The Importance of Compliance Testing | Vigilant Insights
Vigilant Insights
Introduction
As Firms finalize their compliance programs from 2024, a common concern for Compliance Officers focuses on Annual Testing.
Compliance Testing is an essential part of a successful compliance program, and during examinations the SEC routinely requests evidence that a Firm has conducted adequate testing.
What constitutes adequate testing can vary greatly based on the business model. However, there are some of “can’t miss” areas of focus for annual testing.
Important Compliance Testing Areas
- Portfolio Management and Trade Allocation
- Compare performance in client accounts that are managed under similar strategies for favoritism.
- Accounts with performance of two standard deviations above or below the mean should have documentation explaining the disparity.
- Compare the number of profitable trades in a client’s account and compare it to the average number of successful trades for other clients.
- Marketing and Performance Advertising
- Review client account holdings for sector and security concentrations and ensure that the composite they are attributed to is accurate.
- Ensure accounts that are excluded from composites have a documented explanation.
- Periodically review records of marketing materials to ensure recordkeeping practices retain documents necessary to substantiate material claims.
- Review whether your Firm is meeting GIPS standards if they advertise themselves as such.
- Valuation
- Review portfolios for static pricing and inaccurate pricing during trades (compare selling price to pricing in the days prior to the sell).
- Compare the prices at the sale of securities with the valuations performed recently, with consideration to any changing market conditions, to evaluate one’s fair value process.
- Review pricing overrides and/or sales price of positions exited against the historical prices of fair value securities.
- Evaluate dilution/accretion from excessive shareholder turnover to vet the accuracy of a Fund’s portfolio pricing policies.
- Personal Trading
- Personal Trading of access persons:
- Review the Personal Trading practices of access persons for patterns that could suggest trading ahead of clients, use of MNPI, etc.
- Ensure access persons are not trading from any restricted lists.
- Utilize an electronic tracking system that allows employees to easily upload statements for evaluation. Vigilant suggests once your employee count gets close to exceeding ten (10) employees, to consider utilizing an electronic tracking system.
- Compare the overall performance of accounts for access persons with the proprietary accounts of the adviser for any wide discrepancies.
- Compare performance for client and proprietary accounts of the Firm with similar investment styles, with particular attention to trade allocation.
- Calculate the number of profitable trades in proprietary/access accounts and compare it to the number of profitable trades in client accounts.
- Personal Trading of access persons:
- Best Execution and Broker Arrangements
- What is the average commission rate paid to broker-dealers used? Is there evidence of an undisclosed conflict of interest?
- What are the average commission rates paid by advisory clients? Are there accounts with significant disparities indicating they are getting less-effective executions?
- Sample trade errors during a review period and ensure that the corrections have been applied. Are there any employees or broker-dealers that have repeat errors?
Vigilant’s Conclusion
These are just some examples of the testing suggested.
Testing should be performed periodically, with clear documentation of what tests were performed, when, and what results were found.
It can be difficult to know how much testing is enough, and what testing applies to the business practices of your Firm.
Vigilant can provide an analysis of your Firm’s testing practices and can provide on-going support to help aid the performance and documentation of the compliance testing you perform.
Schedule a call today to learn more about how we can help in a variety of ways, customizing and tailoring our service to meet your specific needs.