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ADVISORY

An introduction to unitised funds and unit pricing

ACTUARIES

IntroductionThis 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.

AcknowledgementIn 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.

Synopsis and objective of paper

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: 61 2 9335 8141 Tel: 61 2 9335 7914

Fax: 61 2 9335 8911 Fax: 61 2 9335 8911

[email protected] [email protected]

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 54

10 Bibliography 55

Appendices

Appendix A - Unit pricing structures 57

Appendix B - System reconciliations and controls 61

Contents

2 An int roduct ion to un i t ised funds and un i t pr ic ing

1.1 Description of unitised fundsA 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 paperAlthough 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.

1 Introduction

An int roduct ion to un i t ised funds and un i t pr ic ing 3

1.3 Scope of paperThere 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 1995.

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).


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 productsThe following provides a brief review of the main unitised products available in

Australia.

Unit trustsA 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.

2 Unitised funds in Australia


• 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, fixed-

interest 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.


• 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 fundsSuperannuation 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.


• 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 productsIn 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.


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 productsFriendly societies offer a similar range of retail unitised products to a life insurance

company.

2.2 Unitised fund marketThere 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 2004. 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 $ millionLife insurance corporations(a) 214,586 30,480 184,106 130,000

Superannuation funds 501,840 88,842 412,998 220,000

Public unit trusts 192,761 24,563 168,198 168,000

Friendly societies 6,370 1,851 4,519 2,000

Common funds 10,206 466 9,740 0

Cash management trusts 34,349 0 34,349 34,000

Total 960,112 146,202 813,910 554,000

(a) Investments by pension funds which are held and administered by life insurance offices are included under lifeinsurance offices.Source: ABS Managed Funds, Australia, Dec 2004 (5655.0).


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 AssociationThe Investment and Financial Services Association Limited (IFSA) is a national not-for-

profit 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. 8.00 - 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. 9.00 - 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. 4.00 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.


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 fundsUnitised 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 StatementUnitised 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.


3.1 Returns from pooled investment different frominvesting 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 stand-

alone 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 unitpricing

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:

3 Unitised fund principles


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).


3.3 Proposed concepts of equity in unit pricingThis 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.


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.


4.1 IntroductionA 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 formulaA 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:

4 Product design and unit pricemethodology


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

TCSb = Transaction Cost Spread (buy)

TCSs = 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 costsProtecting existing unitholders from transaction costsMany 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 estimateUnitised 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 stand-

alone 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.

−=

3651 dMF

UnitsNAVcePriMid

( )bTCScePriMidcePriAllocation +×= 1

( )sTCScePriMidcePrileaseRe

+×=

11


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 classesIndicative transaction spreads applying to various asset classes are outlined below:

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 guidancenotes and APRA and ASIC consultation paperIFSA, 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.

Gross of tax transaction spreads

Asset Sector Buy/Sell SpreadCash NilFixed interest 0.05% - 0.15%Australian shares 0.15% - 0.35%International shares 0.20% - 0.40%


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 priceBuy/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.


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.


4.4 Forward and historic pricingDaily unit pricingHistoric 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 ofhistoric pricingTwo 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 co-

operation 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)


4.5 BackdatingHistoric 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 pricingMost 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.


Where prices are calculated less frequently than daily, the ability of unitholders to take

advantage of historic pricing increases.

4.7 Fee deductionDeduction of ongoing asset chargesFor 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 penaltiesEntry 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.


4.8 Income distributionOrdinary 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 approachUnder 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 approachAn 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 seriesA key product design issue involves the choice of unit structure and fee deduction

approach. This section describes two common approaches.

Unitholder and supporting unit structureFund 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 multi-

layered 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.


Fees deducted by cancelling unitsAn 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 presentationAppendix 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.


5.1 Implementation sectionsThe 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 environmentA 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.

5 Overall unit pricing framework

Governance framework

Che

cks,

reco

nciliations and control environment

Cal

cula

tion method and implem

entation

Unit pricing control framework

Constituentdocuments


Governance frameworkThe 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 reconciliationsA 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 implementationThe 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 documentsThe 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.


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 operationsKey business operationsIn 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 structureIt 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.

Securitiesadministration

Investmentmanagement

team

Benchmarking model

Unitholder

Custody

TaxUnit prices

Administration Invetsment accounting

Asset details

Unit pricing team

Tax provision

Funds Ledger (FL)/General Ledger (GL)

Unit Pricing System (UPS)

Unit pricing tax model

Accounting /tax return model

Asset Registry (AR)

Unit Registry (UR)

Gross asset values

Asset details

Purchase and sale advice


Example business structure

Units andcashflow

Cashflowand

fees

Unit prices


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 frameworkAlthough 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.



team

Investmentmarkets

Externalmanagers

Unitholder

Externalparties

Fund manager

Unit Registry (UR)Unit Pricing

System (UPS)

Asset Registry (AR)

Benchmarkingmodel

Accounting/tax return

model

Unit pricing taxmodel

Serviceprovider

Dataprovider


Fundaccount

Suspenseaccount

Units andcash flow

Unit prices

Unit pricesTax liabilities Asset details

Index values

Asset details

Gross asset value

Cash flow and fees


Cash flow Adviceand asset

allocation details

Unit prices,distribution and

unit details

Security details


Purchase andsale advice

Purchase and sale advice Cash flow advice

and asset allocation details

Price feeds

Asset details

Expenses

Tax provision

Example system framework

Key

Flow of moneyFlow of daily informationFlow of monthly information


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 registryThe 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 systemThe 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 taxUnder 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 pricesThe 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).


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 salesWhere 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 actionsDetails 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 controlsThe 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.


5.5 Unit processing cycleImportance of understanding the unit processing cycleIn 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 cycleThe 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.


Application cut-offUnitised 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 priceIn 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.

3:00pmApplication receipt

cut-off (1)

Example of processing unitholder application*

9:00am to 3:00pmApplications receive on day

T processed (4)

Close of marketAsset value calculated

Day T + 1Money deposited into

fund account (5)

OvernightAseet registry

updated (6)

9:00amUnit price for day T

calculated (3)

Day TApplication money

deposited in suspense account (2)

9:00amUnit price for day T+1 calculated (7)

Market openInvestments purchased (8)

Day T

Receipt of applications

Unit registry

Asset registry

UPS system

Domestic investment market

Suspense account

Fund account

Day T+1 Day T+2

Unit Data

NAV

Account balance

Assetdata

(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

Key

Flow of dataFlow of money


Investment of funds and potential impacts on unit priceThe 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.


6.1 IntroductionDetermining 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 approachSource of asset valuesAs 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 valuesThe 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 valuesAssets 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.

6 Asset valuation


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 actionsParticular 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 illiquidassetsCertain 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 valuationThe 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.

FrequencyValuations 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.


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).

SmoothingAs 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.


7.1 IntroductionTaxed and non-taxed fundsAs 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 pricecalculationAlthough 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.

7 Tax provisioning


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 basesFrom 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 fundsWhere 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 fundsFor 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.


7.3 Deferred tax lability provision for unit pricingA 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.


7.4 Future income tax benefitRealisation of future income tax benefit dependent on future gainsRealised 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.


7.5 Incomplete data and approximate approachesDaily unit pricing tax modelTax 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 trustsDifferences 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.


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 trustsEstimates 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 two-

thirds 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.


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 applywhere the tax rate is dependent on the assetholding periodDiscounting of capital gainsFor 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 reasonableIt 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.


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 guidanceThe 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 amountsbetween different unit series and between the unitseries and the fund managerIn 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.


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 provisionMost 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 taxcalculated for accounts and tax paidAs 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.


• 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 guidanceThe 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.


8.1 IntroductionRecently 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.

8 Unit price error correction


8.2 Business continuity planThere 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 errorsAs 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.


• 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 correctionThe 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.


• 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 8.5.

8.5 Theoretical benchmark and unit price errorquantificationTypically, 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 unitholdersIn 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.


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.


• 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.


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 costsAs 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.


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 benchmarksIn 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.


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.


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.

9 Concluding remarks


Attard, S. J., Public Unit Trusts in Australia, Transactions of Institute of Actuaries of

Australia Volume 1 (1995).

Australian Bureau of Statistics, 5655.0 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, 2003.

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).

10 Bibliography


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).


Unitholder and supporting unit structureThe diagram below illustrates a unitholder and supporting unit structure.

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:

Appendix A - Unit pricing structures

Retail investor

Supporting

fund 1

External

investment fund

Supporting

fund 2

Supporting

fund 3

Diversified

fund

Retail investor

Retail investor

Retail investor

Wholesaleinvestor

Asset poolequities

Asset pool fixed interest

Asset pool equities

Uni

t pr

ices

Uni

t pr

ices

Uni

t pr

ices

Uni

t pr

ices

Retail fund (A) Retail fund (B) Retail fund (C) Retail fund (D) Wholesale fund (E)

Example of a unitholder and supporting unit structure

Unitholder level

Internal level

Transaction spreads are set at this level for internal options, with funds above adopting thesespreads

External level

Transaction spreaddetermined at this level for external investment options, with funds above adopting these spreads

Tax may be deducted at this level or the levelbelow for external options

Tax deducted at this level for internal options

Asset management fees and investment charges deducted at this level


• 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 unitsAs 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).


Flat investment structureAn 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.

Fund A

External investment fund

Fund B Fund C

Fund D - Diversified fund

Asset poolequities


Asset pool equities

Tax may be deducted at this level or the level below for external options

External level

A Fund where fees are deducted by cancelling units

Transaction spreads are set at this level for external investment options, with funds aboveadopting these spreads

Transaction spreads are set at this level for internal options,with funds above adopting thesespreads

Asset management fees and investment charges deducted at investor level through the administration system

Layer of funds not needed

Taxdeducted at this level for internaloptions

Uni

t pr

ices

Uni

t pr

ices

Uni

t pr

ices

Retail investor

Retail investor

Retail investor

Retail investor

Wholesaleinvestor


Retail investor

External

investment fund

Retail investor

Retail investor

Retail investor

Wholesaleinvestor

Asset poolequities


Asset pool equities


Asset pool equities

Asset pool equities

Retail fund (A) Retail fund (B) Retail fund (C) Retail fund (D) Wholesale fund (E)

Example flat investment structure

Unitholder level

Internal level

External level

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

Uni

t pr

ices

Uni

t pr

ices


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.

Further notes on the reconciliations in the above diagram are as follows:

1. Unit reconciliationThe 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).

Appendix B - System reconciliationsand controls



team

Investmentmarkets

ExternalmanagersExternal

parties

Fund manager

Unit Registry (UR)10. Unit Pricing System (UPS)

Asset Registry (AR)

Unit pricing tax model

Benchmarkingmodel

Accounting/tax return

model

Serviceprovider

Dataprovider


Fundaccount

Suspenseaccount

1. Reconcile units in UR to UPS

11. Reconcile unit prices in UPS to UR

12. Reconcile gross asset value in AR to UPS

7. Reconcile assetdetails in AR to FL

4. Match reconciliaton and 5. Investment market reconciliation

9. Reconcile unit price movement to estimated unit price movement from benchmarking model. This includes tax and fee reconciliations

8 & 14. Reconcile tax provision in UPS to accounts and tax return figures

2. Reconcile suspense bank account movements to UR movements

13. Review prices for reasonableness, andmonitor stale and illiquid asset values

3. Reconcile bank account movements toFL movements

6. External manager unit reconciliation

Example of key reconciliations

Unitholder


2. Suspense account reconciliationsA 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 reconciliationsThe 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/fundmanager 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 marketsThis 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 managersThe 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 reconciliationThis reconciliation ensures that the value of shares in the asset registry system

reconciles with the value in the general ledger.


8. Tax reconciliation - accountsAs 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 pricesBefore 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 checksThe 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 URThe unit prices loaded into UR should be checked against those intended to be input.

12. Reconcile gross asset value in UPS to ARThe gross asset value in UPS should be checked to the value in the AR.


13. Price feeds controlsThe 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 6.

14. Annual tax return reconciliationThe 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.

kpmg.com.au

© 2005 KPMG, an Australian partnership, is part of the KPMG International network. KPMGInternational is a Swiss cooperative. All rightsreserved. Printed in Australia. The KPMG logoand name are trademarks of KPMG. May2005. VIC9278AAA. KPMG Actuaries PtyLimited is a sub-licensee of KPMG.

The information contained herein is of a general nature and is not intended to address thecircumstances of any particular individual or entity. Although we endeavour to provide accurate andtimely information, there can be no guarantee that such information is accurate as of the date it isreceived or that it will continue to be accurate in the future. No one should act on such informationwithout appropriate professional advice after a thorough examination of the particular situation.

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