What is Investment Management Agreement (IMA)?

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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.

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What is Discretionary Fund Management?

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Discretionary fund management is a fund management arrangement where the investor authorize the fund manager to manage the investor's fund on a discretionary basis. This means that the fund manager can buy and sell stocks and bonds without consulting the investor. The fund manager will be responsible for making all the investment decision at the same time adhere to the requirements of the investor.

Almost all fund managers manage investment on a discretionary basis, whereas most private bankers serve their clients on a non-discretionary basis.  

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Process of Acquiring Institutional Investor

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Usually institutional clients will not investment money with a new and unknown investment firm. Institutional clients will monitor the investment firm’s track record for at least three years. It is the responsibility of the marketer of the investment firm to maintain relationship with a prospective institutional client and furnish investment performance report to the prospective client for review. The marketer also needs to present to the prospective client their investment philosophy and investment process. 

After three years of monitoring, if the institutional investor wants to invest with an investment firm, the client will contact the investment firm to request for investment proposal. After reviewing the investment proposal, the prospective client would proceed further into the next phase. 

During the second phase, the prospective client would study the investment process in more detail and scrutinize the investment performance report. Initial negotiation of fees and investment requirement will start in this phase. If the institutional client is satisfy with the preliminary finding and both parties agreed to the investment requirement and fees, both parties would proceed to the next phase. 

In the third phase, the prospective institutional investor and the investment firm will start negotiating and formulate an Investment Management Agreement. At the same time the institutional investor will perform their due diligence and examine the investment firm’s internal audit & control, compliance procedure, security measure and investment operation. The prospective investor will detail their investment restriction and operational requirement to the investment firm’s operational staff. Once the institutional investor is satisfied with the investment operation, it will proceed to finalize the Investment Management Agreement (IMA) with the management. 

Once the IMA is signed, the investment firm has secured the investment fund from the institutional investor.  The investment firm will receive money or securities from the investor at the stipulated date and invest the money according to guidelines lay out in the IMA.

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Investment System, Invetsment Technology and Investment Technologist

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An investment system is a software application that performs all investment related operation from font office to the back office. Such investment system can perform, but not limited to, the following:

• Presents analytic reports to the fund managers
• Assist fund managers in portfolio re-balancing and portfolio construction
• Help fund managers in portfolio implementation and placing trades with the traders
• Perform pre-trade compliance check of new trades
• Assist traders in order management and trade execution
• Assist traders in allocating executed orders to different investment accounts
• Helps the settlement department in order matching, broker confirmation and sending settlement instruction
• Generate daily valuation report and perform reconciliation with the custodian and any other counter party
• Generate report on investment return and performance

In a larger firm (usually big investment bank), the company employ teams of software developers to develop the system in-house. They will hire software architect, system analysts and programmers to develop the system. Although the cost is high but the developers can tailored the investment system to fit into the bank's investment operation.

For smaller fund managers, they usually buy ready-made investment system and implement such system with limited customization. The company may need to adjust their investment operation to fit the investment system.

Please note that not all software vendors are able to offer a complete solution from the front office to the back office. Some software vendors specialized in front office system, whereas some specialized in trading or back office system.

In the event that your front office system and back office system are from different software vendor, you would need a middle-ware that could interface between both system. Please stay on this blog if you would like to know about choosing investment system and implementing them.

An Investment Technologist is an IT specialist who provides technological solution to the operation of an investment firm. Besides IT knowledge, it is imperative for an Investment Technologist to know about the business operation of an investment firm. 

An investment technologist involves in the development, implementation and support of an investment system. It is the responsibility of the investment technologist to ensure the continuous operation of the investment system because when system goes down so does the business operation. 

An investment technologist usually does not involve in the day to day operation of managing servers and network infrastructure although in some smaller outfit the investment technologist has to double the role as system engineer.

A successful investment technologist should provide solution that fits into existing investment operation. Therefore, an investment technologist must know the detail operation of each department from the front office, trading desk, middle office and back office. It would be easier for a technologist to recommend a suitable technical solution if he/she knows how each department work together. Based on my previous experience, I would say that knowledge of investment operation is more important than technical knowledge.

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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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How does an Investment Firm get Investment Money?

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Disclaimer: As an Investment Technologist, I do not claim to be an expert in marketing. The following article is based on my observation while working for various investment firms.

An investment firm can source their clients from 3 main groups of people or organisation. It can find customer from institutional investor, individual retail investor and wealthy individual / family.

Wealthy Individual or Family

This is not a major venue for securing clients; however, some new or smaller investment firms welcome wealthy individual or family with a minimum investment amount of USD5 million. For larger investment firm, they may require the client to commit a minimum of USD100 million for investment. They would encourage their prospective client to invest in mutual fund for smaller investment commitment.

The only way to secure wealthy individual and family as client is through personal networking. Alternatively, the investment firm’s marketer can establish business relationship with private bankers. Although most wealthy individual trade through private bankers and private bankers also provides investment advisory; some wealthy clients may ask their private bankers to recommend them reliable investment firms and leave the management of money solely to the investment firm.

Retail Investor

An investment firm can setup a mutual fund and collect investment money from individual investors. It is very hard for small investment firm or new investment firm to attract retail investor without a proven track record and substantial investment fund. It requires a lot of resources to setup a mutual fund that conforms to the financial regulation. Therefore, only mid size or larger investment firms could afford to set up a mutual fund. Besides legal fees, the investment firm also needs to invest in  large sum of advertising dollars to attract investment from the public. The risk is high if the mutual fund fails to attract enough investment.

Institutional Investor

This is the main venue for most investment marketers to secure clients. Institutional investors includes pension fund, foundations, charity, trust fund, insurance company, sovereign investment arm or treasury department of a country, treasuries from society, trade associations, religious organisation and corporations that have a large cash reserves.

An investment firm’s marketer needs to establish relationship with these organisations through networking. Alternatively, the marketer can scan through trade journals or the websites of these organisations to look for investment opportunities. Some organisations will routinely post their investment requirement and request any investment firms to submit an investment proposal for their review.

Alternatively, the marketer can establish business relationship with reputable investment consulting firm. Some institutional investor would hire an investment consultant to help them to formulate investment strategy and evaluate investment firm. If an investment consultant like your investment approach, he/she would recommend you to many prospective clients.

A new investment firm without a proven track record would invest with their own money and money from wealthy individuals. Once a track record has been established, it is easier for them to secure clients from the institutional investors. Once the investment firm grows to a certain size, then it would proceed to seek investment money from the public. By then, they would recommend their wealthy individual clients to invest in mutual fund. Once an investment firm grows to a certain size, it is not cost effective to manage funds that are less than USD50 million.

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What is a Custodian Bank?

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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.

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