It is always interesting to ponder the question of what is gambling and what is investment?

Is the pursuit of profit greed or a structured contingency against future requirements, for example, a pension?

In the 1800s canal and railway mania in the UK created and lost fortunes so was this gambling, speculation, or structured investment?

Certainly for the lucky ones it was a foundation for enormous wealth that has sustained the family through generations. Others lost all their money and often ended in debtors jails with families broken and living in terrible deprivation. This was not a UK phenomenon but spread across the globe as the industrialization and growth of economies, often on the back of colonization and empires captured the imagination of entrepreneurs, businessmen, and of course speculators.

In the United States, which originally was what we would call today an emerging market, an example would be the gold rush and this was also in evidence in Australia and New Zealand, Africa, and other countries. In Asia and the Caribbean, the spice trade was heavily “invested in” and of course at the other end of the spectrum slavery was another “investment” that generated huge fortunes for individuals and families.

Today we can look back at this “market” and recognize that most fortunes were built on exploitation, often brutal and uncaring, of people, often children like in mining and industry, and the natural resources of other countries with little or no benefit to the people of that country.

Traders, merchants, and speculators were totally dominant and profit and returns came before all.

Ironically, today we have some disturbingly similar parallels with investment (or some will say exploitation) in “emerging markets” where the wages, working and living condition of workers is appalling, particularly compared to the standards found in the mature markets of the United States and Western Europe.

The kind of highly speculative investment found in the 1800s underwent an evolution and to all intent a purpose became the forerunner of the investment industry we are familiar with today, as those with insufficient capital to take a reasonable stake in an enterprise joined together to create “collective investment” often in the form of syndicates and partnerships.

Earlier “investors” were exposed to some extraordinary risks, often without being aware of such risks, and their general naivety left them vulnerable to scams and frauds.

Today investment is a structured process with collective investment schemes (CIS) created in the form of investment funds, many of which are regulated. In many jurisdictions around the world investors, especially those with limited knowledge of finance and awareness of risk are offered high levels of protection.

Those investors with greater knowledge and awareness can opt to invest their capital in more lightly regulated products and even products that are unregulated.

The need for the regulation of investment and the adoption of change can be found in numerous case studies, some a long time ago but also some more recent.

Fund management became an enormously important component of what was rapidly becoming a key part of the capital markets as the increasing wealth of individuals sought returns and the capital needs of growing companies and indeed economies had to be financed.

Diagram 1.1 shows the general structure of the capital markets broken into sectors. Purists may consider commodities and other assets as being outside the scope of capital markets.

Investor’s pooled capital in a CIS became a prime source of the capital flow. Their capital was either passively managed, which meant it was placed in a fixed, unchanging portfolio of assets or one that tracks a benchmark like an equity index, or is actively managed, which means that an investment manager creates and manages the portfolio seeking to generate a return higher than a benchmark. We will consider this again shortly.

In the capital markets, financial instruments are created and offered to investors by originators such as corporate companies, governments, and sometimes intermediaries. These offerings can be in the form of a public offering or a placement. An offering of securities or financial instruments can be in the form of, for example, an initial public offering (IPO) or can be placed with financial institutions by investment banks.

As the globalization of investment grew and more and more issues arose, regulation increased. Regulatory authorities were established in onshore jurisdictions and also offshore fund centers, where the regulatory environments were suitable for those investors needing less protection and where the regulation was less onerous and costly for the fund promoter. Onshore and offshore refers to the domicile of the investor and the domicile of the fund, for example, a UK investor who has invested in a Jersey domiciled fund (offshore) or a UK investor who has invested in a UK domiciled fund (onshore).

By the latter part of the last century, regulation became focused on funds that would be sold to general investors generically called “retail” funds and those that were designed for more experienced individuals and institutions which became generically called “alternative,” “nonretail” or “qualifying funds.”

The crash of 2008 exposed huge gaps in the levels and efficiency of the regulatory structures.

As a result huge changes took place post the crash.

As noted earlier, the investment is structured and fund management is part of that structure as illustrated in Diagram 1.2.

The process of investment needs support and this is provided by parties that fall under the title of fund services.

The kind of workflow they deal with would be based on:

In addition performance must be monitored and above all the fund must comply with any applicable regulation, have strong governance and control of risk.

The investment process including the investment funds are operated under commercial Law, for example, Partnership, Trust, or Company Law and the legislation and regulation applicable to the markets in which the assets are traded.

However Islamic funds are part of the Islamic finance environment, which operates under quite different circumstances.

What is Islamic finance?

Why does this impact on investment fund products?

An excellent example of the difference between how a fund is invested involves interest or riba. A key feature of Islamic finance is that paying or receiving interest is forbidden. The Muslim holy book the Qur’an warns against this in the strongest terms.

Conventional finance is very often based on the concept of interest and yet the Holy Bible says:

and

and

However, the dynamic nature of Islam means that although both Holy Books condemn interest, only Islam enforces a prohibition on it.

Conventional funds therefore can invest in bonds and other financial instruments and arrangements that involve payment of interest but Islamic funds cannot.

The rules and guidelines that Islamic finance operates under is referred to as Sharia which is a framework of rules, principles, and guidance derived from Islamic teachings. It can be referred to as Islamic Law and financial products used by individuals, corporates, and other institutions like investment funds can be referred to as sharia-compliant.

Other concepts in conventional financial markets and products like profit, income from dividends and rentals, as well as instruments and assets like equities, property etc. are also found in Islamic finance.

Islamic investment funds have grown substantially.

In a recent study by Thomson Reuters and their subsidiary Lipper, it was found that Islamic mutual funds globally now hold $53.2 billion of assets under management, recovering from a low of $25.7 billion in 2008, and that the total numbers of Islamic mutual funds established reached 943 in 2014, up from 828 a year earlier, and double the number in 2008 (May 2015—full article can be found at http://www.reuters.com/article/2015/05/19/islam-financing-funds-idUSL5N0YA04I20150519).

We will return to Islamic funds later.

As markets and the investment industry have changed it has placed more and more pressure on funds and their administrators.

We can summarize the investment industry today as:

It is still recovering from market crash and ongoing liquidity problems as well as more current situations like Greek debt issues, migrants flooding into Europe, and what seems to be a slowing Chinese economy.

Investors, both private and institutional, are wary of issues like strength of control, oversight, and reconciliation over the assets of a fund (Madoff), large and sudden drop in Net Asset Value (NAV) of some funds (suggesting unrealistic valuation of assets) and a general negative view of participants in the financial markets (short selling, high performance fees, bank rip offs, lack of control etc.).

Alternative investments have become popular with some investors, for example, buying gold, art, antiques, stamps etc.

There has been a significant amount of regulation and new legislation introduced including the Alternative Investment Fund Managers Directive (AIFMD), The European Markets Infrastructure Regulation (EMIR), UCITS V, and the Markets in Financial Instruments Directive II (MiFID) in Europe as well as Dodd-Frank (United States) with greater emphasis on transparency and reporting (Full title—the Dodd-Frank Wall St Reform Act).

There is also increasing legislation aimed at tax avoidance like the US Foreign Account Tax Compliance Act (FATCA) although if the following comment is anything to go by it is not always perceived as successful.

America’s controversial global tax law, FATCA, has been slammed as “a masterclass in fiscal imperialism and the law of unintended consequences,” by the boss of one of the world’s largest independent financial advisory organizations.

The comments from Nigel Green, deVere Group CEO and founder, come as it is shown that, despite FATCA, America is increasingly secret in matters of financial data; and because of FATCA, a growing number of US citizens are giving up their American citizenship.

Under the Foreign Account Tax Compliance Act, which came into effect in July 2014, all non-US financial institutions are required to report the financial information of American clients who have accounts holding more than US$50,000 directly to the IRS (Full article can be found at http://www.globalcustody.net/n8163).”

We look more at regulation in Part 2 of this book.

What we do know is that the main drivers behind what is happening in the investment industry today are simply regulation and investor pressures.

For example, in Jersey we find the following fund structure type:

For details of the full Jersey Investment Funds—regulatory options, see Appendix 1.

Note: An unregulated fund must still maintain full and proper records related to the fund and there will be legal responsibilities associated with the directors, general partner, or trustee of such funds. Also, the unregulated fund may still need to be registered with the regulator and only authorized or licensed personnel and service providers can operate the fund.

A closed fund has a fixed investment capital and does not issue or cancel shares however this does not necessarily mean that shares or units cannot be transferred between parties.

In the first part of this section, we saw that the funds have offering documents and so the detail of whether the fund is open-ended or closed will be found there along with other crucially important information.

The Prospectus/Offering Memorandum/Scheme Particulars will contain all the relevant information and disclosures about the fund including:

The information will be used by financial advisers and investors but the fund support teams generically called fund administration and custody as well as the investment manager will also use these documents for guidance and to plan the necessary procedures and processes for the operation of the fund.

The investment process itself depends on the type of fund so a passive fund which tracks a benchmark will invest the capital into the assets in the weighting that makes up the benchmark. There is no decision making and no investment manager.

In an actively managed fund, the investment process will involve portfolio management including asset allocation and selection, which we will look at in later sections.

Active investment management is usually carried out either by an investment manager who operates under a Discretionary Investment Management Agreement (IMA or DIMA), which details what the manager can and cannot invest in, strategies that can and cannot be used etc. plus the expected performance, remuneration including performance fees. In addition the manager must comply with applicable regulation or by an investment committee and investment advisers.

Investment advisers research potential investments and recommend them to, for example, the investment committee who will decide on the final composition of the portfolio. The advisers earn fees and possibly a share of the return the portfolio generates.

By way of example, the manager structure is common in retail funds and the latter structure in private equity and property funds.

While there will always be variances, the investment process looks like that shown in Diagram 1.4.

The boys and girls in the administration and custody teams must be fully conversant with this flow so that they can identify the key sources of data, critical action points, primary reconciliations, and the potential operational risk areas.

A failure to do this would leave the fund vulnerable to costly errors, noncompliance with investment mandates, internal policies and agreements, possible breaches of regulation, and even fraud.

Other fund structures:

There are many possible structures for funds such as Fund of Funds, Multi-Manager Funds, Master/Feeder Funds etc. and Diagram  1.5–1.7 illustrate these.

Each of these will have different characteristics and therefore pose different challenges for the administrator and custodian. For example, the fund of fund structure means that the valuation of the fund is going to be based on the value of the funds invested in rather than a portfolio of assets. A multi manager fund has potentially a series of administrators allied to the individual management and a master/feeder structure has individual funds established in different jurisdictions that investors subscribe capital to. In turn the funds subscribe to a master fund. So the workflow for the administrator of the master fund is mostly to do with investments and the portfolio while the administrators of the feeder funds are mainly dealing with the investors.

As always the regulatory environment and offering documents together with internal procedures and controls determine exactly what work will be involved.

To summarize:

Different fund locations have developed around the world in response to the growth of investment funds both retail and nonretail. For example, Luxembourg and Dublin are home to many UCITS and other structures as well as hedge funds and other alternative investment funds like property and private equity. Other fund centers like Cayman are home to many hedge funds although the administration of these funds may be done elsewhere, for example, Dublin. Each center will have the ability to provide the fund functionaries like lawyers, accountants, administrators, custody services, as well as potentially sourcing directors and trustees. The Channel Isles and Isle of Man offer mature and extensive services and are home to many types of funds. So too are Singapore, Malta, Gibraltar, and Mauritius with the latter servicing many Indian funds. Each center will have its own types of fund structures, which are basically one or more of companies, trusts, and partnerships depending on the Law in that jurisdiction. Common funds, UCITS compliant funds, SICAVs, OEICS, ICVCs, protected cell companies, expert funds, qualifying funds, market professional funds are all examples of the type of fund structures that different centers have created. Developing centers, for example, Cyprus need to build the same kind of strong set of services and to look to attract fund promoters from inside and outside the EU.

One common thing in all successful fund centers is to have strong, workable regulation of investment funds that will give investors comfort. Having advantageous tax arrangements can also be important but expertise and comprehensive services is also very important.

The level of due diligence that prospective investors now carry out means that a good reputation for a fund center the fund promoter plans to use is essential.

The investment process is about assets, strategies, and portfolio management so let us now look at all of these.

This activity is reconciled and then recorded in the records and accounts of the fund by the administrator who will also be involved in the calculation and publication of the NAV etc.

The assets the investment manager can utilize have characteristics that will determine the potential return from those assets, for example:

Equities offer growth (capital increase) and income (dividends).

Debt offers income (risk based and possibly some capital gain).

Money market instruments offer income over a short time.

The instruments used in these assets can be highly liquid or very illiquid and this will impact on the strategies employed by the manager.

Property or Real Estate is a medium to long term investment either direct into retail (apartments, houses) or commercial properties (offices, shopping malls, warehouses) or through shares in property company and construction company shares, land and land company shares etc. In general terms, property is an illiquid asset as the time to complete a purchase or sale can be significant. In Europe UCITS funds are usually prohibited from investing in physical property because of the liquidity issue. However the asset offers both growth and income through the possible rental generation from the properties.

Commodities are based on softs like agricultural products and also on metals, energy etc. that can offer high volatility and therefore capital gain potential.

Alternative investments are assets like antiques, wine, art etc. and like commodities and property, these will need specialist skills and knowledge at both investment and support level.

However earlier we looked at Islamic finance and saw that conventional interest paying bonds are not Sharia compliant however in Islamic finance, we do have a term Sukuk.

A sukuk can be described as Islamic bonds but of course riba is prohibited. Instead sukuk holders receive return based of participation, for example, a manager creates a SPV that holds the sukuk for investors and pays a return based on the investment or participation that the sukuk holder’s capital has been placed in. Naturally, the investment must be Sharia compliant.

It is also clear that an administrator and custodian that provide services to Islamic funds must have the knowledge of Sharia and understand Islamic finance.

We can look at an example of this here:

This process will require the investment manager(s) to comply with any constraints imposed by either regulation or internal policies such as exposure limits, diversification, use of strategies etc.

As mentioned earlier, most investment management processes include research, which can be done inhouse and/or bought in from external analysts, for example, the prime broker.

As well as seeking capital gain from increasing value of the assets and income from, for example, dividends and interest, the investment manager may also seek to generate income from activities like securities lending as well as where permitted, the writing of options to generate premium (the fee the buyer of the option pays to secure the right).

The structure of the portfolio, use of assets, and the strategies employed will generate the workflows that the custodian and the administrator will process.

Assets are allocated into asset classes like equity or debt or commodities and then geographically and finally by sector.

Portfolios can have static or virtually static assets like for instance a tracker fund or be managed so that changes take place to the component parts of the portfolio when targets are realized or market conditions prompt change.

In general terms, we can say that portfolio management involves:

The administrator and custodian will be involved in the workflow associated with the portfolio.

The custodian will be dealing with the settlement of the securities asset trades and potentially other forms of assets as well as dealing with servicing the assets in respect of, for example, corporate actions. Derivatives, commodities etc. may be electronic positions or physically may settle and be held by a clearing broker.

For funds with a depositary, the depositary will be responsible for oversight of the cash management process related to the purchases and sales and associated income or expense items. A depositary under the AIFMD is defined as having duties related to safekeeping of assets, cash management and oversight of leverage, risk management, and regulatory reporting.

The administrator will have a key or primary reconciliation to undertake between the records of the investment manager and those of the custodian and the prime broker or other agents like derivatives brokers and counterparties.

In addition the administrator will need to make sure that any entitlements for and changes to assets as a result of corporate actions have been correctly updated in the fund records.

Finally, the administrator may be involved in monitoring activity in the portfolio to ensure compliance with any regulatory requirements, offering document or policy restrictions, and constraints.

The whole basis of investment performance can be described simply as:

The investment universe might be described as in Diagram 1.8:

Within this universe the investment managers analyze the instruments available, the risk and return of the instruments, and the cost of buying and selling the instrument plus expenses such as brokerage commission.

The fund’s performance will be based either on the index of benchmark it tracks or on the success of the asset allocation in an actively managed fund.

We can summarize the investment performance as being a combination of the following items in relation to the portfolio and operational costs of the fund:

For the investor a key performance indicator is the net asset value of the fund which is derived from the following:

Note: only realized gains and income can be distributed to investors.

The way in which a fund’s performance is analyzed through the use of what is called contribution calculation and also using ratios.

Measuring performance is therefore about

Let us look at an example in Table 1.1.

The investment manager is permitted to use tactical asset allocation and so the end performance of the fund is as shown in Table 1.2.

So the fund has outperformed the benchmark by 0.10% however it is important to know how this outperformance was achieved so we look at the contribution the TAA made in Table 1.3.

This table shows us that actually each of the revised positions in the asset classes achieved a minus contribution which therefore begs the question how was a 0.10% outperformance achieved?

The answer is that the individual stock selections were outstanding and still managed to deliver a higher return despite the TAA.

The performance of a fund is obviously vitally important to the investor but also to the manager as they may be participating in a performance fee arrangement.

This is a method that rewards the investment manager for generating a return for the fund.

It is included in the investment management agreement and details are also contained in the offering documents of the fund.

Criteria exist such as “high water mark” and “hurdle rate,” which must be met before any performance fee becomes due.

The administrator will be involved in the calculations to determine if a fee is due and to then make the payment and adjust the fund records accordingly. The payment of a fee will have the impact of reducing the NAV of the fund and so the administrator may also be involved in a process called equalization, which attempts to ensure that each investor irrespective of when they entered the fund pays the right share of any performance fee. An excellent article by Dermot Butler explains this process and can be found at http://www.customhousegroup.com/speech/equalization-why-is-it-necessary-how-it-works/.

There are many useful websites that offer comparison of fund performance such as; http://funds.ft.com/uk/.

In addition, there may be initial fees and exit fees (in the United States and elsewhere known as “front-” and “back-end loads”).

Let us look at the different fees in more detail.

It is essential that anyone working in administration, custody or fund support understands the investment environment.

To assist with the learning process you may like to look at the questions relevant to this part of the book, which can be found at the end.

In the next Part of the book, we look at the regulatory environment for funds and also at fund structures in more detail.