Outsourcing of Investment Operation

Copyright: 123RF Stock Photo

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.

*****

Overview of Investment Process

Copyright: mab0440 / 123RF Stock Photo

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.

*****

What is Investment Management Agreement (IMA)?

Copyright: photokanok / 123RF Stock Photo

An Investment Management Agreement (IMA) is an agreement between an investor and fund manager, where the fund manager agreed to manage the investment for the investor according to the objective and manner stipulate in the agreement. This agreement is formulate between an investor and the fund manager after rounds of negotiation with the help of legal adviser. 

The main component of IMA includes the investment objective/target, investment restriction, management fees for the fund manager, custody of the investment, valuation and reporting requirement. Like any other business contract it will also includes effective date of contract, duration of contract and condition of termination.

Listed below is some of the key component in the IMA:

Investment Objective / Target

Under investment objective, the investor will stipulate what is the investment objective and the target return. This is the most important component for the fund managers. For example, an investor can demand the fund manager to align the investment portfolio with an established benchmark; while allowing the fund manager a 20% deviation from the benchmark but the fund manager must have a return target of 2% above the benchmark. Therefore, if a benchmark has a 7% return, then the return target should be 9%. There are many types of investment objectives and target returns.

Investment Restriction

This component is very important not only to the fund manager but it is also important to all the operational staff including the traders. Any violation of the restriction may carry a heavy penalty. While the compliance officer will ensure the enforcement of investment restriction; it is usually too late because the trade has been done. The onus is mainly on the fund manager, fund management assistance and the trader to prevent from violating the restriction. Some companies even hire staff just to do pre-trade compliance. Listed below is some examples:

• No investment in xxx country
• No investment in tobacco and liquor stock
• Investment in xxx stock may not exceed x% in the portfolio
• Cash must be maintained between 2% to 5% of the portfolio

Management Fee

This is the income of the fund management firm. Besides the executives, the accounting staff must be aware of the fee so that fees can be accrued and deducted from the portfolio accordingly.

Custody of Investment

If you manage money for a pension fund, usually they will appoint a custodian bank to hold the investment portfolio including the bonds, stock certificates and cash. The custodian bank will also be representing the pension fund in annual shareholder meetings. Any stock splits and rights issue will also be managed by the custodian bank. A lot of central bank and monetary authority encourage such practice because it provides check and balance, and potentially prevent rouge fund managers from misusing the client's asset. Custodian bank has specific instruction to notify the investor if there is large movement of cash or stocks. In addition, the pension fund may ask the custodian bank to provide fund accounting and valuation services.

Valuation and Reporting Requirement

Valuation requirement stipulate how the investment portfolio be valued such as  the date of valuation, the exchange rate and who to provide the valuation. More sophisticated clients will require the valuation be done by the custodian and they  may request additional valuation report from the fund manager for comparison. The client may also stipulate the reporting deadline.

There are many components in an IMA, the items mentioned above are just some key components that are common. Not every IMA is the same and the investor may include anything under the sun as long as the fund manager agrees.

Usually the negotiation of IMA happens between the investor and some key executives of fund management firm. Those key executives includes the CEO, marketing manager and fund manager. Usually the operational staff is out of the loop until the agreement is signed. This presents some problem when the marketing managers promise everything the investor requires without considering whether if the operation staff could deliver those requirement. If the COO is not involve in the negotiation of IMA, it would be advisable to allows the COO to go through the final draft of the IMA to determine if his/her operation staff could deliver the requirement before the CEO sign the IMA.

****    

What is a Custodian Bank?

Copyright (c) 123RF Stock Photos

A custodian bank is a separate entity that hold your stocks and bonds certificates on your behalf. Your custodian could represent you in the annual shareholder meeting, exercise any corporate action such as bonus issue and rights issue on your behalf and it will prevents your name from being disclose to the exchange as the major shareholder. In return, the custodian bank will charge you custodian fee for service rendered.

In the past, ownership of stocks and bonds were represented by a certificate. Most stock certificate are in denomination of 1000 shares. Therefore, if you own 2000 shares you would have 2 certificates. Imagine a pension fund owning 10 million shares of a company, there are a lot of certificates to handle. Most institutional investor uses custodian bank to manage and safe keep these stocks and bonds certificates.   Besides managing these physical certificates, custodian could exercise bonus issue or rights issue on behalf of investor since they have already handled the  stock certificates. For any trades made by the investor or their fund manager, instructions must be given to the custodian bank so that they can deliver the physical certificates to the counter party for a sell trade and expect to receive physical shares for a buy trade. 

In present day where physical stocks and bonds certificates were almost gone, custodian bank still performs the function of keeping records of investors' portfolio. Custodian bank could still exercise any corporate actions on behalf of an investor. In addition, most investor also ask the custodian bank to manage the cash account in the portfolio, provides portfolio valuation and fund accounting services.

Custodian also provides securities lending services for people who wanted to sell short certain stocks. Some stock exchanges requires hedge fund manager to borrow stock before selling short.

Since most of the institutional investors use their own custodian to safe keep the investment, a custodian bank is an important partner for the fund manager. All daily trade instructions, cash instructions are sent to the custodian bank. Actual trade settlement is handle by the custodian bank. 

This arrangement is widely encourage by the regulatory authority because it prevents rogue fund manager from misusing investors' fund. The custodian bank has the responsibility to inform the investor for any unusual activity such as large amount of cash withdrawal.

*****