tend to flow taxable revenue and expenses directly through to their partners rather than being taxed at the partnership level.
PRIVATE INVESTMENT POOLS: Hedge funds, funds of funds, private equity funds, managed futures funds, commodity trading advisers (CTAs), and the like are private investment pools that focus on serving as intermediaries between investors and alternative investments. Most U.S. funds are structured as limited partnerships and offer incentive-based compensation schemes to their managers. These limited partnerships are usually managed by the general partner, while most of the invested funds are provided by the limited partners. Exhibit 2.1 illustrates the basic structure used for most private alternative investment vehicles. The general partner manages the assets in the fund. Hedge funds tend to use sophisticated trading strategies, funds of funds invest in other funds, private equity funds tend to invest in stock of nonpublic companies, and managed futures funds and CTAs are asset managers who, instead of focusing on traditional stock and bond investments, focus on currency or commodity futures markets.
Exhibit 2.1 Structure of a Limited Partnership Investment Vehicle
SEPARATELY MANAGED ACCOUNTS: Separately managed accounts (SMAs) are individual investment accounts offered by a brokerage firm and managed by independent investment management firms. The relationship between an investment adviser and a client to which it provides advice is typically documented by a written investment management agreement. SMAs can be thought of as being similar to pooled investment arrangements, such as mutual funds, in that a customer pays a fee to a money manager for managing the customer's investment, but SMAs tend to be differentiated from funds in five major ways:
1. A fund investor owns shares of a company (the fund) that in turn owns other investments, whereas an SMA investor actually owns the invested assets as the owner on record.
2. A fund invests for the common purposes of multiple investors, whereas an SMA may have objectives tailored to suit the specific needs of its only investor, such as tax efficiency.
3. A fund is often opaque to its investors to promote confidentiality; an SMA offers transparency to its investor.
4. Fund investors may suffer adverse consequences from other investors' redemptions (withdrawals) and subscriptions (deposits), but an SMA provides protection from these liquidity issues for its only investor.
5. Whereas the fund structure may allow investors to have limited liability, the SMA format may allow losses to be greater than the capital contribution when leverage or derivatives are used.
From an investor's perspective, the advantages of the first four distinctions typically outweigh the disadvantages of the last distinction. However, fund managers prefer the simplicity and convenience of pooled arrangements (funds).
MUTUAL FUNDS (’40 ACT FUNDS): Mutual funds, or ’40 Act funds, are registered investment pools offering their shareholders pro rata claims on the fund's portfolio of assets. In the United States, mutual funds that offer their shares for sale to the public are known as ’40 Act funds due to the regulations that permit their offering by registered investment advisers: the U.S. Investment Company Act of 1940. In recent years, ’40 Act funds have increasingly offered alternative asset exposures through these retail fund structures. A general discussion is provided in section 2.4, along with more specific discussions throughout Parts 2 through 5.
MASTER LIMITED PARTNERSHIPS: Master limited partnerships (MLPs) are publicly traded investment pools that are structured as limited partnerships and that offer their owners pro rata claims. Like equities, MLP units are traded on major stock exchanges, but they have legal and tax structures similar to those of private limited partnerships.
2.1.2 The Sell Side
In contrast to buy-side institutions, sell-side institutions, such as large dealer banks, act as agents for investors when they trade securities. Sell-side institutions make their research available to their clients and are more focused on facilitating transactions than on managing money.
LARGE DEALER BANKS: Large dealer banks are major financial institutions, such as Goldman Sachs, Deutsche Bank, and the Barclays Group, that deal in securities and derivatives. Although based on the same economic principles as typical retail banks, large dealer banks are much bigger and more complex. The macroeconomic impact of a large dealer bank failure may be more widespread because of the central role this type of bank plays in the economic system at large. Generally, most large dealer banks act as intermediaries in the markets for securities, repurchase agreements, securities lending, and over-the-counter (OTC) derivatives. In addition, large dealer banks are often engaged in proprietary trading and brokering hedge funds.
Large dealer banks also have large asset management divisions that cater to the investment management needs of institutional and wealthy individual clients. This involves custody of securities, cash management, brokerage, and investment in alternative investment vehicles, such as hedge funds and private equity partnerships that are then managed by the same banks. Some of these types of banks operate internal hedge funds and take on private equity partnerships as part of their business management service. In this role, the bank acts as a general partner with limited-partner clients.
The role of dealer banks in the primary market is to intermediate between issuers and investors, to provide liquidity, and to act as underwriters of investments. In secondary securities markets, large dealer banks trade with one another and with brokers/dealers directly over the computer or the phone, as well as play an intermediating role of facilitating trades.
Large dealer banks also engage in proprietary trading. Proprietary trading occurs when a firm trades securities with its own money in order to make a profit. Large dealer banks serve as counterparties to OTC derivatives such as options, forwards, and swaps that require the participation of a counterparty dealer who meets customer demand by taking the opposite side of a desired position. Dealers may accept the risk or use a matched book dealer operation, in which the dealer lays off the derivative risk by taking an offsetting position.
As part of their business management activities, large dealer banks are active as prime brokers that offer professional services specifically to hedge funds and other large institutional customers. (Prime brokers are discussed in more detail in section 2.1.3.) Several large dealer banks have ventured into off-balance-sheet financing methods, a practice that involves a form of accounting in which large expenditures are kept off the company's balance sheet through various classification methods. Companies use off-balance-sheet financing to keep their debt-to-equity and leverage ratios low.
In addition to their special role in the financial system, large dealer banks share many of the same responsibilities as conventional commercial banks, including deposit taking and lending to corporations and consumers.
BROKERS: Also on the sell side are retail brokers that receive commissions for executing transactions and that have research departments that make investment recommendations. Advantages of using brokers include their expertise in the trading process, their access to other traders and exchanges, and their ability to facilitate clearance and settlement. Because brokers play the role of middlemen in the trading process, traders can use broker services when they want to remain anonymous to other traders. Typically, traders can manage their order exposure by breaking up large trades and distributing them to different brokers or by asking a single broker in charge of the entire trade to expose only parts of the order, so that the full size remains unknown to other traders. Brokers also often represent limit orders for clients (i.e., orders placed with a brokerage to buy or sell shares at a specified price or better). In this event, brokers monitor the markets on behalf of their clients and make decisions based on client limit and stop orders when the
