This is a guide to how funds and managed accounts work, how they are regulated and the pros and cons of each.

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1 GUIDE TO FUNDS AND MANAGED ACCOUNTS This is a guide to how funds and managed accounts work, how they are regulated and the pros and cons of each. Glossary These are some of the common words used in this guide: Firm Appointed Representative Client Product Promote Complians The entity you work for. If your Firm is an appointed representative, the Firm includes the principal Firm who provides the appointed representative services. The Firm is known as a MiFID firm (as opposed to a PRA or AIFM firm). Your Firm may not be directly authorised and regulated by the FCA and is an appointed representative agent of a principal Firm that is. This is a potential or actual consumer of financial Products and this could be a real person or a non natural person like a fund or investment club. A financial instrument or service that can be bought or sold. This means to induce or entice or invite a Client to buy or sell a Firm s Product through communications such as adverts and presentations. This is the app used by the Firm to record its compliance related information and records. As with all regulations and definitions there are many exceptions and exemptions and as this guide is high level it does not address them. -1-

2 For example the term client does include corporate finance or venture capital contacts or beneficiaries of certain trusts but we have ignored this for clarity purposes. Managing the money of others For those who want to be a fund manager the usual route, apart from joining an already existing firm, has been to set up a manager and a fund and have a trading contract between the two entities. Fund managers are often called Asset managers or Investment Managers. Investors give their money to the fund so the fund manager can trade to gain returns based on the strategy documented in the prospectus / information memorandum / offering particulars (collectively called a Prospectus ) of the fund. The fund owns the assets or products managed and these can cover listed and unlisted instruments and physical real assets. Types of products include real estate, equities, fixed income, commodities and derivatives thereon etc. Hedge Fund managers tend to have long and short positions and Long Only managers have no shorts although the lines are blurring between the two given a Long Only manager can buy inverse ETFs which are effectively short positions. The fund is often known as a collective investment scheme (CIS) or collective investment undertaking (CIU) and maybe a UCITS or an AIF (see later). There may be restrictions on who can invest in the fund. However, many managers do not operate funds but use managed accounts instead. To understand why some managers have gone down the managed account route we need to look at the differences between funds and managed accounts and the advantages and disadvantages of each. Funds Traditionally a manager will incorporate a management company and this will have an investment management agreement, or IMA, with another company called a fund (that may be incorporated in Jersey, Ireland or Cayman for example). The investors are parties to the Fund s legal contract or Prospectus. The fund will appoint a service provider, like an administrator, to look after subscriptions and redemptions of the investors. The manager will then usually market the fund to raise more investment because the fund is usually a passive entity with little substance. However, since the Alternative Investment Fund Management Directive (AIFMD) went live in July 2014, most funds are now Alternative Investment Funds (AIF) and the -2-

3 manager (AIFM) is subject to a raft of disclosures and reporting and structural requirements. These requirements depend on the location of the AIF and AIFM (in or outside the EEA), the size of the fund and leverage used. There are also UCITS funds which are available to a wider investor audience but have a much more restricted underlying asset base. Managers may have to disclose how much they earn and the AIF will have to hire outside service providers such as Depositories and independent Risk Managers. Pros of a Fund As the fund is a legal entity in its own right, investors and other interested parties can see how the fund is performing. An independently audited track record helps with marketing and growing the fund too. It is a well trodden path and the operating processes are well known. A fund is transparent to the regulators and other third parties. Cons of a Fund It can be expensive to set up (e.g. lawyers fees, registration fees, minimum capital requirements, drafting of the prospectus etc). It needs a board of directors and may need a full compliance and governance infrastructure in place. It can take many months to set up a fund and legislation changes can mean the jurisdiction chosen may not be optimal in the long run (e.g. recent blitz on tax havens ). The management company as an AIFM is expensive to set up (minimum capital requirements of EUR125k) and to operate. Opening bank accounts is not as easy as it used to be. A fund needs to be a minimum size to be able to cover the costs of operating it. Costs will include setup cost amortization, director s fees, audit fees, transaction fees, administration fees, management fees, ongoing legal fees, AIFM Annex IV reporting etc. For example $5m plus is often quoted as a minimum asset under management although this depends on the performance returns being able to absorb the running expenses. Hedge funds will normally employ a Prime Broker like Goldman Sachs or NewEdge and a Depositary / Custodian like JP Morgan: however these service providers require steep minimum assets under management to make the business worthwhile for them and may not provide any service unless there is a certain turnover in transactions and assets under of management of at least $50m and sometimes $100m. Some investors do not like to have their investments co-mingled with other investors. Some investors do not like not having a lack of control over their assets (e.g. they may have to wait 3 months to receive their money back on redemption, fund could be gated without notice; the manager could change strategy). -3-

4 Managed Accounts There are a number of definitions of a managed account. In this context, an investor who has a trading account at a broker and gives authority (usually via a limited power of attorney or LPOA) to another person (such as a manager) to invest and trade on the investor s behalf is a Managed Account. A LPOA is an agreement where the investor allows someone else to trade their cash and investment portfolio. The ownership and control is at all times with the investor. The manager will be given guidance as to what they can and cannot do and may have performance hurdles to achieve. Often the manager with have an IMA in place. An example would be where an investor has died and a lawyer is given a power of attorney by the investor s trustees to wind down the investors positions held at a broker. Another example is where an investor gives a mandate to a someone more skilled, to manage their money. This is the usual use of managed accounts and it follows the regulations laid down in The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, Chapter VII clause 37 and 38 which details how a managed account can be operated. 37. Managing assets belonging to another person [the Client], in circumstances involving the exercise of discretion, is a specified kind of activity if A. the assets consist of or include any investment which is a security or a contractually based investment; or B. the arrangements for their management are such that the assets may consist of or include such investments or the arrangements have been held out as arrangements under which the assets would do so. 38. Consequently a person does not carry on an activity of the kind specified by article 37 if A. he is a person appointed to manage the assets in question under a power of attorney; and B. all routine or day-to-day decisions, so far as relating to investments of a kind mentioned in article 37(a), are taken on behalf of that person by i. an authorised person [i.e FCA regulated firm] with permission to carry on activities of the kind specified by article 37; or ii. a person who is an exempt person [i.e Appointed Representative, Lawyer, -4-

5 Accountant] in relation to activities of that kind. This means a manager can sign a LPOA with a Client and manage the assets of that Client without the manager needing to being regulated or the account being deemed a collective investment scheme of alternative investment fund. It does however assume the broker who custodies and controls the assets has the FCA permissions to act as an investment manager. In reality many brokers require the manager to be FCA authorised or an Appointed Representative as they may be promoting their services and could be construed as advising and arranging. Pros of a managed account The investor can open up an account in his / her own name with a broker. The investor can control the activity of the managing via LPOA and an IMA they have drafted and executed (unlike a non negotiable Prospectus). Investors like managed accounts as it keeps them in full control of their assets (since they are the beneficial owners of the account) and can terminate the manager s access to the account immediately. The brokers are usually in the UK (or Europe) and are regulated by the FCA. The investor may be treated as a Retail client and so enjoy extra FCA protection. A manager can operate very quickly as there is no need to set up a fund and they need only sign a contract with the broker and / or owner of the managed account. The manager can create a strategy applied across multiple managed accounts and in aggregate manage a portfolio not possible under the minimums required by the service providers of a fund. The manager does not need to carry out transaction reporting to the FCA as this carried out by the broker. The manager appears not to require being an AIFM and can be a MiFID manager (with less capital requirements and fewer disclosures and policies) as the managed account is not technically an AIF. Cons of a managed account Managed account performance cannot easily be audited as the accounts are not owned by an auditable legal entity. The manager may be required by the broker(s) to be regulated by the FCA as an Investment Manager. Some brokers do not. The manager cannot expense certain costs they many fund managers can. The manager cannot use a prime broker and gain access to leverage and shorting opportunities. A fund which is an AIF may have better bankruptcy protection than a broker. Funds of one, as they are sometimes called, do not fall under AIFMD or UCITS -5-

6 and so do not have the same custodian / depositary responsibilities which 1 means the counterparty risk maybe much higher. Our view We believe the managed account route is the best one to start with as a new manager with less than $50m, as some of the top brokers have services almost rivalling the larger prime brokers. A strategy can be traded across multiple managed accounts and the trading activity reports are accessible by the investors in a near real time capacity. Many fund service providers will not engage with funds of less than $50m. A track record can be audited via an accountants report and this can help in the marketing of the strategy. Which ever route is taken, the compliance burden still exists although to a much lesser extent than with a fund. In the longer term, especially in attracting institutional money, a fund maybe a better option. REFERENCES The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001: DISCLAIMER This guide is based on publically available material and these sources are referenced. It is also based on practical experience in the global financial services sector gained over 25 years. The complexity of the regulations means lawyers, consultants, grey hairs, regulators and those in the industry may have different interpretations of the rules and laws underpinning them. There are few people, if any, who know and understand everything in the FCA Handbook and we do not profess to know everything and understand everything either. This means you may not agree with some of the comments or interpretations in our guide. If you have comments then please In all instances we recommend you seek other independent advice. This guide is in draft and is for informational purposes only. Last updated: Sept

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