The SEC Rule 18f-4 comes into effect August 2022, changing the regulatory framework for derivatives use by registered investment companies, including mutual funds, ETFs, and closed-end funds. One of the many requirements of the Rule is to conduct backtesting on those funds that require a VaR based leverage limit.
What is backtesting?
Backtesting is a technique used to determine the appropriateness of a model and its assumptions compared to the observed results. In the case of a VaR model it will typically involve comparing each day’s actual P&L to the previous day’s calculated VaR.
Over the long-term, it is expected that the daily P&L would exceed the prior day’s VaR 99% for 1% of observations. For instance, if over the long-term the fund’s actual daily P&L exceeds the previous day’s VaR only 3% of the time rather than the expected 1%, the VaR could be underestimating the fund’s risk.
The purpose of backtesting a VaR model is to validate the VaR model assumptions such as return distributions, specified risk factors and others. If a model fails the backtest, one or more of these assumptions may require adjustment to achieve the required model accuracy.
For 18f-4, what are the backtesting requirements?
Applicable funds which are not limited derivative users must conduct backtesting on a regular basis—at least weekly. The reporting must note as an exception any day(s) in which the actual P&L exceeded the day(s)’ calculated VaR.
At a minimum, 18f-4 requires that funds will retain each day’s actual P&L and each day’s calculated VaR and conduct the required comparison at the end of each week.
How do I implement an 18f-4 solution with VaR model backtesting?
The August 2022 18f-4 requirement date is fast approaching. Funds must identify a solution that supports all the complex calculations for 18f-4, including backtesting.
You will need a head start in determining the ideal VaR methodology to report on and determine the suitable benchmark for your fund and to accumulate results prior to the reporting requirement date.
The best approach to simplify and streamline 18f-4 calculations is to use a single provider for N-PORT reporting. The goal is to use a turnkey managed service solution that solves all analytic needs for 18f-4 compliance.