Pooled Investment Vehicles

An investment vehicle refers to the type of account(s) used to hold an individual's investments or the ownership structure. There are two primary options: commingled or pooled investment vehicles and separately managed accounts (SMAs). Each has its own unique set of advantages and disadvantages.

Pooled Investment Vehicles

In a pooled or commingled vehicle, the money from multiple investors is held as a single portfolio and managed without customization for any investor. Such vehicles include:

• Open-end funds.
• Closed-end funds.
• Exchange-traded funds.
• Exchange-traded notes.
• Hedge funds.

Pooled investment vehicles enjoy economies of scale. This is true in terms of operational burden, as well as making larger trades at better prices due to higher volume. The disadvantage is that they provide no opportunity for customization, and individual owners can sometimes influence other accounts unwittingly (sudden withdrawal decisions, etc.)

Separately Managed Accounts (SMAs)

A separately managed account (SMA) vehicle holds the money in a segregated account in the investor's name. The funds are managed to a particular mandate with the potential to customize the strategy for each investor.

SMA Advantages

The advantages of SMA vehicles include the following:

Ownership: In an SMA, the investor owns the individual securities directly, which has the benefit of not being affected by the redemption decisions or influences of other investors at the firm. An SMA also provides clear legal ownership for the recovery of assets resulting from unforeseen events, such as bankruptcy or mismanagement.

Customization: SMAs allow the investor to potentially express individual constraints or preferences within the portfolio. It is not a one-size-fits-all approach.

Tax efficiency: SMAs offer customization, which allows for the pursuit of tax-efficient strategies based on the particular client's needs. This can be particularly important for tax-sensitive clients, often high-income earners or retirees who live in high-tax jurisdictions.

Transparency: SMAs offer real-time, position-level detail to the investor, providing complete transparency and accurate attribution to the investor. Even sophisticated pooled vehicles present some delays.

SMA Disadvantages

• Operational Cost: Separate accounts represent an additional operational burden on the manager, which translates into potentially higher costs for the investor. With an SMA, a new account must be established for each investor, and ongoing monitoring is required at an individual account level.
• Trading Costs: SMAs are likely to face higher transaction costs when trades cannot be aggregated to reduce trade volumes (i.e., block trading is not always possible).
• Tracking risk: Customization of the strategy creates tracking risk relative to the benchmark, which can confuse attribution because performance will reflect investor constraints rather than manager decisions.
• Investor behavior: Transparency, combined with control and customization, allows for potential micromanagement by the investor—that is, the investor attempting to manage the portfolio, which renders the hiring of the manager useless and can lead to sub-optimal investment decisions. Potential investor behaviors include:
  1. Performance chasing.
  2. Familiarity bias (being overly averse to unfamiliar holdings).
  3. Loss aversion (a tendency to disaggregate the portfolio and not appreciate the value of hedging).

Considerations in Choosing the Appropriate Account Type

The allocator's goal is to evaluate the costs and benefits of the vehicle used and judge its suitability for the IPS:

Does the vehicle fit the investment process? Does the manager have the operational infrastructure necessary to manage the SMA? Is there a benefit to holding the securities in a separate account? If so, a cost-benefit analysis may be necessary. Is tax efficiency an important objective of the IPS? Are there concerns that the available transparency and ability to customize will result in decisions by the investor that do not add value?

Question

Which of the following is most likely an advantage of a hedge fund?

1. Block trading potential.
2. Customization.
3. Clear ownership.

Solution

The correct answer is A.

Commingled or pooled funds have the advantage of economies of scale. Choice A refers to the kind enjoyed during trading.

B and C are incorrect. Both are advantages of SMAs.

Reading 13: Investment Manager Selection

Los 13 (f) Evaluate the costs and benefits of pooled investment vehicles and separate accounts