Deloitte recently released a white paper which outlined risks associated with alternative data. As risks increase and the industry comes under increasing media and regulatory scrutiny, it will be important for alternative data participants to take steps to mitigate the growing concerns.
The white paper, “Alternative data for investment decisions: Today’s innovation could be tomorrow’s requirement”, argues alternative data may carry greater risk than traditional data. “If the risk control processes at alternative data providers are immature, they may increase extended enterprise risk at IM firms through the incorporation of invalid or noncompliant data—thus, ultimately posing a reputational threat.” Here are some of the risks outlined in the paper:
- Accuracy/validity risk: If the alternative data is unique or scarce, it may be difficult to validate its accuracy.
- Privacy risk: Personally identifiable information (PII) is an important consideration for consumer data. According to Deloitte, it is better to receive data without PII attached than to remove PII upon receipt. The risk should be actively and continually managed.
- Material nonpublic information (MNPI) risk: What is material and what is nonpublic are subject to interpretation. Just because data are accessible does not mean they are public information. Likewise, the definition of material is also subject to interpretation with some firms relying on statistical testing to determine thresholds of materiality. In some cases, if an alternative data set is thought to be too predictive of protected information such as quarterly revenue, then some firms are steering clear of the data.
After the SEC levied a $240 million fine in 2011 against AXA Rosenberg for concealing model error, asset managers instituted controls to ensure investment models are performing within the guidelines of their related investment policy statements and in accordance with client disclosures. As alternative data inputs affect portfolio construction, the impacts on model efficiency need to be monitored. In addition, alternative data may be incorporated in the model incorrectly, creating irregular or inconsistent trading signals under certain conditions.
Deloitte argues that since alternative data is a relatively new phenomena, fund managers should be aware that regulations and accepted practices governing their use are still in the early stages of maturity. As such, regulatory attention is likely to increase.
Deloitte cites an investigation by The Consumer Financial Protection Bureau (CFPB) into the use of alternative data in the generation of credit scores, as an early example of regulatory scrutiny of alternative data. The CFPB issued a request for comment on the use of alternative data and modeling techniques in the credit process in February 2017 and closed the comment period in May, 2017. It has not yet issued any draft regulation.
Alternative data is different enough from traditional data that asset managers should consider modifying investor disclosures about investment policy and processes.
As use of alternative data grows and the number of alternative data sources multiply, associated compliance risks will also increase. There is growing regulatory interest in alternative data, with some experts expecting prosecutors to bring cases. Media scrutiny is also increasing, with growing concerns about privacy violations, copyright infringements and whether alternative data creates an unlevel playing field for retail investors.
We believe that alternative data is at a place analogous to that of expert networks a decade ago. Like alternative data, expert networks gained increasing adoption by asset managers, particularly hedge funds and there was a dramatic increase in the number and variety of expert networks. Abuses by some expert networks led to a series of insider trading investigations which severely impacted the industry, causing many expert networks to exit the business. Nevertheless, by developing consistent compliance practices across the industry, the more compliant expert networks survived, and are now once again on a strong trajectory of growth.
We believe that the time is fast approaching when the alternative data industry, including buy-side consumers, sell-side users, vendors and those that originate alternative data, will need to take proactive steps to inoculate the industry from adverse media and regulatory scrutiny. Deloitte’s white paper is a timely reminder of some of the risks that need to be addressed.