assets and liabilities the number of interests in the scheme a transaction cost factor a rounding adjustment (p. 8, bold letter). The meaning of 'fair and equitable' in the standard includes that the process in determining the price should 'favour neither a seller nor a buyer of scheme interests'. The standard states that pricing should be based on an accurate assessment of the value of the scheme's assets and liabilities. In terms of accuracy, we also understand that the unit price calculation should reflect the intended and documented unit pricing approach. The APRA and ASIC consultation paper also emphasises that unit pricing practices should provide fair and reasonable outcomes for all beneficiaries and members (page 9).

15 An introduction to unitised funds and unit pricing Proposed concepts of equity in unit pricing This paper builds on the work of IFSA, APRA and ASIC in adopting and highlighting unit pricing principles. The list below provides a detailed description of our understanding of how principles of equity and reasonableness in unit pricing should be interpreted. 1. Unit prices should be accurate (meaning described above). 2. Unit prices should reflect all known information - the purpose of unit pricing as described in chapter 1 is to return to unitholders the actual performance of their share of fund assets. Therefore, the unit price should reflect all known information with respect to this objective. 3. Equity between unitholders in the same unit series over time - this is similar to the IFSA requirement that the unit pricing approach should not favour a seller or buyer of units. 4. Equity between unitholders in the same unit series at each point in time - this principle requires that the different unitholders in a unit series be treated identically. All unitholders in a particular unit series should have the same choices and the unit pricing approach should not discriminate between them. 5. Equity between unitholders in different unit series - where synergy benefits/detriments are obtained by managing multiple unit series, such benefits/detriments should be shared equitably between unit series. This is discussed further below. 6. Equity between unitholders and the unitised fund manager - where synergy benefits/detriments are obtained by the structure implemented by the unitised fund manager they should be shared equitably. This is discussed further below. When evaluating whether a particular unit pricing approach satisfies the principles relating to equity under points 3, 5 and 6 above, a useful stating point is to consider the position of each unitholder if they had invested in a fund isolated from other unitholders. The allocation of any benefits or synergies, or indeed costs, that arise from the pooling of assets/transactions in a unitised fund can then be considered. The Unit Pricing Working Party of the Society of Actuaries in Ireland produced a paper that explores concepts of equity in unit pricing, particularly in relation to life insurance funds. It considers the various arguments that may be advanced for allocating synergy benefits to either continuing or exiting unitholders or to the life company itself.

16 14 An introduction to unitised funds and unit pricing A potential argument for allocating it to the life company is that they established the fund structure and therefore any benefits or synergies that arise from the pooling of assets/transactions in a fund should be allocated to them. For example, the unitised fund enables matching of buying and redeeming unitholders and, on this basis it could be argued, it is reasonable to allocate any transaction costs saved to the unitised fund manager. At least in relation to synergy benefits in terms of transaction costs such a view is unlikely to be valid in Australia as there is clear guidance from IFSA and in the APRA and ASIC consultation paper that this is not appropriate unless explicitly set out in constituent documents. This approach would also appear to breach Australian fee disclosure requirements that require the disclosure of all fees, unless such allocation of synergy benefits was clearly disclosed as a fee. A possible argument for allocating such benefits to continuing unitholders is that new and exiting unitholders should deal separately with the unitised fund and that any synergy benefits should fall to the fund. While the paper by the Unit Pricing Working Party of the Society of Actuaries in Ireland (Unit Pricing and Equity in the Management of Unitised Funds, 18 November 1993) does not provide clear guidance on how synergy benefits/detriments should be allocated, it does highlight certain principles that may be considered and areas where decisions are required. Where issues of equity arise it is also important to take account of practical and legal requirements as well as the requirements of constituent documents. Any approach needs to be sufficiently flexible to deal with such principles under radically changing circumstances of asset values or cashflows as well as the business as usual environment.

17 An introduction to unitised funds and unit pricing 15 4 Product design and unit price methodology 4.1 Introduction A key step for fund managers when developing a new product is specifying the methodology. This chapter commences with a brief description of the unit price formula and then discusses the various aspects of the unit pricing methodology. These aspects include: funding of transaction costs forward versus historic pricing funding of backdating costs frequency of unit pricing method of deduction of ongoing asset charges income distribution unit structure and managing multiple unit series. Different approaches are assessed by reference to the unit pricing principles of equity set out in chapter 3, however, in many cases there is no single 'theoretical' right answer to unit pricing. There are often several approaches which are reasonable, where no one approach is inherently better than all others. An example is the allocation of benefits of reduced transaction costs from transaction netting. As there is no single 'best' way to attribute the benefits from transaction netting to individual unitholders, various approaches to allocating or funding transaction costs may be considered reasonable. 4.2 Overview of unit price formula A common high-level description of the unit price formula is: fund net asset value (NAV) divided by the fund number of units. However, this definition is over-simplified as in practice the formula often includes parameters in respect of transactions costs and for management fee deductions. The following represent typical examples of formulae for calculating application and redemption unit prices:

18 16 An introduction to unitised funds and unit pricing Mid Price = NAV Units d 1 MF 365 ( ) Allocation Price = Mid Price 1 + TCS b Release Price = Mid Price 1 ( 1+ ) TCS s Where; d = Number of days since the unit price was last calculated. Weekends and public holidays mean that d is not always 1, even for daily unit pricing MF = Management Fee. For funds that deduct fees by cashing units, rather than as a deduction to the unit price, MF is zero TCS b = Transaction Cost Spread (buy) TCS s = Transaction Cost Spread (sell). The above formula is not the only approach adopted in the industry. For example, it is quite common for the net asset value to be determined after deducting, or accruing for, the management fee for the day, or for wholesale investments for unitholders to be invoiced directly for management fees. In these cases, there is no management fee deduction in the unit price formula. 4.3 Transaction costs Protecting existing unitholders from transaction costs Many funds include an adjustment for transactions costs in the application and redemption prices that reflects the unitised fund's own costs of investing in or redeeming assets. By funding transactions costs via what is effectively a levy on applications and redemptions, the existing unitholders are shielded from costs resulting from other unitholders' transactions. Transaction cost is only an estimate Unitised fund managers normally seek to minimise the actual transaction costs incurred by aggregating unitholder applications and redemptions so that asset purchases/sales are based on the net unitholder cash flow amount. The ability to aggregate transactions is therefore one of the key areas where a pooled fund can optimise returns and minimise costs compared with the situation if each unitholder invested their funds on a standalone basis. As the level of transaction netting depends on the relative volumes of applications and redemptions, it is not possible to predict the precise impact on transaction costs in advance.

19 An introduction to unitised funds and unit pricing 17 Active fund management also involves buying and selling assets even where there are no unitholder applications or redemptions. The basis for attributing transaction costs between those incurred as a result of rebalancing or investment decisions and unitholder transactions is typically somewhat arbitrary. Consequently, the transaction cost factor included in the unit price formula can only be based on an estimate of transaction costs associated with unitholder transactions and there is no single correct transaction cost allowance that can be reliably determined in advance. Transaction costs for various asset classes Indicative transaction spreads applying to various asset classes are outlined below: Gross of tax transaction spreads Asset Sector Buy/Sell Spread Cash Nil Fixed interest 0.05% % Australian shares 0.15% % International shares 0.20% % The transaction spreads applying to listed property trust investments are generally broadly similar to that of Australian shares, while larger spreads are common for direct property and other direct investments. Where the assets of a unitised fund are the units in another fund managed by an external fund manager, and the external fund manager publishes separate application and redemption prices, the spread would in most circumstances simply be based on the spread of the external fund manager. References to transaction costs in IFSA standards and guidance notes and APRA and ASIC consultation paper IFSA, APRA and ASIC recognise that in order to maintain equity between continuing and exiting unitholders, where material, transactions costs should be allowed for in the unit price. Other than where transactions costs are not material, IFSA notes several situations in which an allowance for transaction costs need not be made. IFSA indicates that no transaction factor is required where a fund invests into another fund and there are no separately identified transactions costs. IFSA also notes that the size of the transaction cost allowance in the unit price calculation may be fixed in the fund's constituent documents and that in such circumstances the fund constitution prevails.

20 18 An introduction to unitised funds and unit pricing IFSA, APRA and ASIC note that any overfunding of actual transactions costs by the transaction factor should not accrue to the manager. Any such charge is effectively a fee and one that is potentially subject to manipulation if the fund's legal documents enable transaction cost factors to be altered. Generally, the IFSA standard appears to envisage the transaction factor being an allowance for explicit costs of buying or selling assets, rather than implicit costs such as market price movement effects from the application or redemption. An exception to this is in respect of thinly traded assets where IFSA recognises that market price impacts should be included (if an allowance is not already included in the base value). Methods of funding transaction costs through the unit price Buy/sell spread - no allowance for transaction netting The most common unit pricing approach to transaction costs is to publish separate application and redemption prices, also known as adopting a buy-sell spread. The calculation of the application and redemption prices typically involves determining a mid-market unit price that excludes transaction costs. The application (redemption) price is then obtained by multiplying (dividing) the mid-market unit price by a factor which reflects the transactions costs of purchasing (selling) assets. This approach is consistent with the equation in section 4.2. Depending on the tax status of the unitised fund, the transaction factor calculation may need to include an appropriate allowance for tax. Administratively, this method is straightforward as the manager does not need to monitor net cashflow as in the case of the other methods. However, this method has a systematic bias against transacting unitholders (advantages continuing unitholders) where significant transaction netting occurs. Buy/sell spread - allowance for transaction netting A logical extension of the buy-sell spread approach described above is to reduce the transaction spread for the impact of transaction netting. In this way the transacting unitholders share the benefits of transaction netting rather than this being passed to the existing unitholders. Although this method aligns closely with the unit pricing principles, there are a number of practical issues involved with its implementation. In particular, to achieve the theoretical outcome of matching transaction cost allowances with actual transaction costs, the transaction cost allowance would have to be continually adjusted.

21 An introduction to unitised funds and unit pricing 19 In addition, this approach is likely to be more difficult to explain to unitholders. There are also issues of materiality as differences between this approach and a simpler method may be insignificant. Due to these difficulties, the practical application of this method involves allowing for the beneficial impacts of transaction netting on an approximate basis, usually after considering historic as well as expected future cash flows over an extended period of time. The transaction factor is typically only reviewed periodically. Single price based on mid price (no allowance for transaction costs) Adopting a single unit price based on the mid price allows unitholders to transact units without incurring transactions costs, with continuing unitholders bearing the costs. Under this approach, existing unitholders are systematically disadvantaged and unitholders that transact frequently are advantaged. Therefore, such an approach is not generally regarded as consistent with unit pricing principles and is becoming less popular. Net buyer/seller method The net buyer/seller method involves transacting applications and redemptions at the same price, but alternating this single price over time between a buy price if there is a net unitholder cash inflow and a sell price if there is a net unitholder cash outflow. As applications and redemptions are transacted at the same unit price, the offsetting unitholder transactions do not provide the fund with any margin to fund transaction costs. This does not disadvantage existing unitholders, as offsetting cash flows do not generate transactions costs for the fund. The applications or redemptions that are not offset will result in the fund incurring full transaction costs in relation to the net transaction (as the fund must buy or sell additional assets for the net transaction). Therefore, the transaction spread should not be reduced for the impact of transaction netting. Although this method does not have a stable impact on the unit price in changing circumstances, as long as the switch between application and redemption prices occurs appropriately and in a timely fashion, the theoretical outcome produces fair outcomes in changing circumstances as it does not systematically disadvantage transacting or continuing unitholders. However, it should be noted that in order for this method to be effective, the choice of price must be monitored closely. In addition, where there are large transaction spreads, the switch from a buy to a sell, or from a sell to a buy can result in significant unit price movements that may be difficult to explain to unitholders.

22 20 An introduction to unitised funds and unit pricing 4.4 Forward and historic pricing Daily unit pricing Historic pricing occurs when transactions are processed using a unit price calculated based on asset values before the unitholders' instructions are received (e.g. unit prices are calculated using asset values from 'yesterday'). Alternatively, when the processing of transactions is done at a unit price calculated based on asset values following receipt of the unitholder's instruction this is referred to as forward pricing (e.g. unit prices are calculated using asset values at the end of 'today'). In the case of historic pricing the valuation time for unit pricing and processing transactions is in the past. Therefore, a unitholder monitoring the market can determine whether the current fund, net-asset values are likely to be higher or lower than those used to determine the unit price for transaction processing. In this way the unitholders can take advantage of existing information by making applications if markets have risen or making redemptions if markets have fallen. This can be to the detriment of existing unitholders as the difference between the value of the units created/cancelled and the value of the application/redemption is effectively a cost to the fund and reduces the unit price. Where historic pricing is used, the fund manager should have processes in place to prevent unitholders taking advantage of unit price movements. Late-trading and market timing: examples of one-off applications of historic pricing Two unit pricing practices, late-trading and market timing, have recently received significant negative press in the US. Late-trading involves a fund accepting unitholder buy or sell instructions after the official cut-off time. The cases have tended to occur when fund managers deliberately allowed selected unitholders to do this. Late-trading can be broadly characterised as the deliberate application of historic pricing for selected unitholders for their benefit within a fund that otherwise generally operates on a forward-pricing basis. Market timing occurs when there are difficulties in obtaining net-asset values and the most recent unit price is used for processing unitholder transactions. Again, this is effectively an example of historic pricing and has been used deliberately and with cooperation between managers and certain unitholders to the disadvantage of existing unitholders. In response to these issues arising in the US, ASIC undertook a review of investment practices in Australia and following the review noted that there was no evidence that such practices were widespread in the managed fund industry in Australia. (Sydney Morning Herald, 7 August 2004)

23 An introduction to unitised funds and unit pricing Backdating Historic pricing results in the investment or redemption of unitholder cashflow occurring after the point at which assets are valued for determining the unit price. Consequently, the fund asset returns have a diluted (net cashflow positive) or geared (cashflow is negative) impact on the unit price. This effect may also occur when the investment or redemption of unitholder transactions occurs after instructions are received and transactions are backdated. Backdating occurs when cashflows are processed using a unit price from the past. There may be an element of backdating as part of ordinary processing where transactions are unitised using the unit price on the date of receipt but the processing date is some day(s) after the date of receipt. Some fund managers bear the impact of backdating so that there is no impact on the unit price (and existing unitholders) from processing transactions at a unit price different from the current price. This practice is supported in the APRA and ASIC consultation paper. Some fund managers invest applications immediately when they are received, even where those applications have not been unitised. In this way, any dilution or gearing impacts are minimised compared with other processes that involve holding amounts in a separate cash account until the application is unitised. Historic pricing can enable unitholders to anticipate the likely future movement of the unit price to their advantage. This is not always the case with backdating where unitholders do not have the opportunity to gain any advantage from past information. 4.6 Frequency of pricing Most retail and whole unitised funds in Australia now calculate unit prices and process unitholder transactions each business day. The main funds that calculate unit prices less frequently than daily would be small funds that have been open for a long period, and certain corporate superannuation funds, industry superannuation funds, and hedge funds. There is generally little pressure to produce unit prices more frequently than daily and significant technology and reconciliation challenges would be involved to do this. Despite the increasing complexity and number of unitised funds there appears to be little interest in reducing the frequency for unit pricing. Key reasons for this are likely to include competitive pressures from other fund managers, and unitholders' desire for control and the ability to be invested/withdrawn from the market as soon as possible after they provide their application/redemption request.

24 22 An introduction to unitised funds and unit pricing Where prices are calculated less frequently than daily, the ability of unitholders to take advantage of historic pricing increases. 4.7 Fee deduction Deduction of ongoing asset charges For most modern products, the main revenue source to managers of unitised funds is the ongoing asset charge commonly referred to as the 'assets under management fee'. These fees are typically expressed as a percentage per annum of the fund's net assets. As noted at the beginning of this chapter the management fee deduction can be through the unit price formula, or via an explicit deduction to the fund assets each day before the net asset value of the fund is determined. In other cases, the unit prices can be determined gross of these ongoing asset charges, with explicit fees debited separately, either by cashing or cancelling units, or by a separate invoice to the unitholder. Similarly, a variety of approaches may be adopted for crediting unitholder rebates related to large unitholder discounts or for other reasons. Entry and exit fees/surrender penalties Entry fees may be reflected either in the unit price, by way of a buy/sell spread or as a deduction from the application before the investment is applied to the purchase of units. Both methods are common. Where entry or exit fees are levied via a buy/sell spread it is important that this is disclosed clearly to unitholders so that the buy/sell spread is not confused with a buy/sell spread that is used to fund transaction costs. Surrender penalties or exit fees may also be expressed as a percentage deduction from the unit balance.

25 An introduction to unitised funds and unit pricing Income distribution Ordinary money (non-taxed) trusts need to distribute their realised investment gains (interest, dividends, rents, net capital gains), net of incurred expenses, to unitholders, at least annually. There are two common, general approaches to dealing with these distributions and unit prices in between distribution times: Roll Up approach Under the Roll Up approach, all income and gains (realised and unrealised) are included in the unit price, with the total net income distributed to those unitholders who hold units on the distribution date. This approach is administratively simple and is commonly used for most growth type investment products. Separate income approach An alternative approach is to only reflect the capital (unrealised gains) value of the fund assets in the unit price. All net income is separately recorded and is distributed to all unitholders that held units since the last distribution, based on some measure of their entitlement to the net income (e.g. pro-rata on the number of units and days held). This approach is not uncommon for CMTs and some older style unit trusts. 4.9 Unit structure and managing multiple unit series A key product design issue involves the choice of unit structure and fee deduction approach. This section describes two common approaches. Unitholder and supporting unit structure Fund managers often maintain multiple products that have different fee rates, yet use the same or similar investment options. Maintaining additional asset pools involves additional costs to the manager and limits pooling benefits to the unitholders. Therefore, many fund managers adopt a multilayered unit structure which allows a single asset pool to be used to support unit series with different fee rates. Under this approach, a 'supporting price' is calculated for each investment option before allowing for management fees. Separate transaction unit prices ('unitholder prices') are then calculated for each product from the supporting price by applying the relevant fee deduction. This approach is referred to as the unitholder and supporting unit structure.

26 24 An introduction to unitised funds and unit pricing Fees deducted by cancelling units An alternative to the unitholder and supporting unit structure is to deduct fees via the cancellation of units (or transfer of units to the manager), rather than through the unit pricing process. This approach also enables different fees to be charged to different unitholders that invest in the same asset pool. A similar approach often used by wholesale funds is to deduct a flat rate fee through the unit price, but pay or credit rebates to enable fee rates to be varied between clients. Diagrammatic presentation Appendix A provides a diagrammatic presentation of the approaches described above. Generally, the unitholder and supporting unit structure is common with retail products where published transaction unit prices are typically net of fees. A zero fee rate approach with fees processed by cancelling units, or the flat fee rate deduction with the use of rebates to obtain the appropriate fee for different clients are both common with wholesale funds. The zero fee rate approach is also common for corporate and industry funds.

27 An introduction to unitised funds and unit pricing 25 5 Overall unit pricing framework 5.1 Implementation sections The previous chapter considered some of the theoretical issues involved when determining the unit price formula. Chapters 5-7 discuss implementation issues which begins with a review of the control environment. The consideration of practical unit pricing issues commences with a broad overview of the key systems and processes required to operate unit pricing, as well as the typical business divisions involved. As successful unit pricing is dependent on the appropriate interaction of key systems and interpretation of information hand-offs, the chapter also briefly considers certain common key system and process reconciliations. The sub-processes and timeframes for processing unitholder transactions are also reviewed. Practical issues in determining appropriate asset values and tax provisions for unit pricing are considered in chapters 6 and 7 respectively. 5.2 Control environment A key consideration of the unit pricing implementation is the control environment that covers the entire end-to-end process. The purpose of the control environment is to ensure that the processes are operating as intended and that any errors or failures are promptly identified and addressed. The key aspects of the control environment for a unitised fund manager are represented in the following diagram. Unit pricing control framework Governance framework Checks, reconciliations Calculation method and and Constituent documents control implementation environment

28 26 An introduction to unitised funds and unit pricing Governance framework The governance framework provides a consistent basis for identifying and measuring risk across all areas that impact unit pricing. The reporting provided to the unitised fund manager's overall management team is an important aspect of the governance framework. It should provide details on all the key risk areas. The governance framework also includes the management of outsourced service providers, such as the appropriate documentation and delineation of responsibilities as well as a regular review of the outsourced service provider's performance. There should be clear assignment of responsibilities, particularly in relation to the setting and review of key operating policies and principles. Processes for identification, assessment and reporting of risks, as well as escalation measures for errors or failures, are also key features of the governance framework for all unitised fund managers. The governance framework should ensure that there is adequate process documentation, change management, evidence of performance/review of controls and management of key person risk. Checks and reconciliations A key component of the control environment is well designed and targeted reconciliations and controls to confirm the accuracy of data and processing, and this is discussed further in section 5.4. Calculation method and implementation The calculation method should be documented and compared with established industry views of good practice. It should also be consistent with principles of equity and regulator guidance. Controls should be designed to confirm that the intended unit pricing approach has been correctly implemented in the systems. There should be procedures that support ongoing compliance with methodology requirements including change control. Constituent documents The fund manager should design processes for confirming the intended method is consistent with legal documents (e.g. policy and constituent documents for unitised products). Any specific unit pricing requirements contained within these documents should be consistent with the actual unit pricing methodology.

29 An introduction to unitised funds and unit pricing 27 In practice, this involves a two-way control and implementation process. What is stated in constituent documents needs to be faithfully and reliably reflected in the implemented system. What the system can and does do should be taken into account when products are designed and constituent and promotional documents written. 5.3 Overview of fund manager operations Key business operations In summary, the key day-to-day operations of a unitised fund manager involve: maintaining unitholder records and processing unitholder instructions to purchase/redeem/switch units managing the pool of fund assets valuing fund assets and tax liabilities and deducting and accruing fund expenses and fees calculating fund unit prices. Division and business structure It is common for distinct business divisions to be responsible for each of the operations mentioned above for a large fund manager. The following diagram is an example of a business structure that shows the business divisions that provide inputs to the unit pricing team, as well as a high-level view of the information inputs and systems involved. Example business structure Unitholder Securities administration Purchase and sale advice Purchase and sale advice Investment management team Custody Cash flow and fees Asset Registry (AR) Asset details Administration Unit Registry (UR) Units and cashflow Unit prices Unit pricing team Unit Pricing System (UPS) Gross asset values Asset details Invetsment accounting Funds Ledger (FL)/ General Ledger (GL) Unit prices Tax provision Tax Benchmarking model Unit pricing tax model Accounting / tax return model

30 28 An introduction to unitised funds and unit pricing It is also common for fund managers to outsource one or more of these functions. The diagram indicates that unit pricing can be reliant on the performance of various teams that are responsible for the data and processing across a diverse range of systems. These system processes and interactions, as well as the controls and reconciliations, are considered in more detail below. System framework Although the basic principles of unitised funds are simple, in practice managing them involves interactions between the unit registry system that contains individual unitholder records, tax, accounting and asset registry systems that are used to determine fund net-asset values and the unit pricing system itself which calculates unit prices. An example system framework is set out in the diagram below. Example system framework Unitholder External parties External managers Investment markets Unit Registry (UR) Suspense account Fund manager Units and cash flow Unit prices Fund account Unit Pricing System (UPS) Purchase and sale advice Securities administration Cash flow and fees Unit prices, distribution and unit details Purchase and sale advice Cash flow Advice and asset allocation details Gross asset value Asset details Asset Registry (AR) Asset details Security details Funds Ledger (FL)/ General Ledger (GL) Purchase and sale advice Investment management team Purchase and sale advice Cash flow advice and asset allocation details Price feeds Expenses Data provider Service provider Unit prices Tax provision Tax liabilities Asset details Benchmarking model Unit pricing tax model Accounting/ tax return model Index values Key Flow of money Flow of daily information Flow of monthly information

31 An introduction to unitised funds and unit pricing 29 In considering this hypothetical case it should be noted that there is significant diversity in system structures across different unitised fund managers. For example, in some cases the asset values are loaded into the unit pricing system from the general ledger, rather than the asset registry system. The network of interactions illustrates the dependencies between systems and highlights the scope for compromising unit price integrity if information between systems is misinterpreted, not updated or is simply incorrect. A brief explanation of the key systems and processes from the above hypothetical case is set out below. Unit registry The unit registry system processes unitholder transactions using unit prices from the unit pricing system. The unit registry system records basic unitholder details and for each transaction for each unitholder records the effective date (date of the unit price applied), the processed date, the dollar amount and the units created/cancelled. Unit pricing system The unit pricing system (UPS) uses updated unit balance data from the unit registry system, the gross asset value from the asset registry system, and the tax provision calculated by the unit pricing tax model to determine updated unit prices. Benchmarking or other reasonableness testing of unit prices may be performed in the unit pricing system, or alternatively, unit price results may be downloaded to a separate system for checking. Accounting systems and tax Under the example system framework above the accounting system is not directly involved in the daily unit pricing calculations. It, however, plays an important role in the control and reconciliation process. Periodically, reconciliations between the daily tax model and the tax model used for accounts and tax return are performed. These reconciliations may lead to further adjustments to tax for unit pricing (see further discussion in chapter 7). Asset registry - asset holdings and prices The asset registry system records details of asset holdings and prices which are reconciled periodically with external asset registries (labelled 'investment markets' in the diagram) to confirm their accuracy and existence (this is discussed further below).

32 30 An introduction to unitised funds and unit pricing For market-traded securities and exchange rates, daily prices may be sourced from commercial data providers of security prices, for example, Bloomberg, Reuters and Financial Times (labelled 'Data Provider' in the diagram). Banks, brokers or other professional valuers may be retained to determine valuations for over-the-counter derivatives, property and other unlisted assets. Where investment management is conducted by external manager(s), details of the portfolio value (if not unitised) or unit number and unit price (if unitised) are recorded in the asset registry system. Asset registry - asset purchases and sales Where the unitised fund buys and sells securities directly, details of asset trades reported by the trading area within the investment management team are recorded in the asset registry. The trade details are then matched, confirmed, and settled with external sources. Where the investment management is conducted by external manager(s), confirmation advice of processed applications/redemptions/switches (e.g. number of units purchased/sold) from the external manager is used to update the asset registry. Asset registry - corporate actions Details of dividends and changes to holdings such as share splits, bonus issues, rights issues etc. are entered. For example, these may be obtained from commercial data providers and then checked against information from exchanges. 5.4 System reconciliations and controls The example framework diagram in section 5.3 illustrates the dependence of the unit pricing system on the accuracy of the data inputs and processing from a number of systems. Appendix B discusses certain common reconciliations and controls that are applied to confirm both the accuracy of data entered into or transferred between systems, as well as the calculations performed in them. While this analysis is not a comprehensive discussion of controls and reconciliations it does indicate the potential significant extent and number of controls involved. The required reconciliations and controls vary for different system structures and this discussion is based on the example system framework in section 5.3.

33 An introduction to unitised funds and unit pricing Unit processing cycle Importance of understanding the unit processing cycle In section 4.5 on backdating, we noted that some processing approaches involve investing amounts in cash until applications are unitised. In this case and where unitholder transactions are unitised on the receipt date, which is before the processing date, there is an impact on the unit price (and therefore existing unitholders) through a dilution or gearing effect. This section considers in more detail the timeline involved in processing a unitholder application. A clear map of the timeframes and sub-processes assists in clarifying for unitholder transactions received on a particular day: The date of the unit price (and the effective date of the asset values used for that unit price) for unitising those transactions (i.e. the impact on transacting unitholders). The typical time period taken to invest or redeem funds in respect of those unitholder transactions. The potential for gearing/dilution impacts to affect the unit price (and therefore existing unitholders). In this way mapping out a unit processing cycle assists with assessing methodology (whether forward or historic pricing), exposure to backdating/market timing profits or losses (and whether they are funded by the manager or the unitholder) and the importance of timely investment of funds. Example of unit processing cycle The chart below is an example of the timeline involved in the processing of an application where forward pricing is used and funds are invested in a cash account until they are unitised. As for the system framework, unit processing procedures vary considerably between different fund managers and this is only one indicative example. The date on which the application instruction and funds are received from the unitholder is referred to as Day T.

34 32 An introduction to unitised funds and unit pricing Example of processing unitholder application* Day T Day T+1 Day T+2 Receipt of applications 3:00pm Application receipt cut-off (1) Unit registry 9:00am to 3:00pm Applications receive on day T processed (4) Unit Data Asset registry Overnight Aseet registry updated (6) UPS system 9:00am Unit price for day T calculated (3) Asset data NAV 9:00am Unit price for day T+1 calculated (7) Domestic investment market Suspense account Day T Application money deposited in suspense account (2) Close of market Asset value calculated Account balance Market open Investments purchased (8) Fund account Day T + 1 Money deposited into fund account (5) Key Flow of data Flow of money (1) All applications received up to 3:00pm of day T, including applications received after 3:00pm of the previous day, are stamped as being received on day T. (i.e. will be processed using the unit price effective on the clost of day T) (2) Application money deposited into suspense account (3) The unit price for day T is calculated at 9:00am of day T+1. The unit price for day T uses the market values and unit data at the close of market on day T. It is noted that applications received on day T are not included in the NAV and unit data used in the calculation of the unit price on day T (4) The processing of applications received on T, begins at 9:00AM, after the unit price has been calculated. (5) Money associated with applications received on day T are transferred from the suspense account to the appropriate fund account on day T+1 (6) Asset registry is updated for asset data and applications and redemptions at the end of Day T+1 (7) Unit price for day T+1 calculated. Applications received on day T are included in the NAV and unit data (8) Assets are purchased on day T+2 from money in the fund account in respect of applications on day T * The above diagram assumes no delay in the processing of applications Application cut-off Unitised fund managers may adopt a fixed cut-off time each day (in the above example it is 3pm) and unitholder transactions received after this time are effectively considered to have been received on the following day. Applicable unit price In this example, the application is unitised the day after it is received (day T+1). The unit price available in the morning of day T+1 has been calculated using asset values at close of markets on day T; the day the application was received. Therefore, transacting unitholders obtain exposure to the fund performance from the day the application is received. It is noted that the time in Australia when key US and European markets close on day T is early in the morning of day T+1. For this example it is assumed that there are no international assets.

35 An introduction to unitised funds and unit pricing 33 Investment of funds and potential impacts on unit price The funds remain in a cash account until the application is unitised on Day T+1. On day T+2, the investment manager is notified of the cashflow to take into account when making asset purchase/sale decisions. Therefore, for this example, unitholder transactions impact the proportionate cash holding in the fund (creating a gearing/dilution effect) which affects the unit price and existing unitholders. As noted above, transacting unitholders gain exposure to the fund assets from close of business Day T; however, the investment of the funds (out of cash and into the asset classes intended) does not occur until Day T+2. The various timing impacts above may be unnoticeable for large mature funds. However, for new funds with small asset sizes the effects may be more significant. Managers may deal with this issue by seeding a significant sum to start a new fund. Some funds, and particularly smaller ones, may not transact in the investment markets each day, even where the holding in cash varies from its target due to unitholder transactions.

36 34 An introduction to unitised funds and unit pricing 6 Asset valuation 6.1 Introduction Determining appropriate asset values for unit pricing is reliant on a clear understanding of the valuation basis and effective date of the asset information available. Where a unitised fund invests in thinly traded or non-market listed securities, additional issues are involved as appropriate market-based asset values may not be readily available. These asset valuation issues for unit pricing are discussed in this chapter. 6.2 Asset valuation approach Source of asset values As noted in chapter 5, prices for listed securities and exchange rates can be sourced from a number of commercial data providers. Where the investment management is outsourced, the external fund manager(s) normally provides portfolio values or unit prices. For unlisted securities, the valuation is determined by the fund manager although it is commonly outsourced. Issues relating to the valuation of illiquid and/or non-market traded securities is discussed further in section 6.3. Understanding basis of asset values The asset valuation approach should have reference to any specific requirements of the product's legal documents and marketing material. In order to confirm this and to ensure that the intended unit pricing approach is adopted (e.g. forward or historic pricing), a clear understanding of the effective date of the asset information used in unit pricing is required. In addition, fund managers should also understand the asset valuation basis. For example, the treatment of management fees and rebates for externally managed funds can vary (unit price/asset value may be exclusive or inclusive of fees, while the frequency and method for processing rebates can also vary). For security prices, the fund manager may use the last sale price or an average of the bid and offer prices. Consistency of valuation dates and stale asset values Assets should be valued at the same time. This is particularly important for determining exchange rates for valuing currency hedges where the fund invests in overseas assets. Fund managers should have processes in place to identify when asset information is stale (has not been updated from the previous day) and how 'old' it is.

37 An introduction to unitised funds and unit pricing 35 For example, it is not uncommon for external fund managers to suspend pricing for a short period following a distribution date or for other reasons, such as technological difficulties. Alternatively, for fund managers that invest directly, security prices may become unavailable from the usual provider. Fund managers should have processes in place to evaluate whether their own unit pricing and processing of unitholder transactions should be suspended, or whether it is reasonable to use the stale asset value or an approximation. Such processes and judgements may take into account the proportion of the total fund that the assets with a stale value represent and their likely variability. This will assist in determining the potential variance to the unit price if full information was available. Corporate actions Particular care is required when valuing directly held assets in respect of distributions and rights issues or other corporate actions, and to ensure that these are appropriately valued. 6.3 Valuation of non-market traded and illiquid assets Certain assets, for example direct property, private equity, venture capital, infrastructure assets and over-the-counter derivatives, may not be traded on a regulated market. Other assets that are traded on a regulated market may be traded infrequently. In these cases the fund manager must devise an appropriate asset-valuation approach. Some of the issues involved are discussed further below. Independent valuation The fund manager should consider whether the valuation should be outsourced to a third party. For example, the fund manager may not have the expertise. Alternatively, the fund manager may wish to demonstrate that the valuations have been determined independently. The principle of third party valuations is supported by IFSA. Where asset valuations are outsourced, the instruction and basis for the work conducted should reflect an appropriate valuation basis for unit pricing. It should be noted that in outsourcing such a valuation function, the process can be outsourced, however, the responsibility for the valuation remains with the fund manager. Frequency Valuations for assets such as direct property may be undertaken periodically rather than daily. IFSA notes that in these cases the valuation of multiple assets should be spread out over time in order to minimise the likelihood of sudden large unit price movements.

38 36 An introduction to unitised funds and unit pricing Approximations may be required to enable a reasonable accumulation and increase in the asset value between the more formal periodic valuations (e.g. via the use of price indices). Smoothing As noted in chapter 3, unit prices should reflect all known information. Therefore, changes in asset values should generally be reflected in the unit price, even where this results in a significant movement (up or down). Smoothing in the impact of historic asset-value movements may provide some unitholders with the opportunity to anticipate unit price movements to the disadvantage of other unitholders. Such practices are invariably inequitable to at least one group of unitholders.

39 An introduction to unitised funds and unit pricing 37 7 Tax provisioning 7.1 Introduction Taxed and non-taxed funds As noted in chapter 2, there are unitised funds that do not pay tax and pass the tax obligation on to the unitholder, and those which pay tax in lieu of the unitholder. This chapter focuses on the issues facing unitised funds that pay tax. For these funds (as has been noted in earlier chapters), the unit price calculation includes an allowance for expected future tax payments in order to achieve equity between generations of unitholders. Nonetheless, a number of the aspects discussed in this section apply similarly to information that needs to be gathered, recorded and passed on to unitholders in respect of non-taxed funds. The expected future tax payments are commonly analysed into current and deferred tax components. Current tax items are calculated in respect of tax on income and tax credits received, as well as realised gains less any tax instalments paid. Deferred tax or future income tax benefits are the provision for future tax obligations/receivables on unrealised gains/losses or carried forward capital losses. The calculation is based on current asset valuations, which are consistent with those used for the unit pricing calculation. Judgement required in determining tax provision for unit price calculation Although tax payments are based on tax law there are a number of aspects to determining appropriate unit pricing tax provisions that require judgement in addition to appropriate application of the tax rules. The key areas where judgement is likely to be required include the following. Determining an appropriate allowance for tax on unrealised gains where the timing and amount may be uncertain. Valuing future tax benefits where recovery is uncertain. Dealing with the limitations involved with incomplete or approximate data in order to provide unit prices daily and within short timeframes. This includes setting appropriate tax provisions for a unitised fund that invests in distributing wholesale trusts. Determining the appropriate tax rate to apply where the tax rate is dependent on the asset holding period. Determining allocations of tax amounts between different unit series and, in the case of life insurance, between the unitised funds and the fund manager.

40 38 An introduction to unitised funds and unit pricing This chapter starts with a high-level overview of the tax framework applying to the various pooled-investment vehicles. This background provides a setting for the subsequent sections that explore the key judgement areas faced by fund managers for unit pricing tax provisioning. In practice, the model used for calculating tax for unit pricing purposes is different from that used for determining tax for financial accounts and for completing the tax return. The key controls and reconciliations between unit pricing tax and tax calculated for accounts and tax paid are also discussed. 7.2 Tax bases From a tax perspective, unitised funds fall into two broad categories. Unitised funds that are not tax-paying entities, i.e. the tax obligations with respect to income and gains in the unitised fund, are assessed on the unitholders in proportion to the number of units that they hold. The fund itself is not required to pay tax. Examples of these funds include public offer unit trusts that are not subject to taxation. Unitised funds that are, or are part of, tax paying entities, i.e. tax is paid by the unitised fund. Examples of these funds include life insurance business, superannuation trusts and PSTs, as well as trusts that are subject to taxation. Pension funds do not fit simply into either category. Although they are taxable, the tax rate is zero. However, the fund is able to claim the cash value of imputation credits received. Non-taxed funds Where the unitised fund is not a tax-paying entity it provides unitholders with an annual tax statement containing relevant income/gains/credit information for the unitholder to incorporate in their tax return. Therefore, although the unit price calculation for the fund itself does not incorporate a tax provision, maintaining and communicating accurate tax information is important as unitholders rely on this information in completing their tax returns. Taxed funds For tax-paying funds, the net asset value for the unit price calculation is determined as the gross assets, less provision for tax and other liabilities. Therefore, it is essential for unitholder equity that the tax provisions in respect of both current and deferred tax are appropriate.

41 An introduction to unitised funds and unit pricing Deferred tax lability provision for unit pricing A deferred tax liability is held in respect of unrealised gains on directly held investments as well as on any gains in units in external funds (unless the unitised fund itself is a taxed entity). In Australia, capital gains tax is payable on realised gains only, therefore, as long as the volume of unitholder applications is sufficient to fund unitholder redemptions there is no need (other than for investment management decisions) to sell assets, and the payment of tax on capital gains can be deferred. Prior to final realisation of the asset and the associated capital gain, the funds backing this future tax liability remain invested and earn investment returns. In this way, the overall position of the unitised fund is improved, compared with the situation if redemptions were funded via asset sales and tax payments were brought forward. The issue that needs to be considered by the unitised fund manager is to design a unit pricing tax provisioning basis that shares this benefit on a fair basis between unitholders. Some unitised fund managers calculate the deferred tax provision on a 'discounted basis' by applying a discount factor to the tax that would be payable if the asset were to be sold immediately. This factor is intended to reflect the time value of money effect between the current date and the date the gain is expected to actually be realised. However, providing for tax on an undiscounted basis is also common in the industry. The equity considerations in allowing discounting or not goes beyond considering the expected timing of gain realisation and needs to have regard to investor turnover, the mix of applications and redemptions, and the future expected growth of the fund. For example, in a closed fund, unitholder redemptions may well be funded by selling fund assets with tax becoming payable on any associated capital gains. It is, therefore, generally not appropriate to incorporate discounting in this case. However, in the case of an open fund, redemptions can be funded by new applications reducing the need to sell assets. Therefore, the decision on whether to discount is dependent on a view of an equitable value to exchange this non-interest bearing liability between new and exited unitholders.

42 40 An introduction to unitised funds and unit pricing 7.4 Future income tax benefit Realisation of future income tax benefit dependent on future gains Realised capital losses may be applied against realised capital gains before the capital gains tax is calculated but cannot otherwise be claimed as a deduction against taxable income. Therefore, in the event that the overall realised/unrealised capital gain position is negative, judgement is required in determining whether the fund is likely to have sufficient capital gains in future and whether a future income tax benefit (FITB) should be included in the net asset value calculation. Fund managers should have a policy on recognising FITB based on an analysis of the points at which the likelihood of realising the value of tax losses diminishes. Those potential values should then not be taken into account or should only partially be taken into account. Such a judgement should be made after an examination of the unitised fund's characteristics, for example, whether the fund is open to new applications. If the expected time to realisation of the FITB is significant it may be appropriate to incorporate an allowance for time value of money impacts. Furthermore, even where there may be a high degree of confidence, future capital gains are likely to be realised to make good current capital losses (realised or not), from a financial economics standpoint, the fair value of the FITB may be significantly less than its face value (and be more in line with an option pricing value). IFSA, APRA and ASIC guidance IFSA Standard 9.00 emphasises that the basis for determining the value of a FITB for unit pricing purposes should not favour unitholders buying or selling units, and that the unitised fund manager should consider whether the losses will have use in the long term. IFSA also noted that for superannuation funds where the tax rate applied to capital gains depends on the holding period, the value of the FITB similarly depends upon the holding period of the assets that the capital losses are applied against. The APRA and ASIC consultation paper noted that adopting a policy that either always or never recognised a FITB is unlikely to be appropriate. The paper also noted the importance of systematically reviewing the FITB to achieve equity between unitholders and to avoid sharp movements in unit prices.

43 An introduction to unitised funds and unit pricing Incomplete data and approximate approaches Daily unit pricing tax model Tax provisions are required with the same frequency as unit prices are calculated, which for many funds is each business day. In addition, the timeframes for calculating unit prices are also typically very short. In order to meet these requirements the unit pricing tax model may not reflect all the detail and complexity of the tax calculation used for determining the tax provision for accounts and completing the tax return. For example, the unit pricing model may calculate the tax on a stand-alone basis for each unit series, whereas the tax calculation for accounts will typically determine the tax at a tax-entity level and also deal with allocations of the difference between the aggregate tax and the sum of the stand-alone tax calculations. In these cases, a regular update of the unit pricing tax model (quarterly or monthly - but at least six monthly) to deal with any differences is often made to ensure that the unit pricing model does not get too out of line with the more accurate calculation for accounts and the intended allocation basis. Equity issues relating to dealing with these differences is discussed further below. Allowing for imputation credits when investing in wholesale trusts Differences between investing directly and investing through wholesale trusts For unitised funds that invest in assets indirectly through wholesale trusts, final accurate tax information in relation to distributions is typically not available until some time after the wholesale trust year end. Therefore, a basis that can apply incomplete information to determine the tax provision is required. In determining such a basis, it is important to note that a unitised fund's actual allocation of income/gains/credits will typically (but not always) be based on the proportion of the wholesale trust units that it holds when the distribution is paid, rather than the proportionate unitholding when each item of income/gain/credit is realised by the wholesale trust (however, this later basis can apply for some distribution methods based on unit days etc.). Therefore, the tax payable is not necessarily the same as that payable if the unitised fund had owned the underlying assets of the wholesale trust directly. For example, if a unitised fund unexpectedly redeems a significant proportion of its wholesale units prior to the distribution date it may receive less imputation credits than anticipated before the need to redeem the units was identified, and may incur capital gains tax in place of income tax.

44 42 An introduction to unitised funds and unit pricing This issue should be taken into account in determining whether it is equitable to allow for an estimate for imputation credits on wholesale trust distributions before they are actually paid (and other items such as foreign tax credits or deferred tax credits to the extent that these are expected to be material). At the same time, adopting a method that does not anticipate imputation credits until after the distribution is paid may be perceived as inequitable to unitholders that exit just prior to a wholesale trust distribution date. Such a method may also result in sharp unit price movements at the wholesale trust distribution date, notwithstanding that this reflects the position of the unitised fund itself in relation to entitlements to imputation credits. IFSA, APRA and ASIC guidance IFSA produced a draft guidance note, Guidance Note No. 17 Recognition of Tax in Unit Prices for Tax entities which suggests that, in relation to credits, an estimate should be made that should be supportable and documented. Prior-year experience or the wholesale trust managers own estimates are sited as potentially worthwhile bases for estimation. The APRA and ASIC consultation paper indicates that an allowance for imputation credits should be included during the year based on periodic information or a soundly based estimate. Waiting for final notification of tax splits, which is often annual, is too late. There does not appear to be a clear view expressed by IFSA, APRA or ASIC on the issue of whether the estimate for imputation credits should be incorporated before or only after a distribution accrues. In the draft guidance note, IFSA noted that not anticipating the distribution could lead to potentially unfair low payments to unitholders that exited prior to the wholesale trust distribution date. However, we note that providing for such credits leaves the remaining unitholders exposed to loss. Allowing for income/gains when investing in wholesale trusts Estimates may also be required for the income/capital gain component of wholesale distributions. The proportion of discounted gains in the distribution in particular impacts the tax payable. For superannuation funds, the tax on discounted gains is twothirds of the tax on undiscounted gains. Income and undiscounted capital gains are generally taxed similarly. In addition, tax deferred components of distributions generally result in reductions to the cost base of the holdings in the wholesale unit trusts. Therefore, although estimating these amounts in total, relative to discounted gains is important, determining their split tends to be less critical.

45 An introduction to unitised funds and unit pricing 43 As for imputation credits, IFSA suggests an estimate for income/gains that is supportable and documented and that prior-year experience or the wholesale trust managers' own estimates may be suitable for this purpose. The wording in the IFSA guidance note seems to suggest that an estimate of the split of the distribution between interest, dividend and capital gain is only required after the units go ex-distribution, rather than anticipating the distribution. 7.6 Determining the appropriate tax rate to apply where the tax rate is dependent on the asset holding period Discounting of capital gains For superannuation business, the tax rate on capital gains is 15 percent. Except where assets are held for more than 12 months, the gains may be discounted by 1/3rd before the 15 percent tax rate is applied. The discounting rules result in complexities when determining the appropriate tax rate to apply on unrealised gains for assets held for less than 12 months but where it may reasonably be anticipated that the asset is likely to be held for more than 12 months. The approach that produces the largest tax provision is to assume all assets are realised immediately. On this basis, no allowance is made for discounting on assets held for less than 12 months. On the other hand, the lowest tax provision is obtained by assuming that all assets on which there are unrealised gains are held for at least 12 months. Where no discounting is allowed for assets that are held for less than 12 months, a jump in value occurs when the asset reaches the 12-month holding period, providing a windfall gain for unitholders that entered just prior to this point. Additional complexities can arise in determining the capital gains tax for funds that own a large share of units in an underlying trust. Additional tests apply to discounting of gains on units sold which may deny discounting on the wholesale units where the underlying assets in the wholesale trust are held for short periods. Progressive recognition of discounting seems reasonable It seems reasonable that calculations for unit pricing take into account a longer time horizon than simply considering the tax provision if all assets were realised immediately, particularly where a fund is open to new investors.

46 44 An introduction to unitised funds and unit pricing However, we suggest that fully allowing for discounting is likely to understate the deferred income tax liability as, given normal portfolio turnover, a proportion of assets that are held for less than 12 months are realised before they reach the 12-month carrying period. This is likely to be true even when net unitholder cash flows are positive. Where a fund is closed, it would seem reasonable that no discounting be applied. A basis that recognises the period for which existing unitholders have held the assets and, therefore, contributed to running down the 12-month holding period and does not provide the entire benefit of the discounting of capital gains to new unitholders seems to satisfy unit pricing principles of treating new and exiting unitholders equitably. Such a basis would take into account average portfolio turnover and the basis for selecting assets for sale (e.g. first in first out or first in last out). For example, if the rate of fund turnover was such that 20 percent of assets held for less than 12 months are expected to be sold before reaching the 12-month carrying period, this would imply a tax rate of 11 percent on unrealised gains (a level of discounting of approximately 27 percent). APRA and ASIC guidance The APRA and ASIC consultation paper seems to suggest that applying the undiscounted rate of 15 percent for assets held for less than 12 months is appropriate in many cases, although it does leave open the possibility for adopting a rate of less than 15 percent. 7.7 Determining allocations of tax amounts between different unit series and between the unit series and the fund manager In many cases, the level at which tax is determined (tax paying entity) covers many different unit series. As a result of various features of the tax framework including optimising the value of capital losses (e.g. the value of capital losses depends on whether they are offset against discounted or undiscounted capital gains) and expense deductions over a larger pool of assets, the overall tax expense is often different from what would be incurred if the tax calculation were performed using the same rules, but on a stand-alone basis for each unit series. The allocation of the actual tax expense requires the fund manager to address unitholder equity issues. As noted in section 7.5, it is quite common for the unit pricing model to calculate the tax on a stand-alone basis for each unit series, whereas the tax calculation for accounts will determine the tax at a tax-entity level and needs to be able to deal with allocations of the difference between the aggregate tax and the sum of the stand-alone tax calculations.

47 An introduction to unitised funds and unit pricing 45 In order to make some allowance for this difference in day-to-day unit pricing, a key starting point is to obtain a clear understanding of the reasons for the differences. The allocation basis for the differences should be documented and supportable and should be based on sound principles to ensure that the tax provisions within each fund satisfy the principles of equity. The APRA and ASIC consultation paper notes that such differences should be applied equitably, taking account of the reasons for the difference and the nature of the products. It notes that such differences would normally be expected to be applied for the benefit of unitholders and that this practice would be applied consistently and would be disclosed. 7.8 Interest on tax provision Most unitised funds maintain reserves for current tax within the unitised pool of assets so that interest on these assets also forms part of the net assets of the unitised fund. Where the fund manager adopts an approach of transferring assets backing the current tax liabilities out of the unitised fund, the fund manager should consider whether the unitised fund should be compensated for any interest earned on them before payments are made to the tax office. This issue mainly arises in the context of life insurance entities. 7.9 Reconciliations between unit pricing tax and tax calculated for accounts and tax paid As noted above, it is important from an equity perspective to understand and allocate differences between unit pricing tax, tax for accounts and the tax return that have arisen due to differences in methodology and modelling approximations. It is also important to undertake such reconciliations in order to identify any errors in data or in the implementation of the methodology in each model. This will help monitor the continued appropriateness of the tax provision for the unit price calculation. This testing should be completed regularly as any errors can expose the manager to losses arising from any resulting compensation payments to unitholders. Errors in tax calculations represent one of the most common sources of large unit pricing errors. These reconciliations often involve analysing differences due to the following items. Differences between information populating the unit pricing tax model and the tax calculation for accounts. These differences may arise due to timing differences, changes due to data manipulations or other inconsistencies due to being sourced from different systems.

48 46 An introduction to unitised funds and unit pricing The full tax calculation may include information and tax calculations relating to activities outside the unitised fund, for example, interactions with the funds manager or life insurer. The full tax calculation may present results at an aggregate level rather than calculating or allocating amounts specifically for each unit series. APRA and ASIC guidance The APRA and ASIC consultation paper notes the importance of comparing and allocating differences between unit pricing tax, the tax for accounts and the tax return. These reconciliations should be completed for current tax and deferred tax, although it is noted that for deferred tax there is no tax return calculation to reconcile with. APRA and ASIC also note that differences in the movement in current and deferred tax should be analysed. APRA and ASIC note that these reconciliations should be undertaken at least annually and within three months of the due date for payment of tax. Given the potential impact on unitholder equity and the importance of strong controls around these highly complex calculations, APRA and ASIC's suggestion of quarterly reconciliations does not seem unreasonable for unitised funds that involve tax entities that span more than one unit series.

49 An introduction to unitised funds and unit pricing 47 8 Unit price error correction 8.1 Introduction Recently there have been a number of well-publicised, unit pricing errors, both in Australia and overseas, where fund managers have materially mis-stated the unit price over a period of time and have had to process corrections. Many of these errors have involved significant out-of-pocket costs for the managers in terms of both administrative and professional costs, and management distraction, as well as unitholder 'make good' payments. Given the complexity of the unit pricing methodology and formulae, and the basic data and systems framework that are relied upon to support unit price calculations, it is clear that errors can emerge in a number of areas. Even with well-controlled systems, processes and checking, unit pricing errors can arise. For example, basic asset value, tax or unit number data can be incorrect due to incorrect calculation, input or allocation between unit types. System errors or mapping between systems and interpretation of data feeds can also result in unit pricing errors, and the unit pricing formula itself may be mis-specified or the parameters, such as transaction cost factors or management fee rates, may be outdated or otherwise incorrect. Despite the complexity of unit pricing processes, unitholders' expectations of large, established wealth management companies is that they reliably control the fundamental day-to-day business processes, such as unit pricing. The announcement of unit price errors can alarm unitholders and threaten the trust that unitholders have in the manager to safely manage their funds. It is also likely to draw significant attention from regulators. Therefore, it is critical that any correction process is handled professionally and that unitholders are reassured that the unitised manager understands the importance of the error, is capable of rectifying it and has implemented measures to prevent such errors occurring again. This chapter considers the issues managers face in rectifying a unit price error that has been identified.

50 48 An introduction to unitised funds and unit pricing 8.2 Business continuity plan There has tended to be a misunderstanding that if anything goes wrong it will be easy to fix. However, as noted in the ASIC and APRA consultation paper, this is generally not the case, particularly where a unit pricing error persists over a significant period of time and affects many transactions. Even with well-controlled systems and processes, the likelihood of a unit price error occurring is high. A key risk-management issue is having in place a 'business continuity plan' for unit price errors. This will assist with communicating with the regulator and moving quickly to address the issue, rather than delaying the implementation by having to develop the error-correction policy and strategy after the error is identified. 8.3 Types of unit pricing errors As noted above, unit pricing errors can emerge at various points in the unit pricing process. The following are examples of errors that have occurred within the Australian industry in recent years. Unitised fund formula/price Fee parameter resulted in charging investment management fees twice. Transaction cost factor out-of-date or misapplied. Transaction costs applied inconsistently between different classes of unitholder. Misinterpretation of transaction cost factors as a fee. Incorrect manual override of system-calculated unit price or asset values. Methodology inconsistent with specific requirements of constituent documents. Asset related Failure to properly include the value of some derivatives. Errors in the allocation of bank account balances across unit series. Asset values not updated. Overseas assets valued inconsistently with related currency hedge.

51 An introduction to unitised funds and unit pricing 49 Tax related Incorrectly allowing for the value of imputation credits. FITB value higher than could reasonably be expected to recover. Other systems Processing in unit registry system not reflected in unit pricing system. Unreasonably long processing delays (not specifically a unit pricing error but an issue that may lead to compensation). Customer abuse of systems, for example, making risk-free profits where methodology is historic pricing and there is a nil cost for switching. 8.4 Response to error correction The overall implementation of a unit price error correction program involves significant management issues in addition to the recalculation of corrected unit prices. These include the following. Project management - successful completion of the correction program is dependent upon the involvement and co-ordination of different divisions within the fund manager. For a large correction program this typically includes unit pricing, IT, legal, accounting, customer service and public relations/communications as well as any external advisors. Data and systems - the calculation of any compensation amounts is based on individual unitholder data and therefore robust checks should be applied to the data, as well as the system calculations. Advice to the board - the basis for the correction needs to be signed off by senior management/trustees. The presentation of the proposed basis for correction to senior management/trustees is likely to include the suggested materiality levels, the basis for dealing with approximations and adjusting compensation for exited unitholders for time value of money, as well as cost estimates for the program. Regulator liaison - the regulators ASIC and APRA monitor unit price error correction programs closely. This includes the basis for the correction as well as the timeline for implementation. For large correction programs, they will typically issue a public announcement so communication with the regulator is a key consideration for management.

52 50 An introduction to unitised funds and unit pricing Investor and media communications - as noted in the introduction to this chapter, announcement of unit pricing errors may have a negative impact on the reputation of the fund manager. Communications sent to individual unitholders and the media generally needs to be managed carefully. Professional review - the fund manager may obtain (or a regulator may ask them to obtain) an independent review over the calculations and/or the implementation of the correction program. Payment execution and verification - the fund manager should confirm consistency between the intended correction approach, amounts actually paid and system calculations. A discussion of some of the theoretical issues involved in determining corrected unit prices are discussed in section Theoretical benchmark and unit price error quantification Typically, the impact on a given unitholder of a unit pricing error will depend on whether they have bought, sold or held units. For example, where the unit price has been understated the position of unitholders that purchased units at the understated price will be improved, while unitholders that exited while the unit price was understated (and bought units before the unit price error) are worse off. Continuing unitholders will generally also be impacted as a result of the gains or losses made by transacting unitholders. Therefore, although the overall position of unitholders as a group may be correct, the position of individual unitholders may be materially altered as a result of the error. The unit pricing principles set out in chapter 3 (as well as industry guidance and regulator proposed guidance) require that equity be preserved between unitholders in the same series. Therefore, material unit pricing error corrections should be made at an individual unitholder level and should be designed to restore the unitholders from their current position to their theoretical position had the error not been made. Calculating corrections for unitholders In order to determine the unitholders' correct theoretical position it is necessary to calculate a corrected series of historic unit prices. Where an error has occurred over one or two days and the details of the error are clear it is often a straightforward exercise to determine accurately the theoretical corrected unit prices and unit numbers. However, in some cases an error may span a period of weeks, months or even several years and in such cases a more structured approach to determining the correction may be required.

53 An introduction to unitised funds and unit pricing 51 The following list sets out some of the high-level considerations involved in error correction. 1. Determine corrected net asset values for each day from the first day the error occurred (where there are several errors they should be added together - and not considered separately). 2. Determine corrected (dollar value) unitholder transactions from the first day the error occurred (often the unitholder transactions are unchanged). 3. Calculate a corrected unit price history using the corrected net asset values and unitholder transactions from the first day the error occurred. 4. Recalculate the position of each unitholder including exited unitholders using the corrected unit price history. 5. Compare the corrected position for each unitholder with their current position and apply a materiality basis. 6. Determine a basis for accumulating interest on compensation amounts for exited unitholders. 7. Implement corrections. While the above may appear straightforward, approximate approaches are often required due to lack of data or quality of data. Judgement may also be required to evaluate the impact the initial error may have had on the subsequent management of the unitised fund. The following list, while not exhaustive, notes the potential practical issues that may arise throughout the error correction process. Data for determining corrected net asset values - where the error has existed for several years, the data available to determine the precise size of the error for each day in the past may not be available and approximate approaches may be required. Calculating flow on effects on the net asset value - the error itself may have had consequential impacts on subsequent investment decisions. For example, an incorrect bond valuation for an international fixed interest fund may be expected to lead to changes in the number of currency hedge contracts purchased. In addition, where an error has resulted in a fund having insufficient interest-bearing assets, assumptions are required as to how error amounts, if received by the fund at the correct time, would have been reinvested and what investment income might have been earned on them. These changes may also have implications for tax balances.

54 52 An introduction to unitised funds and unit pricing Data for recalculating the position of each unitholder - a unit pricing error may affect hundreds of thousands of unitholders. There may be significant practical issues in amassing the data, developing the correction approach and testing, and, where necessary, correcting the data. Accumulating interest on compensation amounts for exited unitholders - when determining the compensation for time value of money for exited unitholders there are a number of ways of considering the issue. A logical approach is to determine the payment by considering what the unitholder would have done with the funds. This approach seems consistent with legal principles, however, it is often impractical to determine where each unitholder would have invested any additional payment. The final decision is likely to have to balance these competing considerations. Tracking switches - a particular problem with certain systems is tracking where switched amounts have been invested. Consequently, assumptions may be required in determining an appropriate corrected position of a unitholder with switches. Implementation approach - there are two common approaches to restoring the position of existing unitholders. One is to move the current published unit price to the correct unit price. The number of units also needs to be adjusted for current unitholders that made applications, or partial redemptions, while the unit price was in error so that they have the correct unit balance. An alternative approach is to not adjust the current unit price, but to change the unit balances so that each unitholder's account balance (incorrect unit price times new unit balance) restores their correct position. One disadvantage of this approach is that it will not be possible to accurately calculate fund performance from published prices as they are not corrected in the rectification process. A slightly different version of the second approach is to leave the current unit price unchanged but to make the compensation by way of direct payment, rather than increasing the number of units. Under the first approach there is a step change in the unit price on the date the correction is implemented. Therefore one challenging aspect of this first approach is that transactions that occur after the date the error was identified (but prior to the date of implementation of the correction) are processed at the 'wrong' unit price and therefore the number of units on these transactions will also need to be adjusted as part of the rectification process. This can reduce the time available for testing and significantly increase the complexity of cut-off issues. For example, systems/models used to determine the correction need to be updated for the most recent transaction data to calculate unit prices before going 'live' with the changes.

55 An introduction to unitised funds and unit pricing 53 Under the second approach the unit prices are not changed. During the period between the identification of the error and the implementation of the rectification (changes to unit numbers) unit prices can be calculated that have the correct 'relative' movement. This quarantines new applications/unitholders from the error rectification process. As this approach restricts the need to adjust unit numbers to only those unitholders that held units before the 'relative' unit price movements were corrected, it provides the fund manager with more time to test and implement the error correction and reduces the need to update models/systems with data right up to the day before the rectification is implemented. Under either approach, the unit balance and unit price changes coincide with the appropriate increase/decrease to the fund net asset value with an appropriate share of this increase being provided by the fund manager. Implementation delays - due to processing and system constraints, there is often a delay of more than one day between the calculation of the corrected unit prices and the updating of production systems and unitholder balances. Therefore, it may be necessary to suspend transactions or roll fund values forward using approximate techniques for a period of days while the corrected position is being implemented. Tax consequences - the tax consequences of the changes to unitholder benefits needs to be considered. Agent commission impacts - impacts on agent/advisor commissions as well as the unitised fund manager's fees or other external fund manager fees may also need to be considered. The regulator's interest is generally that the entitlements of each individual unitholder are preserved and this view is supported by the unit pricing principles in chapter 3. Therefore, where the corrected position cannot be determined with sufficient precision a conservative approach may need to be adopted. For example, in the above cases of accumulating interest for exited unitholders, lack of switching data and other miscellaneous data issues, a basis that does not disadvantage any individual unitholder and is overall generous to most unitholders may be preferred. This, however, generally adds to the compensation costs. Manager costs As noted above, for some unit pricing errors, the position of individual unitholders is distorted although the overall position of unitholders as a group may be correct. In such cases, correcting the error may still result in significant manager costs (in addition to reputation damage) even where benefits are reduced for existing unitholders that have been advantaged by the error.

56 54 An introduction to unitised funds and unit pricing The aspects of the correction process where fund manager losses can often arise are as follows. Inability to recover overpayments to exited unitholders. The interest accumulation rate paid on compensation to exited or switched unitholders may need to exceed the historical return earned on the supporting assets. Adopting approaches that are generous to unitholders where approximate assumptions or approaches are required. Administration costs associated with the error correction project including hiring staff and/or external consultants. The drain on internal management time is also often significant and large errors may create regulator interest and result in undertakings to perform further analysis. Of course, where the unit pricing error has resulted in the fund overall being disadvantaged this will be an additional source of loss for the fund manager. For example, losses due to fraud or being over-invested in the wrong unit series where the investments earned a lower rate of return. 8.6 Error materiality benchmarks In addition to a fund manager's desire to adopt appropriate unit pricing principles, where an error is made, fund managers may also be directed to correct an error by a regulator such as APRA or ASIC. In determining whether an error is significant and requires correction there exists industry guidance and proposed guidance from APRA and ASIC. IFSA Guidance Note No. 4.00, Incorrect Pricing of Scheme Units - Correction and Compensation, sets out the basis for correcting unit pricing errors that its members are expected to adopt. It notes that a unit price error is generally considered material where it is more than 0.3 percent of the unit price. In these circumstances, compensation for disadvantaged unitholders should be considered. IFSA further notes that a $20 materiality benchmark at an individual unitholder level may be appropriate. The APRA and ASIC consultation paper recognises that there are two common types of unit pricing errors. Certain errors may have a large one-off impact on the unit price, while other errors, such as an incorrect fee rate deduction, may have a small impact each day but may be cumulative so that the impact over a period of time is significant. Therefore, a two test framework is proposed which is also based on a 0.3 percent level. The first test is similar to that suggested by IFSA and deals with one-off unit pricing errors where the impact on a transaction is more than 0.3 percent. The second test, dealing with cumulative errors, requires analysis to determine whether the impact on a unitholder is more than 0.3 percent per annum.

57 An introduction to unitised funds and unit pricing 55 Fund managers have commonly applied this general materiality level of 0.3 percent in considering whether a unit pricing error should be addressed. Historically, it was not uncommon for trustees to undertake certain unit pricing functions, such as administration, directly. It is also not uncommon for trustees to be indemnified in respect of certain expenses. Therefore, a consideration in determining the 0.3 percent level was to balance the costs of rectifying an error and any impact on existing unitholders against the materiality of the correction. However, it is becoming less common for the trustee entity to be directly involved in day-to-day management of the unitised fund. An issue to consider going forward is whether the 0.3 percent remains suitable where a third party administrator or life company is at fault and may be required to make good the loss at common law without being indemnified from the fund. A key consideration would appear to be the point at which unit prices could be considered inaccurate and would therefore have resulted in a significant change (within the normal parameters of unit pricing). This may not lead to a different conclusion to the 0.3 percent basis points for error correction, although it is a different framework for reaching that conclusion. A potential outcome of such an approach is that it may be appropriate to adopt different materiality levels for funds with different asset mixes. For example, a 0.3 percent materiality level on a cash fund may be seen as too great. On the other hand, a 0.3 percent materiality level may be seen as relatively stringent for a leveraged fund with overseas equities or non-market traded securities. It will be interesting to see where this issue will progress over time.

58 56 An introduction to unitised funds and unit pricing 9 Concluding remarks There are many issues covered in this paper that fund managers should be aware of. Historic perceptions were that unit pricing is simple and straightforward and that it was acceptable if unit pricing delivers broadly fair outcomes over all unitholders, rather than being as accurate as possible, and developing refined approximation techniques where final data is not available. However, these attitudes to unit pricing are changing rapidly. In addition, the environment in which unit pricing is conducted is becoming ever more complex in terms of product design, numbers of products/unit series, outsourcing, tax and variety in asset classes including the use of external fund managers and the pressure to reduce costs. The future environment for fund managers in terms of complexity and the tolerance of errors is only going to become more onerous. Unit price error corrections are now a core part of the process and fund managers should construct a plan for dealing with unit pricing errors when they arise.

59 An introduction to unitised funds and unit pricing Bibliography Attard, S. J., Public Unit Trusts in Australia, Transactions of Institute of Actuaries of Australia Volume 1 (1995). Australian Bureau of Statistics, Managed Funds, Australia (Dec 2004). Australian Prudential Regulation Authority, Life Insurance Market Statistics June 2003, (2003). Australian Prudential Regulation Authority, Superannuation Trends December Quarter 2003, (2003). Australian Prudential Regulation Authority, APRA Review of Unit Pricing Practices, (2003). Australian Prudential Regulation Authority and Australian Securities & Investments Commission, Consultation Paper: Unit Pricing Guide to good practice, (2004). Australian Venture Capital Association, AVCAL Valuation Guidelines, Caslin, J. and McCutcheon G., Taxation and disclosure issues in unit-linked life insurance, Society of Actuaries in Ireland (1993). Goold, J., Profit Management and Reporting in Unit Linked Business, Society of Actuaries in Ireland (1997). Gribble, Equity and Unitised Investment Products, Institute of Actuaries of Australia (2004). Investment and Financial Services Association Limited, IFSA Standard No. 8, Scheme Pricing, (2004). Investment and Financial Services Association Limited, IFSA Standard No. 9, Valuation of Scheme Assets and Liabilities, (2004). Investment and Financial Services Association Limited, IFSA Guidance Note No. 4, Incorrect Pricing of Scheme Units - Correction and Compensation, (1999). Investment and Financial Services Association Limited, Draft IFSA Guidance Note No. 17, Recognition of Tax in Unit Prices for Tax Entities, (2004). Lantz, Ramstedt & Stebrant, Valuation Procedures for Portfolio Investments - A Comparative Study between Investment Companies in Sweden, the United Kingdom and the United States, Goteborg University (2001).

60 58 An introduction to unitised funds and unit pricing Office of Thrift Supervision, US Treasury Department, OTS Trust and Asset Management Handbook, (2001). Parwada, Trends and determinants of Australian managed fund transaction costs, Accounting and Finance (2003). Richard Hardman, Valuation of Unlisted Assets, AMP Henderson Global Investors (2002). Suruhanjaya Sekuriti Securities Commission, Guidance on Areas of Compliance and Internal Controls for Management Companies and Trustees, (2003). The Association of Superannuation Funds of Australia Limited, ASFA Best Practice Discussion paper: Fund Valuation and Unit Pricing (2004). The Unit Pricing Working Party of the Society of Actuaries in Ireland, Unit Pricing and Equity in the Management of Life Assurance Unit Funds, Society of Actuaries in Ireland (1993).

61 An introduction to unitised funds and unit pricing 59 Appendix A - Unit pricing structures Unitholder and supporting unit structure The diagram below illustrates a unitholder and supporting unit structure. Example of a unitholder and supporting unit structure Retail investor Retail investor Retail investor Retail investor Wholesale investor Unit prices Unit prices Unit prices Unit prices Retail fund (A) Retail fund (B) Retail fund (C) Retail fund (D) Wholesale fund (E) Tax may be deducted at this level or the level below for external options Supporting fund 1 External investment fund Unitholder level Internal level External level Transaction spread determined at this level for external investment options, with funds above adopting these spreads Supporting fund 2 Asset pool equities Diversified fund Supporting fund 3 Asset pool fixed interest Transaction spreads are set at this level for internal options, with funds above adopting these spreads Asset management fees and investment charges deducted at this level Tax deducted at this level for internal options Asset pool equities A brief explanation of the unitholder and supporting structure taking as an example the retail investors in Fund D and wholesale Fund E is as follows:

62 60 An introduction to unitised funds and unit pricing The retail unitholders buy units in Fund D and the wholesale unitholders buy units in Fund E (unitholder units). Both funds are a diversified investment option, within respective retail and wholesale products, providing exposure to equities and fixed interest. Both funds D and E hold units in the supporting units in the diversified fund, which in turn holds units in the asset class specific supporting funds, 2 (equities) and 3 (fixed interest). By structuring the funds so that the investment management fees are deducted through the Fund D and Fund E unit prices, this enables both funds to invest in the same diversified fund, but have the correct fee deducted. The fund manager also has a product that has an investment option (Fund C) for equities only. In the diagram, Fund C invests in the same equity asset pool (supporting fund 2) as the diversified fund. It is noted that fund managers may establish separate asset pools for funds that have the same asset mix but different tax treatments. Transaction cost factors are also normally set at the supporting unit fund level, which flow through to the unitholder unit prices. In practice some of the nominal funds shown can be combined into one fund with a 'synthetic split'. Fees deducted by cancelling units As for the Unitholder and Supporting Unit structure, the fund structure where fees are deducted by cancelling units enables unitholders with different fee rates to invest in the same asset pool. This approach requires one less layer of funds/unit prices compared with the unitholder and supporting structure, however, this is an unusual structure for retail products (that would generally be regarded as complex and overly highlighting fees in this segment of the market).

63 An introduction to unitised funds and unit pricing 61 A Fund where fees are deducted by cancelling units Retail investor Retail investor Retail investor Retail investor Wholesale investor Asset management fees and investment charges deducted at investor level through the administration system Layer of funds not needed Unit prices Unit prices Unit prices Tax may be deducted at this level or the level below for external options Fund A External investment fund External level Fund D - Diversified fund Fund B Fund C Asset pool equities Transaction spreads are set at this level for external investment options, with funds above adopting these spreads Asset pool fixed interest Transaction spreads are set at this level for internal options, with funds above adopting these spreads Tax deducted at this level for internal options Asset pool equities Flat investment structure An alternative to the above structures is to adopt a flat fund structure. Under this structure, each fund holds the assets directly. This increases the number of asset pools required and, therefore, is likely to only suit fund managers that manage a small number of funds.

64 62 An introduction to unitised funds and unit pricing Example flat investment structure Retail investor Retail investor Retail investor Retail investor Wholesale investor Unit prices Unit prices Retail fund (A) Retail fund (B) Retail fund (C) Retail fund (D) Wholesale fund (E) External investment fund Unitholder level Internal level External level Asset pool equities Transaction spread set at this level for external investment options, with funds above adopting these spreads Tax may be deducted at this level or the level above Asset pool equities Asset pool fixed interest Asset pool equities Asset pool fixed interest Asset pool equities

65 An introduction to unitised funds and unit pricing 63 Appendix B - System reconciliations and controls The following diagram illustrates some common system reconciliations that would be required for the system framework in chapter 5 in relation to the unit pricing process. This is by no means an exhaustive list of reconciliations and the reconciliations should be tailored to the systems configuration of the unitised fund. Example of key reconciliations Unitholder External parties External managers Investment markets Suspense account Fund manager Fund account Securities administration 6. External manager unit reconciliation 4. Match reconciliaton and 5. Investment market reconciliation Investment management team 2. Reconcile suspense bank account movements to UR movements Unit Registry (UR) 1. Reconcile units in UR to UPS 11. Reconcile unit prices in UPS to UR 10. Unit Pricing System (UPS) 9. Reconcile unit price movement to estimated unit price movement from benchmarking model. This includes tax and fee reconciliations 3. Reconcile bank account movements to FL movements 12. Reconcile gross asset value in AR to UPS 8 & 14. Reconcile tax provision in UPS to accounts and tax return figures Unit pricing tax model Asset Registry (AR) 7. Reconcile asset details in AR to FL Funds Ledger (FL)/ General Ledger (GL) Accounting/ tax return model 13. Review prices for reasonableness, and monitor stale and illiquid asset values Data provider Service provider Benchmarking model Further notes on the reconciliations in the above diagram are as follows: 1. Unit reconciliation The purpose of the unit reconciliation is to ensure that the number of units recorded in the unit pricing system equates to the number of units held in the unit registry (UR) system. The unit reconciliation should be performed on a frequent basis (e.g. some managers perform this check daily).

66 64 An introduction to unitised funds and unit pricing 2. Suspense account reconciliations A bank reconciliation should be performed to ensure that the flow of money into and out of the suspense account reconciles to the value of units created or cancelled by the unit registry system. 3. Fund bank reconciliations The bank reconciliation ensures that the source of all movements in the fund bank account balance are understood and can be reconciled to the cash movements recorded in the general ledger. The actual bank balance is also reconciled to the general ledger. As part of this process outstanding items are 'aged' to ensure that they are resolved on a timely basis. This checking assists in determining that assets are recognised consistently with the timing of payments/receipts of money. For example, that no timing issues impact the asset values and that there is no double counting of assets or missing assets. 4. Match purchase sale and settlement instructions with market/fund manager advice For directly held securities, the instructions to purchase and sell securities are reconciled to an independent market source. For external fund manager units, the instructions to purchase and sell units are reconciled through the bank reconciliation. A similar process is also followed for investment income (e.g. dividends). 5. Custody reconciliation - investment markets This custody reconciliation ensures that numbers of securities on the fund managers' asset registry (AR) system reconciles to the figure recorded by the external registry, for example, Australian shares on CHESS. This reconciliation should not identify any errors if the match reconciliations are being performed accurately. 6. Custody reconciliation - external managers The external managers reconciliation is similar to reconciliation 5 (investment market reconciliation), and ensures that, for external fund managers, the number of units held or portfolio value on the asset registry equates to the manager statements. 7. Custody reconciliation - general ledger reconciliation This reconciliation ensures that the value of shares in the asset registry system reconciles with the value in the general ledger.

67 An introduction to unitised funds and unit pricing Tax reconciliation - accounts As discussed in chapter 7, the tax model used for unit pricing is often different from that used for accounts. Therefore, a reconciliation is performed between these values. This reconciliation should identify and explain any differences between the tax provisions held by the unit pricing system and the amounts held for statutory reporting and the amount paid. The reconciliation to the final tax return is discussed at point number 14 below. 9. Controls over release of unit prices Before releasing unit prices, a number of controls may be performed. These include: A comparison between the movement in the unit price and the movement in a suitable benchmark (e.g. ASX 200 accumulation index for an Australian Equities fund). Where the unit price movement deviates outside a pre-determined level of tolerance, additional analysis and explanations are pursued. A comparison with the previous day's unit price to confirm that information has been updated and unit prices have changed. Management fees deducted by asset registry and the unit pricing system are reasonable. Comparison of unit prices with similar investments. Comparison of unit prices with similar investments but different tax treatments and confirmation that differences in unit price performance seem reasonable. 10. Backdating checks The unit pricing system should identify whether any backdating of transactions has occurred, so that the administration area may investigate significant impacts. A common check performed is to calculate the following statistic: Cashflow/unit movement multiplied by unit price expected to apply (e.g. yesterday's). 11. Reconcile unit prices in UPS to UR The unit prices loaded into UR should be checked against those intended to be input. 12. Reconcile gross asset value in UPS to AR The gross asset value in UPS should be checked to the value in the AR.

68 66 An introduction to unitised funds and unit pricing 13. Price feeds controls The fund manager should have in place controls and processes to check the reasonableness of prices obtained from the data providers and to identify stale or illiquid investment values. Valuation approaches for stale or illiquid investments are discussed in chapter Annual tax return reconciliation The annual tax reconciliation should identify differences between the tax provision held by the unit pricing system and the amounts calculated for the annual tax return. Controls should also be included to ensure that the data in the Account/Tax return model is consistent with the data in the GL. Further details on this tax reconciliation are provided in chapter 7.

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