change.
The brokerage firm's proprietary trading operations involve the firm's own account, called the house account. Other sources of broker revenue include soft commissions, payments for order flow, interest on margin loans, short interest rebates (on short sales), underwriting fees when the firm helps clients sell securities, and mergers and acquisitions (M&A) fees. The major cost of running a brokerage firm is labor: the brokers and other employees who provide the firm's services to clients.
Brokerage firms and other firms with major investment activities organize their activities into three major operations: (1) front office, (2) back office, and (3) middle office. Front office operations involve investment decision-making and, in the case of brokerage firms, contact with clients. Back office operations play a supportive role in the maintenance of accounts and information systems used to transmit important market and trader information in all trading transactions, as well as in the clearance and settlement of the trades. Middle office operations form the interface between the front office and the back office, with a focus on risk management.
2.1.3 Outside Service Providers
Other major participants in the world of alternative investments are outside service providers, such as prime brokers, accountants, attorneys, and fund administrators. Alternative investment funds rely on outside service providers for their successful creation and operation. Details regarding outside service providers are provided in Chapter 31, and their roles are briefly discussed here.
PRIME BROKERS: Prime brokers allow an investment manager to carry out trades in multiple financial instruments at multiple broker-dealers while keeping all cash and securities at a single firm. The prime broker has the following primary functions: clearing and financing trades for its client, providing research, arranging financing, and producing portfolio accounting. Prime brokers offer a range of services, which are discussed in more detail in Chapter 31, on due diligence.
ACCOUNTANTS AND AUDITORS: The accounting firm providing services to a hedge fund or to another alternative investment fund should include an experienced auditor and tax adviser. During the creation of the fund or investment vehicle, the accounting firm provides services largely parallel to those of an attorney: reviewing legal documents to ensure that accounting methods and allocations are appropriate and feasible, and that relevant tax issues have been addressed. The accountant helps prepare partnership returns and the necessary forms for the investors in the fund to report their shares of partnership income, deductions, gains, and losses (e.g., Schedule K-1 in the United States). The adviser also provides tax-related advice to the fund throughout the year and may be called on as a consultant on structuring and compensation issues for the principals of the general partner. The auditor performs a year-end audit of the fund, including the review of security pricing, and presents the results of this audit to the fund and its investors. Accountants usually cooperate with the prime broker and fund administrator to gather the necessary information for audits and tax returns.
ATTORNEYS: An attorney helps determine the best legal structure for a fund's unique investment strategies, objectives, and desired investors. The attorney takes care of filing any documents required by the government (federal or other levels) and creates the legal documents necessary for establishing and managing a hedge fund or another alternative investment, including (1) private-placement memoranda (a.k.a. offering documents), which are formal descriptions of an investment opportunity that comply with federal securities regulations; (2) a partnership agreement, which is a formal written contract creating a partnership; (3) a subscription agreement, which is an application submitted by an investor who desires to join a limited partnership; and (4) a management company operating agreement, which is an agreement between members related to a limited liability company and the conduct of its business as it pertains to the law. The attorney can offer guidance on marketing a hedge fund or another alternative investment in full compliance with all legal requirements, as well as on operational issues, such as personal trading. For example, in the United States, an attorney can provide advice regarding Securities and Exchange Commission (SEC) rules governing the use of testimonials, performance statistics, and prior performance statistics.
FUND ADMINISTRATORS: Many hedge funds and other alternative investment funds now engage a fund administrator to be responsible for bookkeeping, third-party information gathering, and securities valuation functions for all of their funds, both onshore and offshore. The fund administrator maintains a general ledger account, marks the fund's books, maintains its records, carries out monthly accounting, supplies its monthly profit and loss (P&L) statements, calculates its returns, verifies asset existence, independently calculates fees, and provides an unbiased, third-party resource for price confirmation on security positions. The same administrator also produces a monthly capital account statement for investors, and apportions fund income or loss among them. The administrator takes over the duties of day-to-day accounting and bookkeeping so that managers can focus on maximizing the portfolio's returns. The administrator can also be an important source of information for the auditor and tax adviser in completing required audits andtax returns.
HEDGE FUND INFRASTRUCTURE: Hedge funds can require a complicated infrastructure and extensive technological systems. The infrastructure may have three main components: (1) platforms, (2) software, and (3) data providers. Financial platforms are systems that provide access to financial markets, portfolio management systems, accounting and reporting systems, and risk management systems. Financial software may consist of prepackaged software programs and computer languages tailored to the needs of financial organizations. Some funds use open-source software, and others pay licensing fees for proprietary software. For a hedge fund, most of the raw material that goes into its strategy development and ongoing investment process is in the form of data. Financial data providers supply funds primarily with raw financial market data, including security prices, trading information, and indices. The amount of data is dictated by the investment style. Nonetheless, most hedge fund managers are required to keep abreast of market developments and macroeconomic news.
Due to legal implications, directly marketing alternative investment vehicles can be problematic. One method of indirectly marketing private funds is to report a fund's performance to an index provider, especially if the fund's performance is attractive. Index providers compile indices of prices that assist fund managers in evaluating performance.
CONSULTANTS: Consultants may be hired by pensions, endowments, or high-net-worth individuals to provide a number of roles and services that center on advice, analysis, and investment recommendations. Clients rely on consultants to offer unbiased analysis of money managers’ investment performance, as well as advice on how to best allocate funds. Clients expect their consultants to help them lay out the parameters of their investment objectives by setting out a plan for allocating assets within the framework of their objectives and risk tolerance. Consultants work closely with their clients to monitor the performance of investments while continuing to play an advisory role in a client's choice of other service providers.
Consultants are increasingly being used to serve the role of chief investment officer in small organizations. The role of an outsourced chief investment officer (OCIO) ranges from performing all of the decision-making duties of an in-house chief investment officer to a reduced role of assisting staff with a subset of decisions.
Consultants have traditionally been compensated for their services in one or both of the following ways: fees from their clients, or compensation packages from the money managers for whom they generate business. This latter form of payment presents a conflict of interest on the part of consultants because it can detract from the ability to offer independent advice to clients. Further, the compensation that consultants receive from money managers is undisclosed and can be quite substantial. Some consultants waive their regular consulting fee, giving the impression that their services are free.
Consultants' integrity and expertise are vital parts of the consultant-client
