Many asset managers have “unsupervised assets.” These arise when a client tells  you “don’t sell the 1,000 shares of my IBM stock.” [Isn’t it funny that IBM is typically used as the example? Well, I might as well continue the tradition.] The reasons they’re unsupervised might be because of low cost basis or sentimental value, or perhaps a host of other reasons. Many, if not most, portfolio accounting systems provide you a way to flag these securities as “unsupervised,” so that they don’t factor into your performance. This is all fine and lovely. But, there are three potential challenges.

Sales of unsupervised assets

Let’s say that your client instructs you to sell their previously cherished 1,000 IBM shares. If you’re now allowed to invest the proceeds, you’ve transferred an unsupervised asset into a supervised one. Great! From an accounting standpoint, how’d you do it? Did the cash just appear because of the sale? If yes, then you’ll get a nice boost in performance which is not yours to take credit for. To properly handle this situation, you must create an external cash flow for these proceeds.

Dividends and other income from unsupervised assets

What about income from unsupervised assets? If it’s yours now to do with whatever you wish, how’d it get there? Unless you create cash flows for them, you’re getting credit where credit isn’t due. That is, this income, which came from something you had no control over, isn’t technically yours unless it’s delivered as a cash flow, and it has to be an external one, otherwise your return benefit is in error.

What was once unsupervised, is now supervised!

What if your client tells you “okay, you can now do whatever you think best for those IBM shares. My uncle, who gave them to me, and who I told I’d never, ever sell them, has just died, and so they’re now under your control. Keep them, sell them, whatever you think best.” And so, you go into your accounting system and switch the flag from “unsupervised” to “supervised.” What happens beyond that? Do we see an inflow, or did your portfolio’s value (i.e., the portion that you had control over) just suddenly gain market value? Unless you reflect a cash flow for the market value of the asset on the date of this switch, your increase is improperly being handled.

An example might help

Consider the following:

• Status of portfolio on 2/9/2015:
  • Value of supervised assets = $100,000
  • Value of unsupervised assets = $10,000
• Activity on 2/10/2015
  • Client directs you to sell their unsupervised assets; proceeds equal $10,000
• Status of portfolio at close on 2/10/2015
  • Value of supervised assets = $110,000
  • Value of unsupervised assets = $0

Unless you reflect a cash flow for the proceeds, you just gained a 10% return, which isn’t yours to take credit for. The same holds for dividends from unsupervised assets, but I’m generally less concerned with these, because they tend to have less of an impact on performance, though technically, they, too, should be treated as an external cash flow into the portfolio. This also holds for securities that were unsupervised, but that you’ve now been told are supervised. You need to reflect a cash flow equal to their market value on the date of the transition.

How does your system handle unsupervised assets?

If you don’t know how your portfolio accounting system handles unsupervised assets when they (a) get sold, (b) provide dividends or interest income, or (c) get converted to “supervised,” it’s probably a good idea to check. As always, your thoughts on this are welcome.