Outsourcing of Investment Operation

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In a smaller fund management firm, the back office operation is usually outsourced to external parties such as custodian bank. Some fund managers will call the broker and place the order themselves instead of hiring a trader. As the firm’s Asset Under Management (AUM) getting bigger, then a trader is added to the team so that the trader will be responsible for managing various brokers and monitor trade execution done by the brokers. Eventually, the front office team will include fund managers and fund manager support staff. The trading team will include a second trader and some trading support staff. 

The fund managers and traders are the essential team members to the investment firm, although some larger companies have outsourced its support operation overseas. For example, some fund managers may outsource some of its data analysis work to companies in India. However, it is rare for fund management firm to outsource other front office support operation. 

For middle and back office operation, we need to ask if we need to outsource them or do it in-house. Please note that because of the arrangement of using custodian bank to hold the portfolio asset, it usually doesn't cost much for the custodian bank to provide fund accounting services and portfolio valuation service. However, such custodian bank may not provide in-depth performance analysis.

The advantage of outsourcing the back office operation is that you are free from the problem of staffing the back office team, managing them and managing the back office operation. The management will also be free from investing in investment technology and IT staff. In addition, it gives client some assurance for mitigating fraud risk since the fund management and the back office operation is not done by the same company. 

The disadvantage is that you do not hold the investment data and there is not much you can do for data analysis except to rely on the standard report. Additional costs is required if you want to transfer the investment data back to you for data analysis. However, custodian banks are gearing up to provide additional services such as performance analysis. 

The cost of outsourcing the back office operation is cheap compare to setting up your own back office operation especially if your AUM is small. As your AUM grows to a certain amount, it might be feasible for you to setup a back office operation and mirror the investment data. 

Please note that base on a dollar to dollar comparison, it might not be feasible to outsource the back office operation. The management should consider hidden cost such as the efforts on managing additional staff, cost of operational mistakes and cost of managing the technology.

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Overview of Investment Process

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Now let us look at the entire investment process. Imagine that you have recently signed an IMA with an institutional investor. The first thing you need to do before receiving money is to setup all the accounts.

Account Setup

Although you might already have existing relationship with different brokers, you would need to setup separate trading account with your brokers to trade on behalf of your new client. You also need to establish trade confirmation protocol with the respective brokers. In addition, you need to setup a new account with the custodian bank and establish standard trading instructions. You would receive cash or you might receive cash & stocks from your client on the day of the commencement.

Constructing Investment Portfolio

Before you received the money, you would need to construct the investment portfolio for your client. On the day you received the money, you need to implement the portfolio within a period of time stipulated in the IMA. Please refer to the article “How Fund Managers Manage Investment” and “Investment Philosophies & Strategies” if you would like to know briefly how fund managers manage an investment portfolio. The most common practice for fund managers is to implement the portfolio based on a previously constructed model portfolio.

Portfolio Implementation

Once the portfolio is constructed, the implementation of portfolio is done by the support staff under the supervision of the fund manager in-charge. A portfolio re-balancing exercise is done against the model portfolio. During portfolio re-balancing, the system would distribute the cash to the respective stocks and trading orders are generated. If you received stocks and cash, the system would determine how much more to buy compare against the existing holding and sell those stocks that are not in your model portfolio.

Trading

The trading desk would receive the trading orders from the front office system. For a smaller setup, boutique fund manager uses spreadsheet to calculate the trading amount and he either place the order himself or hand it over to the trader. On rare occasion where there is a buy on a new account and sell on the rest of the account, the trader can create a married deal based on a predetermined price and adhere to the married deal guidelines of the respective exchange.

The trader then distributes the trade quantity to a number of different brokers. This is to ensure that different brokers can execute a better deal; because by splitting the trade among different brokers, the market would not know how big is the order. This practice also prevents front running by brokers. Sometimes, when the trading quantity is high it may take a few days to complete the trade. 

Once the trade is complete, the completed trade will flow to the back office.

Trade Confirmation

Trade confirmation is done by the back office to ensure that the completed trade is accurate when check against the broker. This practice is to reduce trading error and prevent trade dispute and at the same time prevents rogue trader from creating bogus trade. The back office will received trade confirmation from the brokers and it will match the order against the completed trade ticket issued from the trading desk. For a smaller outfit, this process is usually done by hand. Larger investment uses their computer system to do order matching. Some companies use external services such as Omgeo to do order matching.

Settlement Instructions

After the orders are confirmed, the back office staff will need to issue settlement instructions to the respective custodian. Most of the custodian only accepts settlement instructions uploading to their websites. Some custodian banks still accepts fax, however, such practice is discourage in favor of web entries. Larger firms use SWIFT transfer to send settlement instructions.

Foreign Exchange

For global accounts that deals with multiple currencies, the front office system will generate all the necessary foreign exchange (forex) instruction. These forex instructions may flow to the trading desk if there is someone that could deal with the foreign exchange market. Most of the time, such instruction will flow to the back office and the back office will send the forex instruction to the custodian bank since the cash account is maintain by them.

Portfolio Reconciliation

Portfolio reconciliation is usually done on the next day. The purpose of portfolio reconciliation is to compare and confirm the stock holding records of the custodian against the fund manager's system. Any discrepancies between the custodian and fund manager have to be resolved.  

Trade Settlement

The actual trade settlement is done by the custodian. Most of the time these trade settlement is done with computer system without any problem. However, failed trade can occurs if the counter party failed to deliver the stocks or there is insufficient fund. Most custodian banks will cover failed trade since they have a large cash and stocks holding. However, they would charge a fee and report such incidents to the investor (your client). On such occasion, the fund manager has to bare the charges. Such error rarely happens because most of the trade orders are computed by the system. Human error happens when the whole trading process is done manually.

Below is a flowchart of a typical investment process.

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Structure & Organization of an Investment Firm

The main function of an investment firm is to investment money for clients. Therefore, fund managers play the most essential roles in the firm. A new investment firm usually starts with two or three fund managers and gradually additional functions and roles are added as the company grows.

In an investment firm, besides fund management, other key business functions include trading, marketing, compliance and trade settlement. As the firm grow larger, additional business function are added including fund accounting, customer service, IT and Administration.

An organisation structure of a typical small size investment firm

An organisation structure of a typical medium size investment firm

Let’s discuss each business functions in details:

Management Office

The CEO, President or Managing Director of an investment firm is usually the main partner / owner of an investment firm. Most of them are experienced fund manager themselves and they usually also act as Chief Investment Officer overseeing the front office or fund management department.

Some of the investment firm were founded by experienced bankers and they usually partner with an experienced fund manager to manage the investment while they bring in the money. In some cases, the owner will take up the role of Chief Investment Officer and hired an experienced banker or business manager to run the company.

Chief Investment Officer (CIO)

For smaller investment firm, this role is also taken by the CEO. In the case where the CEO is an experienced banker, this role will be given to someone with experienced in managing investment.

CIO usually oversees the management of the investment portfolios. He or she will also be responsible for formulating the firm’s investment strategy as well as managing the investment team.

Investment Team

Fund Managers / Investment Managers

Fund managers are responsible for managing the investment portfolio. They have to make decision on stock selection, asset allocation and sector allocation. For smaller setup, fund managers will perform other operational task such as portfolio implementation, cash management and trading. For most countries, fund managers are required to be licensed.

Analyst

Analysts are responsible for analyzing individual stock and bonds. They also perform industry analysis. Some analyst team may include an economist to analyze the economy. They will make recommendations to the Chief Investment Officer and fund managers. For some countries, analysts are required to be licensed.

Fund Management Support

Fund management support (aka Front Office Support) would assist the fund managers in portfolio implementations and cash management. Sometimes, they would place the orders with the approval of fund managers. In some organization, fund management support reports to the Chief Operating Officer.

Traders

The primary responsibility of traders is to execute orders from the fund management team. Since these traders are not members of the exchange, the traders would in turn place trading order with some primary brokers. The secondary responsibility for traders is to manage different brokers during trade execution. After the trade is done, it is the trader’s responsibility to ensure that all portfolios are allocated with the correct amount of stocks.

Some larger trading team includes foreign exchange traders and a team of support staff that would assist the principal traders in order execution.

Operations

The operations division usually includes Middle Office, Back Office, IT and Administration. In a larger organization, the operations division is usually managed by Chief Operating Officer.

Middle Office

Middle office usually includes risk management team and performance measurement team. However, the use of the term is not always the same. Some company consider fund management support as middle office whereas some company consider their trading support staff as middle office. In a smaller firm, risk management and performance analysis are usually perform by the same team.

Risk Management

Risk management team involves in computation of the investment portfolio’s investment risk against the market or benchmark. They focus on tracking error, VAR, information ratio and standard deviation.

Performance Measurement

Performance measurement team involves in computation of the investment portfolio’s returns and performance attribution.

 

Back office

Back office usually consists of trade settlement and fund accounting department, although smaller firm combined both function into a single department.

Trade Settlement

Trade settlement department involves in processing trades after trade have been made by the trading team. The usual task involves order matching, order confirmation, sending settlement instruction and transfer of money for trade settlement.

Fund Accounting

Fund accounting involves in taking care of subscription and redemption of the fund. The team also need to accrue any fees and expense including income receivables.

Information Technology

The IT department is responsible for the IT infrastructure of the firm. An IT department usually consist of the system group and the application group.

System Group

The system group is responsible for the network infrastructure, the servers and the desktop PC of the company. System group also provides user support for the desktop PC.

Application Group

The application group is responsible for developing, maintain and support the core business application of the company. For smaller investment firm which could not afford to develop the core business application in-house, the company will buy readymade investment application from the outside. Such company will have only a few application support staff.

Support Office / Administration

The support office or administration department is responsible for all other administrative matters necessary while conducting a business.

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