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SMA Conflict of Interest


DeepValuePlay
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Hi everyone,

 

I'm establishing a small hedge fund and for tax reasons I will need to manage my own account separately from the fund (I live outside the US).

The intent is to manage my personal account as similarly as possible to the hedge fund.

Some LPs have voiced concerns regarding conflict of interests. For example - when a new investment presents itself who will buy it first - the fund or my personal account (assuming there is potential that such buying might raise the price for low volume stocks)?

 

I'm trying to think of a fair mechanism and was wondering how does the Separately Managed Accounts industry handles this potential conflict and avoids favoring a specific account...

 

Any input would be highly appreciated!

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I really wish I could.

The mechanism through which LPs invest in the HF allows them to postpone taxes on profits in the HF until they withdraw the funds - which is a huge compounding advantage.

Unfortunately, as the fund manager the taxes I would pay on profits of my own investment in the fund would be 50% and I would have to pay it at the end of every year which is devastating from a compounding point of views and deifies the purpose. Using a personal account which is separate from the HF allows me to enjoy the same tax advantage that my LPs receive. So, the tax implications of me investing in the HF are catastrophic and so I don't feel that's a valid option.

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If you manage both accounts with IB you can specify that you want to split allocations according to the net liq of each account (or another predefined ratio - some info). That could solve the technical aspect of your question. Maybe such a solution also solves the 'trust' issue if you and your LP's agree upon a certain allocation method and if you can show your clients at the end of the year that you did all your trades that way (I'm not sure if that's supported in IB reporting).

 

Alternatively if you want to manage a large amount of outside money just put your own savings in a Vanguard funds - easiest way to avoid any conflict of interest. I think you need a clear-cut solution, anything that is in the grey area where you 'promise to have the intent to do things as good as is reasonably possible' is asking for problems further down the road.

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Alternatively if you want to manage a large amount of outside money just put your own savings in a Vanguard funds - easiest way to avoid any conflict of interest. I think you need a clear-cut solution, anything that is in the grey area where you 'promise to have the intent to do things as good as is reasonably possible' is asking for problems further down the road.

Except who wants a HF manager that doesn't have its own money at risk?

 

The cleanest solution is probably setting up a offshore hedge fund with a master feeder structure so both US investors and international investors can participate in the fund in a tax efficient way: that's how all the other (big) funds do it. The big downside is that this structure isn't cheap to set up and maintain, and since you would presumably be starting with a limited amount of money it might just be too expensive.

 

So the other option is what what advisors do with SMA, using a broker that supports automatic trade allocations based on certain rules. It will absolutely not solve all your problems though, because taxes for example, will seriously complicate things. The international account probably doesn't have short-term/long-term capital gains, or not the same system as in the US. Companies that are classified as a PFIC would be a major tax headache for US based investors, but no problem for you. Dividend taxes aren't equal. If you go this road, no matter what you do it will be messy. So there needs to be trust that you try to do your best to do things in an ethical way.

 

The mechanism through which LPs invest in the HF allows them to postpone taxes on profits in the HF until they withdraw the funds - which is a huge compounding advantage.

I'm not a US tax expert, but I think this is 100% wrong. Otherwise everybody in the US would put all their money in a hedge fund, and people would defer capital gains taxes indefinitely. That's why these PFIC rules exist in the first place, making it also impossible to put money offshore  in a fund and defer capital gains taxes.

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I agree with longlake.  IMO, any new ideas should go to the fund first, you have an obligation to your shareholders before yourself, then if after you have a full position for them, there is some available for your personal account then you can buy some. 

 

Packer

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I think that's also quite a reasonable approach, but also not perfect. What about those positions you never manage to acquire a full position for the fund, without ever getting a position in your own account? If that position end up going up a lot I'm sure your LPs are fine with it, but what about when it goes down -100% overnight?

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Except who wants a HF manager that doesn't have its own money at risk?

 

I agree with longlake.  IMO, any new ideas should go to the fund first, you have an obligation to your shareholders before yourself, then if after you have a full position for them, there is some available for your personal account then you can buy some. 

 

Both good points. Ignore my stupid advice about index funds.

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I think that's also quite a reasonable approach, but also not perfect. What about those positions you never manage to acquire a full position for the fund, without ever getting a position in your own account? If that position end up going up a lot I'm sure your LPs are fine with it, but what about when it goes down -100% overnight?

 

What Hielko said. Same issue with selling: sell yours first or clients' first? Both could lead to better/worse results for clients.

 

Ultimately it's an issue of trust: either your clients trust you or they don't. If they don't, doing the right things may help but may not. If a client wants to distrust you, they can always find a reason.

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That said; I think it's quite reasonable to expect that buying your clients positions first, and selling them first has the best expected outcome for them and should be a good and fair mechanism, if doing things pro-rata is too complicated.

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That said; I think it's quite reasonable to expect that buying your clients positions first, and selling them first has the best expected outcome for them and should be a good and fair mechanism, if doing things pro-rata is too complicated.

 

You realize that what you wrote is self contradictory?

 

Assume stock is rising. Then buying client positions first is better, but selling them first is worse.

Assume stock is falling. Then buying client positions first is worse, but selling them first is better.

 

You are assuming at least one of two things:

1. That your purchases/sales influence market price more than the overall trend does. Which might be true for microcaps, but it's not true in general.

2. That you will be buying on uptrend and selling on downtrend, which would be very lucky but not achievable in real life.

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I think that's also quite a reasonable approach, but also not perfect. What about those positions you never manage to acquire a full position for the fund, without ever getting a position in your own account? If that position end up going up a lot I'm sure your LPs are fine with it, but what about when it goes down -100% overnight?

 

What Hielko said. Same issue with selling: sell yours first or clients' first? Both could lead to better/worse results for clients.

 

Ultimately it's an issue of trust: either your clients trust you or they don't. If they don't, doing the right things may help but may not. If a client wants to distrust you, they can always find a reason.

 

The industry standard is that clients accounts are traded first. This is enshrined in regulations and in things like the CFA rules. It doesn't matter whether the client gets a better price or not: you can't control that. All you can do is trade for them first and avoid front-running.

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I think that's also quite a reasonable approach, but also not perfect. What about those positions you never manage to acquire a full position for the fund, without ever getting a position in your own account? If that position end up going up a lot I'm sure your LPs are fine with it, but what about when it goes down -100% overnight?

 

You're just personally out of luck here if you miss out on the upside. Clients have to come first and you'll get your fees anyway.

 

If you miss out on the downside and your clients don't, well, you made a mistake. That is the risk the clients are taking.

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I think that's also quite a reasonable approach, but also not perfect. What about those positions you never manage to acquire a full position for the fund, without ever getting a position in your own account? If that position end up going up a lot I'm sure your LPs are fine with it, but what about when it goes down -100% overnight?

 

What Hielko said. Same issue with selling: sell yours first or clients' first? Both could lead to better/worse results for clients.

 

Ultimately it's an issue of trust: either your clients trust you or they don't. If they don't, doing the right things may help but may not. If a client wants to distrust you, they can always find a reason.

 

The industry standard is that clients accounts are traded first. This is enshrined in regulations and in things like the CFA rules. It doesn't matter whether the client gets a better price or not: you can't control that. All you can do is trade for them first and avoid front-running.

 

Well if it's industry standard and is in regulations, that's another story.  8) Have to do what regulations and rules say.  8)

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That said; I think it's quite reasonable to expect that buying your clients positions first, and selling them first has the best expected outcome for them and should be a good and fair mechanism, if doing things pro-rata is too complicated.

 

You realize that what you wrote is self contradictory?

 

Assume stock is rising. Then buying client positions first is better, but selling them first is worse.

Assume stock is falling. Then buying client positions first is worse, but selling them first is better.

 

You are assuming at least one of two things:

1. That your purchases/sales influence market price more than the overall trend does. Which might be true for microcaps, but it's not true in general.

2. That you will be buying on uptrend and selling on downtrend, which would be very lucky but not achievable in real life.

 

I think you are wrong with your assumptions. Your implicit assumption is that you can predict tomorrow's prices based on today's move. What is a 'rising stock'? A stock that goes up next week? If so, why would you sell it at all? Same for buying a 'falling stock'. Better to think of stock prices as opportunities. If you think it's too cheap / too expensive it is an opportunity and it seems unethical to act on that opportunity for yourself before you act on it for your LP's. What happens afterwards is anyone's guess. And if you think an opportunity will be even better tomorrow than today (because of a perceived uptrend / downtrend) why would you act on it today for yourself or for your LP's?

 

 

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That said; I think it's quite reasonable to expect that buying your clients positions first, and selling them first has the best expected outcome for them and should be a good and fair mechanism, if doing things pro-rata is too complicated.

 

You realize that what you wrote is self contradictory?

 

Assume stock is rising. Then buying client positions first is better, but selling them first is worse.

Assume stock is falling. Then buying client positions first is worse, but selling them first is better.

 

You are assuming at least one of two things:

1. That your purchases/sales influence market price more than the overall trend does. Which might be true for microcaps, but it's not true in general.

2. That you will be buying on uptrend and selling on downtrend, which would be very lucky but not achievable in real life.

 

I think you are wrong with your assumptions. Your implicit assumption is that you can predict tomorrow's prices based on today's move. What is a 'rising stock'? A stock that goes up next week? If so, why would you sell it at all? Same for buying a 'falling stock'. Better to think of stock prices as opportunities. If you think it's too cheap / too expensive it is an opportunity and it seems unethical to act on that opportunity for yourself before you act on it for your LP's. What happens afterwards is anyone's guess. And if you think an opportunity will be even better tomorrow than today (because of a perceived uptrend / downtrend) why would you act on it today for yourself or for your LP's?

 

I am not saying I can predict tomorrow's prices. But I am saying that assumption that buying/selling for clients first is best is not necessarily correct. In fact, depending on your style of investing, it could be wrong more than right. Edit: I'm somewhat just referring to the old value investing trope that value stock continues falling after you buy it and continues rising after you sell it.

 

But since I've been told that there are rules and regulations, I'm just gonna say that OP should follow them.

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Maybe you're overthinking this.

 

What's the end goal here? To do well for yourself correct? And you do that primarily by building a business and harvesting fees from clients.  Unless you have some giant pot of money that dwarfs your fund, and in that case why do you have a fund... clients and the fund come first.

 

Say you have $300k in personal wealth and $10m in the fund with a 2/20.  You do 10% on the year, and personally earn $30k on your funds, and $200k in management fees, and another $200k in performance fees.  You earned $400k vs $30k.  Why are you even worried about your own account?  Dump 10% of your fees into your fund and you suddenly "outperformed" the market.

 

Obviously the math has a tipping point the lower your AUM, but from what I understand $10m is where you need to start these days.

 

If the case is you have a few million then spend the extra money and get your cash in the fund with investors.

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I think that's also quite a reasonable approach, but also not perfect. What about those positions you never manage to acquire a full position for the fund, without ever getting a position in your own account? If that position end up going up a lot I'm sure your LPs are fine with it, but what about when it goes down -100% overnight?

 

You're just personally out of luck here if you miss out on the upside. Clients have to come first and you'll get your fees anyway.

 

If you miss out on the downside and your clients don't, well, you made a mistake. That is the risk the clients are taking.

Sure, but the point is that clients want you to be sharing in their risks. They don't want you to miss out on the downside! (and presumably also not on the upside, although arguably less important for them)

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I am actually surprised that OP can get a hedge fund off the ground in the US even though he does not live in the US. It seems to me that his investors must already place a decent amount of trust into him, since he could well defraud them and perhaps never get caught ( depending on where he lived).

 

In that case, I would just put the personal account into an index fund in his home country. A cynical person would say thet by doing so, he will likely outperform his clients  ::).

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I am actually surprised that OP can get a hedge fund off the ground in the US even though he does not live in the US.

 

I don't think he said that his hedge fund is/will be in US. Some people assumed that but I would have guessed it's not in US.

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I think that's also quite a reasonable approach, but also not perfect. What about those positions you never manage to acquire a full position for the fund, without ever getting a position in your own account? If that position end up going up a lot I'm sure your LPs are fine with it, but what about when it goes down -100% overnight?

 

The outcome doesn't speak to the ethics or the appropriateness of the approach.

 

Buy for the clients first. Sell for the clients first. Do your PA later.

 

In some instances clients will do better. In some instances clients will do worse. The goal isn't to make sure clients are guaranteed the best outcome in every case - the goal is to make sure the conflict is eliminated which is done IF the fund's buys/sells are executed first.

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  • 1 month later...

I am actually surprised that OP can get a hedge fund off the ground in the US even though he does not live in the US.

 

I don't think he said that his hedge fund is/will be in US. Some people assumed that but I would have guessed it's not in US.

 

That is correct - the fund will be based in the Cayman Islands for tax purposes. Both me and all of the investors are residents of the same non-US country.

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I wanted to thank the forum for all of the feedback. For technical reasons I don't believe I can use a broker to allocate the purchases to both accounts.

 

I was thinking about avoiding the possibility of front running by buying / selling first in the fund but was happy to hear this is industry standard. If anyone can link to the CFA document that mentions that standard that would be extremely helpful.

 

To those who suggested I invest my PA in indexes - that defies the purpose on so many levels LOL.

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...

I was thinking about avoiding the possibility of front running by buying / selling first in the fund but was happy to hear this is industry standard. If anyone can link to the CFA document that mentions that standard that would be extremely helpful.

...

https://www.cfainstitute.org/-/media/documents/study-session/2018-l1-readings.ashx?la=en&hash=CF0C95241ECE0CB2F0A4F70F94D6CBA5E3E0FB00

Section VI: Conflicts of interest    B. Priority of transactions

http://www.portfoliomanagement.org/wp-content/uploads/2011/04/CFA-code.pdf

Section C: Trading  2. Priority

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