Your Next NAV Error

Your next NAV error will be caused by a corporate action. How can I make such a bold prediction? More NAV errors are caused by corporate actions than by anything else. It might be a stock split or a rights issue, a paydown or a merger. Nobody knows. But what we do know is it’s coming. So what can you do about it? In this post I’ll focus on a common enough error caused by a simple corporate action; a stock split.

The Error: A Stock Split Error of Omission

What would happen if a stock split takes place but the Corporate Actions department misses it?  And the Fund Accounting department misses it?  Let’s consider an example.

The Kroger Company (KR) has a 2-for-1 stock split with an ex-date of 14th July.

• The closing price on 13th July is $76.95
• The closing price on 14th July, after the stock split, is $38.20

The XYZ Equity Fund held 1,000 KR shares on 13th July.  The market value of the position, $76,950, is included in the NAV calculated as at the close of business on 13th July.

After the 2-for-1 stock split the XYZ Equity Fund should be showing a position of 2,000 KR shares.  But the corporate actions team failed to process the stock split.  And the fund accounting team failed to pick it up.

So in the NAV calculated as at the close of business on 14th July, the fund incorrectly shows 1,000 shares at the price of $38.20 and a market value of $38,200 is included in the NAV.

The Impact: $38,200

The total NAV of the fund is understated by $38,200.  The implications of this depend on, amongst other matters, the size of the fund.  Refer to my earlier post to review the implications of NAV errors.

Prevention

This type of error indicates a failure to implement standard controls around pricing, corporate actions and, perhaps, fund accounting:

• Pricing controls should highlight that the price of KR fell by 50.36% on the 14th.  Such a decrease really does scream ‘STOCK SPLIT’. 
• Corporate Actions need to assess the effectiveness of the process for capturing basic corporate actions activity.  Either the process needs to be improved or the team needs to be made more aware of the importance of existing procedures and controls.  Or both.
• There may or may not be any fault with Fund Accounting on this one.  If the size of the error has no impact on the NAV per share, the issue may not have been flagged for Fund Accounting to review.  Alternatively, if there was a NAV impact, this is something that should have been picked up by the fund accountant and investigated further.  As with the Corporate Actions team, either the process needs to be improved or the team needs to be made more aware of the importance of existing procedures and controls.
• The Reasonability Test.  There is a basic reasonability test that can ensure that the position* on ex-date is in line with the position the day before ex-date.  The simple ‘before-and-after’ comparison for KR would look like this:

...

*Some corporate actions will require related positions (e.g. rights issue) and/or cash movements (e.g.rights exercise) to be taken into account.
 
This example is quite straight-forward.  In my next post, I’ll work through a rights issue where things can be a little bit more complicated.