Managed Products 23

CHAPTER OUTLINE
In this chapter, you will learn about several types of managed products and the role they play in an investment
portfolio. You will learn the features and uses of mutual funds, wrap products, exchange-traded funds, and hedge
funds. We discuss the impact of fees, portfolio turnover, and taxes on managed product returns. We also discuss the
concept of overlay management, in which a single wealth manager oversees the management of multiple managed
accounts. Finally, you will learn about outcome-based investments, which differ from traditional investments in that
they are designed to achieve a specific client goal.

LEARNING OBJECTIVES CONTENT AREAS

1 | Explain the role of managed products within a client’s The Role of Managed Products in
portfolio. Investment Management

2 | Explain the features and applications of mutual funds Mutual Funds

and platform-traded funds.

3 | Explain the features and applications of wrap products. Wrap Products

4 | Explain the types, the risks, and the investment Exchange-Traded Funds
strategies related to exchange-traded funds.

5 | Describe the key areas of due diligence regarding Hedge Funds

hedge fund investment.
6 | Describe the role of hedge fund service providers.
7 | Explain the process for including hedge funds in a
client’s portfolio.

8 | Discuss the impact of fees, portfolio turnover, and Fees, Portfolio Turnover, and Taxes
taxes on managed product returns.

9 | Describe the skills required for successful overlay Overlay Management

management.

10 | Compare outcome-based investments to traditional Outcome-Based Investments

investments.

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KEY TERMS

The Key Terms list targets some significant concepts covered in the textbook. Key terms appear
in bold text in each chapter to help you focus your study efforts on these important topics.

core and satellite overlay management

funds of funds portfolio turnover

high-water mark separately managed account

hurdle rate separately managed wrap

managed asset superficial loss rule

managed product unified managed account

management fees unified managed household account

mutual fund wrap account

net asset value per share wrap fund

offering memorandum wrap product

outcome-based investments

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INTRODUCTION
Over the past few decades, managed products have exploded in popularity with both advisors and clients. Managed
products are ideal tools to help clients achieve their goals because they allow for immediate diversification in a vast
array of different portfolio types. In some types of managed products, there is a low minimum investment amount
which allows smaller investors to achieve the benefits of diversification. Many wealth advisors also use managed
products in tactical asset allocation, adding important alpha to the otherwise straightforward job of maintaining
a client’s strategic asset allocation. Portfolio managers with the proper skill and expertise can tailor managed
products to almost any investor need. An important consideration is the cost of holding managed products
compared to the cost of holding individual equity and debt securities. It is also important to consider the benefits
and drawbacks of having a single overlay manager oversee the management of multiple managed accounts.
Before you begin, read the scenario below, which raises some of the questions you might have about managed
products. Think about these questions, but don’t worry if the answers don’t come easily. At the end of the chapter,
we will revisit the scenario and provide answers that summarize what you have learned.

MANAGING THE LEWIS-MAIER HOUSEHOLD’S INVESTMENTS

As the advisor to Mark Lewis and Karl Maier, you are now in a position to provide them with specific investment
recommendations for their sizable portfolios, which comprise both registered and non-registered investments.
Mark and Karl are a married couple. They are newly retired and wish to generate solid after-tax income. They are
in excellent health, so they expect to live for another 20 to 30 years, and they wish to leave a substantial estate
to their heirs. Much of the investment funds they transferred to you were in the form of cash from redeemed
underperforming and high-cost managed portfolios that their previous advisor had recommended. They also
own some bonds and blue chip equities. Mark is a very knowledgeable investor, so Karl leaves most decisions
to him.

• How can managed products be used to help the Lewis-Maiers’s achieve their goals? What aspects of these
products should you, as their advisor, be most aware of to ensure that their portfolio return is maximized?
• Your clients require significant cash flow from their portfolio. What else do they require? What specific managed
products can they use to ensure that their portfolios meet their investment goals?
• As their advisor, what do you need to do to ensure that you are choosing the right managed products and
performing your role as an overseer of your clients’ portfolios? What evidence do you need to be assured that
the managers of the investment products you are recommending to your clients are meeting their mandate and
performance goals?

THE ROLE OF MANAGED PRODUCTS IN INVESTMENT MANAGEMENT

1 | Explain the role of managed products within a client’s portfolio.

A managed product is a pool of capital gathered and invested in a portfolio of individual securities according to a
specific investment mandate. This mandate is carried out and monitored by a professional money manager, who
receives a management fee for performing this service.
For our purposes, the definition of managed products goes beyond individual products and includes what we call
managed assets. This burgeoning sector of the business includes mutual funds, wrap funds, wrap accounts, fee-
based brokerage, and discretionary accounts. These products were once the domain of the ultra-rich. Today, they are
available to most investors, and their popularity among advisors and clients continues to grow.

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Not all advisors use managed products, and those who do, use them in different ways. Some advisors rely
exclusively on managed products to create client portfolios; others use them to form a part of their clients’
portfolios. There is no “correct” mix of managed products and individual securities in a client’s portfolio. The choice
of whether, and how extensively, to use managed products depends on the client’s needs.
One consideration is the size of the client’s portfolio and the need for diversification. Clients with relatively small
portfolios may not be able to buy enough individual securities to achieve adequate diversification. Managed
products allow for the diversification they need.
Transaction costs are another consideration. Bid/ask spreads on individual securities such as bonds can be large,
relative to the size of the trade. This cost is a disadvantage for clients attempting to enter a particular market with
only a small amount to invest. High transaction costs on individual securities also make certain types of managed
products, especially mutual funds, an ideal investment for clients looking to invest money on a regular basis.
Finally, clients who want to invest in individual securities outside Canada and the United States may have difficulty
finding a broker who can carry out trades in a foreign country. It can also be difficult to get adequate information
about foreign securities. For these clients, managed products consisting of foreign securities may offer a solution.

MUTUAL FUNDS

2 | Explain the features and applications of mutual funds and platform-traded funds.

A mutual fund is an open-ended investment company, structured either as a corporation or a trust, that raises
capital by issuing shares (in the case of a mutual fund corporation) or units (in the case of a mutual fund trust). (For
the sake of brevity, we’ll use only the term “units” for the remainder of this chapter.) The capital is used to purchase
securities according to the fund’s investment mandate.
Mutual funds are in a continuous state of distribution. Investors can buy a fund’s units from the fund itself or
redeem units by selling them back to the fund. They can place an order to buy or sell during any business day on
which the Canadian markets are open for trading. At the time the order is entered, however, the investor does not
know the price at which the transaction will occur because the price is determined after the Canadian markets have
closed. The price of a mutual fund on any given business day is known as its net asset value per share (NAVPS).
The NAVPS, excluding commissions, is determined by adding up the value of the securities held by the fund,
subtracting the fund’s liabilities, and then dividing by the number of units outstanding.
The classification of mutual funds in Canada is carried out by the Canadian Investment Funds Standards Committee
(CIFSC) which comprises Canada’s major mutual fund database and research firms. Because there are no industry-
standardized categories for mutual funds in Canada, the CIFSC has a self-imposed mandate to standardize the
classifications of Canadian-domiciled mutual funds.

DIVE DEEPER

More information about the various categories for Canadian-domiciled mutual funds can be found on
the CIFSC website.

PLATFORM-TRADED FUNDS
Platform-traded funds (PTFs) are listed in Canada on Cboe Canada. Those PTFs currently listed include both mutual
funds offered by a prospectus and investment funds offered by an offering memorandum. Several of the PTFs listed
are a class or series of an existing investment fund.

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A PTF is traded at the fund’s end-of-day net asset value per share or unit. A PTF structure allows investment dealers
to make bulk trades in the fund across many accounts. This process can simplify the administration process for the
fund company and the dealer, which should result in lower fees for the client, such as a lower management expense
ratio.

WRAP PRODUCTS

3 | Explain the features and applications of wrap products.

Wrap products include wrap funds and wrap accounts, which are defined as follows:

• Wrap funds are portfolios of managed products “wrapped” together and sold as a single product.
• Wrap accounts are accounts for which a qualified portfolio manager is authorized to select securities and
execute trades on behalf of a client. The securities can include mutual funds, pooled funds, or individual
securities such as stocks and bonds.

Wrap products, often referred to as portfolio solutions, have become very popular in the last few years. They have
been marketed as a way for advisors to spend less of their time selecting investments for their clients and more on
providing services such as retirement, estate, and tax planning.
There are two basic types of wrap products: funds of funds (FoFs) and separately managed wraps.
Funds of funds invest in portfolios of other managed products, usually mutual funds. Investors purchase units of the
FoF, but they have no say over which funds go into the FoF or the weighting of those funds within the FoF. Most FoFs
are designed to target a specific risk profile, which determines the relative weighting of the underlying funds.

EXAMPLE
A conservative FoF will have a greater weight in mutual funds that invest in debt securities than it will in mutual
funds that invest in equity securities.

Separately managed wraps (or simply wrap accounts) target investors with higher levels of investable assets.
Accounts are managed on a segregated basis, thereby enabling the client to own individual securities. Clients
can select from a range of professional money managers to manage their portfolios. Wrap accounts have higher
minimum investment requirements than other wrap products, usually starting in the $150,000 range.

EXCHANGE-TRADED FUNDS

4 | Explain the types, the risks, and the investment strategies related to exchange-traded funds.

Exchange-traded funds (ETFs) are increasingly becoming an important part of both individual and institutional
investor portfolios primarily due to their cost effectiveness, liquidity, real-time transparency, and the opportunities
they provide to access a variety of markets.
In this section, you will learn about certain types of ETFs and the specific risks associated with the use of derivatives,
leverage, or commodities by ETFs. We also discuss international ETFs, the tax consideration of foreign investments
held in an ETF, along with some ETF investment strategies.

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TYPES OF ETFs
Four types of ETFs are particularly important to our discussion: synthetic, leveraged, inverse, and commodity.

SYNTHETIC ETFs
Synthetic ETFs are different from other ETFs in that they do not hold the same underlying exposure as the index
they track. Synthetic ETFs are constructed with derivatives such as swaps to achieve the return effect of the index.
As a result, the exposure of synthetic ETFs is notional, rather than real.
Swaps are over-the-counter (OTC) derivatives that are privately negotiated between two counterparties. They
can be thought of as a series of forward contracts and are subject to the same pricing factors, namely cost of carry
(which include such costs as financing, storage, and insurance). Simply put, each counterparty agrees to swap fixed
and variable cash flows based on the price of a reference asset over a set period.
Swap-based synthetic ETFs are less transparent to the retail investor than their physical versions, where the
underlying assets (consisting of stocks, bonds, or bullion) are held in trust. Exchange-traded funds that use swaps are
exposed to counterparty risk, which is the risk that the counterparty will no longer be able to meet its obligations.

LEVERAGED ETFs
Like synthetic ETFs, leveraged ETFs use derivatives such as swaps to achieve the leveraged return effect. The
portfolio transparency of leveraged ETFs is similar to that of synthetic ETFs.
Leveraged ETFs are designed to achieve returns that are multiples of the performance of the underlying index they
track. The use of leverage, or borrowed capital, makes them more sensitive to market movements. The fund uses
borrowed capital, in addition to investor equity, to provide higher exposure to the underlying index. Typically, a
leveraged ETF uses two dollars of leverage for every dollar of investor capital. The goal is to generate a return made
with the borrowed capital that exceeds what it costs to acquire the capital itself.

EXAMPLE
A leveraged ETF might attempt to achieve a daily return that is two times the daily return of the Standard &
Poor’s (S&P) 500 index.

The challenge with these structures is that they are path dependent, which means that longer holding periods can
create differences between an expected and realized return.

CREATION AND REDEMPTION PROCESS OF A LEVERAGED ETF

The format of a leveraged ETF shares some similarities with that of a standard ETF; however, it differs in certain
ways, including in the examples described below:

Increased supply If there are enough units selling in the open market, the market maker forms a creation
unit and redeems it for cash from the ETF. The ETF, in turn, raises the cash by selling off
some of its swap position in the OTC derivatives market. The ETF unit is cancelled at the
day-end NAV to cover the long position of the market maker or designated broker.

Increased demand Cash is given by the designated broker to the ETF sponsor. The sponsor, in turn, issues
ETF units to the broker and uses the cash to increase the swap position. ETF units are
issued at the day-end NAV to cover the broker’s short position.

EXAMPLE
An example of a leveraged ETF is the ProShares Ultra S&P 500, which attempts to deliver daily investment results
that correspond to twice the daily performance of the S&P 500.

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INVERSE ETFs
Inverse ETFs can be constructed with derivatives such as swaps to achieve an inverse return effect.

EXAMPLE
An ETF could be based on a $300 million value swap with a 10-year term referenced to the S&P 500. During the
swap’s term, the ETF sponsor makes periodic fixed payments in return for variable payments received every time
the S&P 500 declines.

The portfolio transparency of an inverse ETF is similar to that of leveraged and synthetic ETFs. Inverse ETFs can be
either leveraged or unleveraged.

EXAMPLE
An example of an inverse ETF is the Horizons BetaPro S&P/TSX 60 Daily Inverse ETF that seeks to replicate (net
of expenses) the inverse daily performance of the S&P/TSX 60 Index.

Inverse ETFs, whether leveraged or not, are highly complex financial instruments, as are leveraged ETFs. Both
leveraged and inverse ETFs are typically designed for trading during the day. Because of the effects of compounding,
their performance over longer periods can differ significantly from their stated daily objective. Therefore, leveraged
and inverse ETFs that are reset daily are typically unsuitable for retail investors who plan to hold them for longer
than one trading session. It is particularly unsuitable to hold them for longer periods in volatile markets.

CREATION AND REDEMPTION PROCESS OF AN INVERSE ETF

The creation and redemption process for an inverse ETF is similar to the leveraged ETF process. Cash, rather than
securities, is exchanged.

COMMODITY ETFs
There are three types of commodity ETFs: physical-based, futures-based, and equity-based. Each type offers exposure
to the respective commodity; however, they all present challenges in providing access to the spot price of a
commodity, as described below:

Physical-based ETFs Physical-based ETFs invest in the commodity directly. This structure has the benefit of
closely matching the spot price, but it is affected by the cost of carrying the commodity.
Carrying costs include those of storage, insurance, and interest.
Physical ETFs are limited to only a few non-perishable commodities that are storable,
such as gold and silver. Commodities such as energy are not economical to store because
of the large volume of storage space required. Agriculture-based commodities are
perishable and thus are not suitable for physical exposure in an ETF.

Futures-based ETFs Futures-based ETFs invest in futures contracts of different commodities, with an
underlying portfolio of money market instruments to cover the full value of the
contracts.
The futures contract represents the buyer’s right to take possession of the commodity
at a specified future time for a price agreed upon today. As near-term futures contracts
approach expiration, they are rolled over into more distant contracts. In a normal
market, the distant contracts are priced higher to reflect the underlying commodities’
cost of carry. As such, rolling over the contracts in a normal market can result in a roll
yield loss. This loss affects the performance of the ETF to the same extent (although less
explicitly) as the costs incurred by physically holding the commodity.

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Equity-based ETFs Equity-based ETFs invest in listed companies that are involved in exploration and
development or in the processing or refining of a commodity. Because they are
constructed with equities, many factors may affect corporate performance. The
price movement of the commodity is only one of these factors, albeit an important
one. The equity price is also affected by the stock market trend as a whole. As such,
commodity-based equities, and the ETFs based on them, often are not great proxies for
the underlying commodity price. If an investor is looking for more of a pure play on the
underlying commodity price, futures-based and physical-based ETFs are generally more
effective.

Physical holdings in a commodity ETF are quite transparent; they simply have commodity holdings in designated
warehouses and vaults. The transparency of securities holdings in a commodity ETF using derivatives depends on the
type of replication the ETF sponsor is using. Visibility is clear if the ETF uses exchange-traded futures. It is less clear if
the ETF portfolio uses a complex set of OTC derivatives.

EXAMPLE
An example of a commodity ETF that is based on the physical holding of a commodity is the State Street SPDR
Gold Shares ETF. The underlying assets consist of gold bullion stored in secure vaults. Accordingly, the price of
this ETF can be expected to move in lockstep with spot gold prices.

CREATION AND REDEMPTION PROCESS OF A COMMODITY BASED ETF

Physical-based ETFs typically use in-kind exchange during the creation and redemption process.

EXAMPLE
Institutional investors in the SPDR Gold Shares ETF can create units only in exchange for institutional-quality-
grade gold bars.

Derivatives-based ETFs can use either the in-kind redemption or the cash creation process. Futures-based ETFs use
in-kind redemption because the futures contracts are based on commodities that are fungible (i.e., identical in all
markets). Over-the-counter derivatives-based ETFs use cash creation because the private contract nature of the
derivatives used does not lend itself to fungibility.

RISKS ASSOCIATED WITH THE USE OF DERIVATIVES, LEVERAGE,

OR COMMODITIES BY ETFs
Some risks are specific to ETFs that use derivatives, leverage, or commodities. This category includes the
following risks:

• Risk of roll yield loss

• Risk of front running
• Counterparty risk in derivatives
• Risk related to volatility and leverage factors
• Risk of short selling bans
• Risk related to futures position and sizes
• Credit risk in currency ETFs
• Risk of using swaps (in comparison to exchange-traded derivatives)

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RISK OF ROLL YIELD LOSS

Exchange-traded funds that hold front-month futures contracts to track their reference asset are subject to an
implied risk in the commodity’s forward pricing curve. As the ETF periodically rolls its contracts into the next
month, it is effectively betting that the forward pricing curve will rise and become steeper. A normal forward pricing
curve (i.e., price plotted against time) shows an upward slope, reflecting costs of carry. The normal, upward-slope
condition is known as contango, and the premium of a deferred month over a prior month is known as the roll yield.
If the slope of the curve merely stays constant from one rollover to the next, the value of the ETF will decline to
reflect the loss of the roll yield. If the commodity’s forward pricing curve shows historically steep contango, the
odds increase that it will return to its historical normal slope. The tracking ETF will therefore show a roll yield loss.
Investors in these commodity ETFs should be aware that they are making a judgment on both the future level of
spot prices and on the future shape of the forward curve.

Exhibit 23.1 | Risk of Roll Yield Loss

A new ETF is launched with an objective of replicating the return on gold using gold futures contracts. The ETF’s
strategy involves buying the most active near-term futures contract and rolling it to the next-most-active futures
contract as soon as the current contract enters the delivery month. Assume that it is early January, and gold is
trading at $1,500 per ounce in the spot market.
The following active futures contracts are available:

Contract Month Price

February $1,505

April $1,510

June $1,515

Notice that the price of gold futures increases the further out the maturity goes, which means that price is
in contango.
The ETF buys enough February gold futures contracts at a price of $1,505 to give it an exposure equal to the value of
its net assets. During the month of January, the spot price of gold rises 5% to $1,575. At the end of the month, the
futures contracts are trading at the following prices:

Contract Month Price

February $1,576

April $1,580

June $1,585

The ETF now rolls the February contracts into April contracts by selling the February contracts at a price of $1,576
and buying April contracts at $1,580.
During February and March the spot price of gold continues to march higher, reaching $1,600 by the end of March.
At this point futures prices are as follows:

Contract Month Price

April $1,601

June $1,605

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Exhibit 23.1 | Risk of Roll Yield Loss

The ETF rolls its futures position again, selling the April contracts at $1,601 and buying June contracts at $1,605.
During April and May, the price of gold in the spot market keeps rising, finishing May at $1,650. The June gold
futures contract is trading at $1,651, and the ETF sells its June futures at this price before rolling them into the next
active contract.
Now, consider what has happened during the first five months of the year. The spot price of gold has risen 10% from
$1,500 to $1,650. The ETF, in its attempt to replicate the price of gold using futures contracts on a commodity in
contango, has only been able to earn a return of 9.15%, calculated as follows:
éæ $1,576 ö æ $1,601 ö æ $1,651 öù
êçç ÷´ç ÷´ç ÷ú – 1 = 0.0915 = 9.15%
êçè $1,505 ø÷÷ ççè $1,580 ÷÷ø ççè $1,605 ÷÷øú
ë û
Note that the numerator of each term in the brackets is the price at which the contract was sold, and the
denominator is the price at which it was bought. Each term therefore represents the return on that position.
Multiplying all of these returns together gives us the compound return on the rolling strategy.
But what’s going on here? By having to continuously buy futures contracts that are consistently priced higher than
the spot price, the ETF is essentially locking in a small loss every time it rolls its futures position. In fact, it doesn’t
matter whether the price goes straight up or straight down or is quite volatile. As long as the market is consistently
in contango, the ETF will always underperform the spot price using the futures roll strategy.

RISK OF FRONT RUNNING

Front running is buying or selling a security ahead of a larger trader who is buying or selling the same security. The
purpose is to take advantage of the market impact of the large order. Commodity ETFs using futures contracts raise issues
when traders front run their portfolio activity. Commodity ETFs must periodically roll over their holdings as the futures
contracts’ front months expire. The exact period for rollover is specified in the prospectus (e.g., the day before expiration,
four days before expiration, or within two weeks of expiration). In anticipation of the rollover, traders have been known to
buy the new contract and attempt to profit on the tide created by the ETF’s large buy orders. This activity has diminished
in recent years as the market has come to anticipate front runners, making the tactic less beneficial for them.

COUNTERPARTY RISK IN DERIVATIVES

Exchange-traded funds that employ swaps are exposed to counterparty risk. The ETF assumes the risk that the
other side of the swap may not be able to fulfill its obligations over the life of the contract. This risk is a very real
concern, given the bankruptcies in 2008 of Bear Stearns and Lehman Brothers. The demise of Lehman Brothers was
a particular concern to the U.S. ETF industry because several ETF sponsors employed Lehman Brothers as their swap
counterparty in their products.
The loss in a counterparty swap default is not a loss of the principal value of the position itself, but rather the failure
to receive payments for the changes in the reference asset. Nevertheless, an ETF sponsor that finds itself in such a
situation would have to find a new counterparty to assume the former counterparty’s position.

RISK RELATED TO VOLATILITY AND LEVERAGE FACTORS

Inverse and leveraged ETFs’ actual performance has differed from what investors may have expected, especially during
periods of extreme volatility of a fund’s underlying asset. This difference between actual performance and investor
expectations is due to the lack of investor understanding about the investment goal and investment strategy of the ETF.
Inverse and leveraged ETFs are specifically designed to perform as stated only over short holding periods – generally
a day. Many investors incorrectly assume that inverse and leveraged ETFs were designed to deliver their
performance over medium-term to long-term investment horizons.

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Inverse and leveraged ETFs offer a fixed multiplier of the daily return of the ETF’s underlying asset. As such, inverse
and leveraged ETFs are suitable investment vehicles for the individual investor in only two specific applications:
hedging a current portfolio exposure and day trading.
The deviation between the inverse and leveraged ETF’s expected performance and actual performance is primarily
attributable to the need for the ETF to frequently reset. The purpose of the reset function is to constantly maintain
the ETF at its specified fixed leverage ratio to its changing asset base.
The investment advisor and the investor need to determine if the ETF under consideration has a reset feature, prior
to investment in the ETF. Most traditional non-leveraged ETFs do not include resets. Inverse (non-leveraged) ETFs
may or may not have a reset. Almost all leveraged ETFs (whether long or inverse) have resets. Most ETFs with resets
do so on a daily basis, with a small number resetting on a monthly frequency.
The following table provides a summary of the use of reset features by the four major combinations of ETFs.

ETF Type Reset Feature

Long, non-leveraged (i.e., traditional ‘long ETF’) No (*)

Long, leveraged Yes

Inverse, non-leveraged (i.e., traditional ‘short ETF’) Varies (*)

Inverse, leveraged Yes

Note: (*) The vast majority of traditional (non-leveraged) long or inverse ETFs do not require a reset feature if the ETF’s investment strategy
utilizes fully-collateralized underlying futures position(s).

Resetting is an integral part of the investment strategy for inverse and leveraged ETFs. However, resetting can
materially erode ETF returns in many market environments. Resetting is accompanied by compounding. It is the
compounding that eventually leads to the variance (tracking error) between the ETF and its underlying index.
Resetting and compounding lead the ETF’s actual performance to be path dependent. This means the ETF returns
are dependent on the exact path that the underlying index followed over time. The effect of compounding works
against medium-term to long-term ETF investors.
The following example demonstrates the impact of compounding and path dependency on the ETF return for a
hypothetical 3X leveraged inverse ETF over a four day timespan with volatile returns.

Level ETF’s Exposure Before ETF’s Exposure After

Reset Reset

Day 1 Index 100.00

−3x ETF 100.00 −300.00 −300.00

Day 2 Index up 10%, ETF loses 30 Index 110.00

−3x ETF 70.00 −330.00 −210.00

Day 3 Index down 10%, ETF gains 21 Index 99.00

−3x ETF 91.00 −189.00 −273.00

Day 4 Index up 15%, ETF loses 40.95 Index 113.85

−3x ETF 50.05 −313.95 −150.15

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In the example above:

• Both the Index and the ETF are set at a level of 100 on Day 1.
• On Day 2, the Index rises by 10% to a level of 110, and accordingly the ETF falls in value by 30% to a value of 70.
• On Day 3, the Index declines by 10% to a level of 99, while the ETF rises by 30% to a level of 91.
• On Day 4, the Index rises by 15% to a level of 113.85, and accordingly the ETF falls by 45% to a level of 50.05.
• The two farthest right columns show the ETF’s risk exposure size on both a pre-rebalancing basis and post-
rebalancing basis for each day, respectively.

In summary, the respective cumulative rate of return (RoR) for the Index and the ETF (both expected and actual) are
as follows:

Cumulative RoR (%) Calculation

Index Return 13.85 113.85/100.00

Expected: −3x ETF Return −41.55 −3 × (113.85/100.00)

Actual: −3x ETF Return −49.95 (−150.15 − (−300.00))/−300.00

In this example, the daily reset and associated effect on compounding results in an actual RoR (−49.95%) that is
8.40% lower than the expected RoR (−41.55%). The example shows that calculating a RoR based on the percentage
change between the final Index value and initial Index value (i.e. the expected approach) differs from the actual RoR
for the ETF.
Tracking error for inverse and leveraged ETFs would, in general, be minimized under two simultaneous market
conditions: a strong directional trend and exceptionally low intra-day volatility.
Inverse and leveraged ETF investors need the ability to predict the future direction of the underlying asset and also
the path of the predicted price movement.

RISK RELATED TO SHORT SELLING BANS

For a brief period in September 2008, the U.S. Securities and Exchange Commission (SEC) banned the short
selling of financial stocks on American exchanges. The ban created a dilemma for some U.S.-listed inverse and
leveraged inverse ETFs that employed swaps. Unable to short sell financial stocks to hedge their positions, their
swap counterparties refused to write any more contracts. As a consequence, the ETF sponsors suspended the
creation process of additional units by their authorized participants. This created large premiums to the ETFs’ NAVs.
Essentially, the ETFs became closed-end funds. After a month, the short selling ban was lifted and some equilibrium
was restored to the NAVs.
If chaotic trading conditions such as those of 2008 were to return to the stock markets, it is unclear whether the
SEC or any securities commission would return to some form of a short selling ban. Nonetheless, investors should
note any market developments that suspend the usual mechanisms that keep the NAV close to its true value. In the
wake of such a development, investors should refrain from purchasing these ETFs to avoid losing the premium when
market conditions return to normal.

RISK RELATED TO FUTURES POSITION AND SIZES

One example of a market development that interrupted the NAV equilibrium was a proposed limit on futures
positions held by some of the larger U.S. commodity ETFs. The huge asset size of the United States Oil Fund (trading
symbol: USO) and the United States Natural Gas Fund (trading symbol: UNG), prompted U.S. regulators in mid-
2009 to consider contract limits on their holdings. The regulators believed that the ETFs and other big institutions
were manipulating the markets, and that positions limits would curb this activity. Even though USO, UNG, and

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other similarly constructed ETFs permitted themselves to use options and OTC derivatives, the possibility of
regulatory limits interfered with the normal creation/redemption process. The firms that manage futures-based
commodity ETFs, such as USO and UNG, were reluctant to buy futures contracts and issue new units for fear that
regulators would force them to sell out newly established positions. As a result, these ETFs traded like closed-end
funds, but at a premium to their NAVs. As noted earlier, investors should refrain from purchasing ETFs at premiums
to their NAVs to avoid losing the premium when market conditions return to normal.

CREDIT RISK IN CURRENCY ETFs

Currency ETFs hold either physical currency or time deposits and short-term commercial paper in the foreign
exchange concerned. In the case of actual cash, it is held as bank deposits where it is exposed to the credit risk of the
bank. These deposits of the ETFs are treated by the bank like any other deposit and subjected to the same rights and
risks. Accordingly, the deposits have limited protection under deposit insurance programs. If the bank holding the
deposits were to fail, the ETF would likely lose most of that money.

DID YOU KNOW?

Time deposits have similar exposure to the creditworthiness of the financial institution and may
not have insurance protection. The riskiness of short-term commercial paper depends on the
creditworthiness of the issuer because this type of investment is completely unsecured.

COMPARING THE RISKS OF SWAPS VERSUS EXCHANGE-TRADED FUTURES

AND OPTIONS
In comparing ETF use of derivatives, there are some general benefits and risks associated with swaps in comparison
to exchange-traded derivatives. The major risks are described below:

Counterparty risk Swaps carry far more counterparty risk than exchange-traded futures and options.
Futures and options are processed and guaranteed through a clearinghouse that marks
to market position values daily. This activity adds assurance that each contract will be
honoured.

Costs With counterparty risk and non-standardized features, swaps are more expensive to use
than exchange-traded derivatives. The additional cost is eventually passed on to the
investor.

Tracking error A swap-based ETF is more likely to use cash creation, whereas an ETF that holds futures
contracts is more likely to use the in-kind redemption feature. Because the swap is a
customized contract between the ETF and the swap counterparty, it is not an easily
fungible asset that can be transferred over to an institutional investor. Cash is fungible,
and is used instead in the exchange process. But an exchange-traded future is very
fungible, which allows for an in-kind redemption. As such, ETFs using futures have less
tracking error risk compared to those that use swaps.

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The benefits associated with swaps in comparison to exchange-traded derivatives are described below:

Flexibility Swaps are much more flexible than exchange-traded derivatives. The swap maturity
can be tailored to exactly what the ETF needs, especially for time horizons several years
out. With exchange-traded derivatives, the ETF would have to choose from a set of
predetermined dates. Furthermore, there may not be adequate liquidity in the futures
contract for the ETF’s needs.
Swaps can also be used to replicate returns of indexes that are physically difficult to
construct, such as aggregate bond indexes.

Disruption of trading Swap contracts do not have daily price fluctuation limits, as futures contracts do, which
allows for the normal creation/redemption process to continue. Commodity futures
markets sometimes trade lock limit up or lock limit down. If there are too many buyers
and too few sellers, the exchange locks the price at an upper limit (lock limit up). If there
are too many sellers and too few buyers, the exchange locks the price at a lower limit
(lock limit down). Exchanges set limits on most, but not all, futures contracts. The limits
restrict how far futures prices may move up or down on a given trading day.
Daily price limits are designed to allow for a cooling off period after an extreme price
move, so that traders can absorb any new information and decide whether the price move
was warranted. Such activity has implications for the operation of a futures-based ETF.
For example, an ETF based on futures contracts that happens to be in lock limit up will
trade at a substantial discount to NAV. The ETF may not be able to buy futures and
create units, as designated brokers try to conduct arbitrage and meet investor demand.

DID YOU KNOW?

Most exchanges have adopted procedures to deal with limit moves. One procedure expands price
limits after a few days of limit moves. Expanded limits, for example, may widen out to 150% of regular
limits, which gives traders holding losing long or short positions a greater chance to liquidate. Another
procedure removes limits entirely for futures contracts trading in their delivery month. Finally, some
exchanges have abolished limits on some contracts altogether.

CIRO GUIDANCE: SALES PRACTICE OBLIGATIONS RELATING TO LEVERAGED AND

INVERSE EXCHANGE-TRADED FUNDS
CIRO issued this guidance note on April 27, 2020 based on the extreme capital market volatility that was being
experienced in April 2020 and its impact specifically on leveraged and inverse ETFs. In summary, the guidance,
originally issued in 2009, focuses on the following points:

• A reminder that these types of ETFs, as a result of their investment strategy and resetting process, often lead to
investment results that are markedly different from what many investors and investment advisors expect.
• That dealer members have additional and specific know-your-client requirements associated with the
distribution of these two types of ETFs.
• That dealer member sales practices must be thorough and balanced when discussing potential investment in
these types of ETFs.
• That dealer members establish an appropriate supervision system designed to ensure that all registrants adhere
to applicable CIRO’s IDPC rules pertaining to the distribution of these types of ETFs.
• That registrants obtain the requisite training related to the features and risks associated with these two types of
ETFs.

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RISKS TO ETFs THAT USE DERIVATIVES, LEVERAGE, OR COMMODITIES

What are the risks to ETFs that use derivatives, leverage, or commodities? Complete the online learning
activity to assess your knowledge.

INTERNATIONAL EXCHANGE-TRADED FUNDS

Below are brief descriptions and examples of the primary types and categories of ETFs with international or global
investment mandates.

BROAD-BASED INTERNATIONAL ETFs

Broad-based ETFs have the broadest investment mandates of all international ETFs. They are generally designed to
passively track widely used international equity indexes, such as the MSCI EAFE Index. They are viewed as the best
method (at least in the ETF world) for obtaining exposure to international investments on a well-diversified basis.
Not surprisingly, broad-based ETFs are by far the most popular international ETFs.

REGIONAL ETFs
Regional ETFs provide exposure to a specific region or group of international equity markets. More specifically,
they provided exposure to regions with developed or emerging economies, or both. One popular regional ETF
theme covers the Brazil, Russia, India and China (BRIC) group. An example of a regional ETF is the iShares MSCI BIC
ETF (symbol: BKF). Other popular regional ETFs, such as Asian-based ETFs, European-based ETFs, and even Latin
American-based ETFs, provide exposure to various regions of the world.

INDIVIDUAL COUNTRY ETFs

Individual country ETFs provide diversified exposure to the equity markets of an individual country. Passive
investment mandates attempt to match the performance of either the country’s popular equity market indexes
or a custom benchmark. These country-based benchmarks, whether popular indexes or custom benchmarks,
tend to have minimum capitalization cut-offs and include only larger-capitalization companies. An example of a
specific country ETF is the iShares MSCI Germany ETF (symbol: EWG). This ETF tracks the performance of the MSCI
Germany Index which is a diversified index designed to be representative of the German economy.

FOREIGN-STYLE ETFs
Funds that are considered “foreign-style” ETFs cater to investors who want to gain international equity exposure by
using specific investment styles. Such investment style parameters include the popular size style criterion (small-,
mid-, or large-capitalization), and valuation styles (growth, value or growth at a reasonable price), or a combination
of these. An example of a foreign-style-based ETF is the iShares MSCI EAFE Small-Cap ETF (symbol: SCZ). As its
name implies, it is designed to track the performance of the small-capitalization component of the MSCI EAFE
Index.

INTERNATIONAL BOND ETFs

International bond ETFs allow investors to add a fixed income component to their portfolio, thereby receiving the
benefits and rewards associated with a fixed income-type of investment. These ETFs offer the ability to increase
exposure to international markets and earn a revenue stream. One popular international bond ETF is the SPDR
Bloomberg Barclays International Treasury Bond ETF (symbol: BWX).

FOREIGN DIVIDEND ETFs

Foreign dividend ETFs are essentially a “philosophical” combination of international equity-style ETF investing
and (to a lesser degree) international bond ETF investing. These types of ETFs invest primarily in equities that offer

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an income stream from dividends. They appeal to investors who want to diversify the potential returns of their
international portfolios away from capital gains and coupon income. An example of a foreign dividend ETF is the
Global X SuperDividend ETF (symbol: SDIV).

FOREIGN CURRENCY ETFs

Another way to bet on an economy’s future performance is to invest in its domestic currency using ETFs. The
theoretical argument is that a country’s currency is a more accurate measure of its economy than its equity market
returns. An example of a foreign currency ETF is the Invesco CurrencyShares Australian Dollar Trust (symbol: FXA),
which invests in the Australian dollar.

COMMODITY-THEMED ETFs
Generally, commodity-themed ETFs invest directly or indirectly in commodities themselves, or in the companies
that produce commodities. Some investors regard commodity investing as an integral part of their total investment
portfolio. It is viewed as a bet on the direction of the global or regional economies (or both), as well as an effective
diversifier for solely domestic investment portfolios. As such, commodity investing is an essential part of the
international investment component of an investor’s portfolio. An example of a commodity-themed ETF is the
iShares S&P/TSX Global Gold Index ETF (symbol: XGD).

TAXATION CONSIDERATIONS OF FOREIGN INVESTMENTS HELD

IN AN ETF
As an advisor, you should be aware of certain tax implications relating to foreign investments held in an ETF, which
are discussed in this section.

TAX IMPLICATIONS OF DISTRIBUTIONS FROM FOREIGN INVESTMENTS

Investors can hold non-Canadian securities in a Canadian or U.S.-listed ETF. Holders of Canadian-listed ETFs that
hold U.S.-based stocks are subject to U.S. tax that is withheld on dividends paid to the ETF. When the Canadian
ETF distributes the dividend to the investor, no further tax is deducted. If the ETF is held in a taxable account, the
investor can get the withholding tax back by claiming a foreign tax credit (but not if the ETF is held in a non-taxable
account).
All distributions by U.S.-listed ETFs are taxed as ordinary income. Even capital gains that are distributed are taxed
in full, unlike Canadian ETFs, where, for individual investors, only half of capital gain distributions up to a total of
$250,000 in a given year and 66.67% for amounts in excess of $250,000 in that year are taxed.
Dividends from U.S.-listed ETFs that invest in U.S. stocks that are distributed to Canadian investors are exempt
from withholding tax if the ETF is held in a registered retirement account but will be withheld if the ETF is held
in a taxable account. However, in the second situation a foreign tax credit is available. If the U.S.-listed ETF holds
international non-U.S. stocks there may be two levels of withholding tax. The non-U.S. dividend issuer will withhold
tax from the ETF; if the ETF is held by a Canadian investor in a taxable account, U.S.-based withholding tax will
apply. The unit holder can claim a foreign tax credit, but only on the tax withheld by the ETF (i.e., not on the tax
withheld by the non-U.S. company). If the ETF is held in a non-taxable account, the U.S.-listed ETF will not withhold
taxes.

U.S. ESTATE TAXES

High net worth Canadians with a worldwide estate of greater than US$12,920,000 and with U.S. assets exceeding
US$60,000 may be required to pay U.S. estate tax on the value of their U.S. assets. Although U.S.-listed ETFs are
considered a U.S. asset, Canadian ETFs holding U.S. securities are generally not considered U.S. assets.

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FORM T1135—FOREIGN INCOME VERIFICATION

Canadian investors who own certain foreign property with a total cost over $100,000 must file form T1135.
However, Canadian-listed ETFs are exempt from this reporting requirement, even if the ETF holds foreign securities.

INVESTMENT STRATEGIES USING ETFs

The strategies described below illustrate some examples of the role of ETFs in an investment portfolio.

CORE AND SATELLITE

The term core and satellite refers to a portfolio construction strategy that uses broad-based ETFs as a passive
core holding. The core is intended to contribute the majority of returns. The satellite assets are more focused on
riskier sectors that are intended to be traded as market conditions change. The satellite assets are intended to boost
returns above the core asset returns.

EXAMPLE
A core could be an ETF tracking a broad equity index such as the S&P 500. Around that core, an investor could
have smaller holdings representing sector ETFs, style funds, or country ETFs.

REBALANCING
Asset allocation is often considered the most important decision. Rebalancing to the strategic asset allocation is
frequently a requirement of a portfolio’s mandate. Rebalancing helps to mitigate drift and keeps the risk of the
portfolio within predefined limits. An efficient way to rebalance across the asset classes, when needed, is to have
a small allocation to domestic and international equity and fixed income ETFs. This strategy provides a simple and
liquid way to rebalance the asset allocation without affecting the core holdings. The use of ETFs also helps to lower
the number of transactions that must be rebalanced.

TACTICAL ASSET ALLOCATION

Investment managers can use ETFs as tools to gain quick, diversified exposure to the targeted asset class while
instantly exiting the previous holding. With the vast choice now available in ETFs, investors and advisors can use
ETFs as the primary tool to implement these tactical shifts.
There are many approaches to conducting tactical asset allocation. All of these top-down investment management
approaches have been enhanced by the growing number of choices in ETFs. A few tactical asset allocation
approaches, along with examples of ETFs that can be used, are shown below:

• Shifting between equities, cash, fixed income, and commodities allocations using broad market ETFs
• Equity sector rotation using sector ETFs such as utilities, industrials, energy, and financials (to name a few)
• Transitioning between different credit qualities and durations for fixed income with federal and corporate bond
ETFs of different durations
• Global positioning for equities and fixed income allocations with ETFs that focus on emerging or developed
markets and country-specific ETFs

Each of the above examples shows how investment managers can efficiently implement a top-down investment
style using ETFs.

CASH MANAGEMENT
Exchange-traded funds allow investors to put their money in the stock market until they make a long-term
investment decision. This strategy allows investors to take advantage of potential price rises or maintain an income
stream while their money is held temporarily.

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SIMPLIFIED EXPOSURE TO ONCE HARD-TO-ACCESS ASSET CLASSES OR STRATEGIES

As ETFs have expanded into offering hard-to-access asset classes, new levels of portfolio optimization have become
available. For example, gold was not easily purchased, stored, or sold until physical gold ETFs were created. Before
this development, investment managers often used the equity position in a gold-producing company to indirectly
provide their gold exposure. With physical gold bullion ETFs, they can now access this asset class directly through
low-cost ETFs.
Other ETFs offer other types of exposures, such as specific countries, emerging market bonds, and strategies such
as covered calls. These new ETFs have expanded the investment horizon by allowing investment managers to build
different types of portfolios that until recently could not be created.

TAX LOSS HARVESTING

Exchange-traded funds are useful in harvesting tax losses on an investment in that they can be used to maintain
exposure to a sector while respecting Canada Revenue Agency’s superficial loss rules. As long as an ETF being
purchased is not identical to an asset being sold, the ETF can be used as a substitute for the asset. The swap strategy
works equally well with mutual funds and other ETFs, as long as the fund being sold is not an index fund tracking the
same index as the substitute ETF.

DID YOU KNOW?

The superficial loss rule states that an asset cannot be sold to realize a capital loss and then purchased
again within 30 days of the sale. The rationale behind the rule is to prevent investors from temporarily
disposing of an asset solely for the purpose of realizing a deductible capital loss.

HEDGE FUNDS

5 | Describe the key areas of due diligence regarding hedge fund investment.
6 | Describe the role of hedge fund service providers.
7 | Explain the process for including hedge funds in a client’s portfolio.

Hedge funds are lightly regulated pools of capital with managers who have great flexibility in their investment
strategies. These strategies are often referred to as alternative investment strategies.
Some hedge funds are conservative; others are more aggressive. Despite the name, some funds do not hedge their
positions at all. Therefore, it is best to think of a hedge fund as a type of fund structure, rather than a particular
investment strategy.
In Canada, as in many other countries, hedge funds are not constrained by the rules that apply to standard mutual
funds. For example, they can take large short positions, use leverage and derivatives for speculation, or perform arbitrage
transactions. In other words, they can invest in almost any situation, in any market where they see an opportunity to
achieve positive returns. Because hedge fund managers have tremendous flexibility in the types of strategies they can
employ, the manager’s skill is more important in hedge funds than in almost any other managed products.

WHO CAN INVEST IN HEDGE FUNDS?

The market for hedge funds can be split into two categories:

• Funds targeted toward high-net-worth and institutional investors

• Funds, and other hedge fund-related products, targeted toward broader individual investors in the retail market

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Hedge funds targeted toward high-net-worth and institutional investors are usually structured as limited
partnerships or trusts, and are issued by way of private placement. Rather than issuing a prospectus, these hedge
funds issue an offering memorandum. This legal document states the objectives, risks, and terms of investment
involved with a private placement. In Canada, only accredited investors can invest in these funds. Accredited
investors must meet certain minimum requirements for income or net worth.

DUE DILIGENCE FOR SELECTING APPROPRIATE HEDGE FUNDS

As an advisor, you should perform a certain amount of due diligence on any hedge funds you recommend to clients,
even if your firm performs its own due diligence. Eight key areas to focus on are described below:

Fund track record Consider only those single-strategy hedge funds that have at least a two-year track
record and $25 million under management. Funds of hedge funds should have at least a
three-year track record and $100 million under management.

Risk characteristics Make sure your client’s risk profile is consistent with the risk characteristics of the hedge
fund. You should also identify different measures of the fund’s risk and risk-adjusted
return, and compare them to the same measures for the fund’s peers.

Hedge fund managers Examine the experience and reputation of the hedge fund firm and manager; if possible,
arrange to meet and interview the manager. It is important to focus on the people who
make the investment decisions, rather than the sales representatives trying to sell the
fund.

Hedge fund features Read the marketing material and the term sheet, as well as the prospectus, offering
memorandum, or information statement, rather than relying solely on sales
presentations. In reading these materials, you should seek to understand the fee and
expense structure, the potential use of leverage, and the liquidity terms.

Return statistics Understand the nature of return statistics published in marketing materials. Are they
actual results, pro forma (simulated) results, or a mixture of the two?

Tax treatment Make sure you understand the tax implications of the fund.

Currency risk Learn whether the fund is exposed to currency risk, whether the manager intends to
hedge that risk, and, if so, whether the manager has expertise in that regard.

Operational risk Find out how big the fund management firm is and whether there is adequate
segregation of duties. There should also be sufficient checks and balances in operational
controls to limit the chance of fraudulent activity. Finally, you should identify the fund’s
service providers and determine whether they are reputable.

A COMPREHENSIVE DUE DILIGENCE PROCESS

This section provides a comprehensive, but not exhaustive, description of the due diligence process performed by
some firms perform before they allow their advisors to recommend a hedge fund. There are eight main areas of
inquiry:

• Structure of investment management organization

• Investment management information
• Risk analysis
• Operations

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• Fund structure
• Investment performance
• Account structure and composition
• Fees

STRUCTURE OF THE INVESTMENT MANAGEMENT ORGANIZATION

Whether a hedge fund is organized (domiciled) offshore or onshore for legal and tax purposes will determine
the tax characteristics of the fund and the degree of transparency of its financial records. Offshore funds are less
transparent and are taxed lightly or not at all in their domiciled country. A manager may want to establish an
offshore fund to allow deferral of management and incentive fees, thus allowing the fund to accrue on a tax-
deferred basis. You should advise your clients to consult with tax specialists to determine the status of any hedge
fund investment.
It is important that you understand the structure of management in hedge fund organizations. For example, if the
positions of chief executive officer, chief investment officer, and chief operating officer are all held by the same
person, the hedge fund may run into operational problems. Many hedge funds are run by a handful of people who
are more skilled at investment management than at operational management. Of special importance is the chief
financial officer (CFO), who is responsible for reporting the hedge fund manager’s performance. Consequently,
you should make certain that the CFO has a strong background in accounting, preferably holding a recognized
designation. Experienced senior managers are also needed in important areas of operations, such as trading,
systems, marketing, reporting, and back office management.
You should also consider the fund’s ownership and the alignment of the owners’ interests with the fund’s interests.
The owners’ current affiliations and business contacts may aid or hinder their hedge fund activities, depending on
the degree and nature of their involvement. Outside business interests may distract them from effectively running
the hedge fund. On the other hand, those interests may provide a useful source of information for making hedge
fund investments.
Ideally, the fund’s employees should have a significant financial stake in the hedge fund. Performance tends to be
better when the hedge fund principals and staff are investors in their business. People tend to work harder when
their own money is at stake.
Staff turnover is another important consideration. Although there is a natural turnover rate in any investment firm,
prior loss of key personnel could be a sign of fundamental instability in the hedge fund organization. Compensation
is important in staff retention, and key personnel and their experience must be retained. Bonuses and, in particular,
ownership structure should be fair and in line with the industry.
Given the unregulated nature of the hedge fund industry and the large sums of money involved, you need to be sure
of the integrity of the people managing client funds. You must check into the legal records of the management staff.
Past proceedings of a criminal, civil, or administrative nature could be an indicator of future trouble.
The hedge fund’s plans for growth and future business will determine how other aspects of the business affect
investment operations. If the business is grown too quickly and multiple product lines are added, personnel,
systems, and capital resources will be strained, and performance could suffer. In certain trading strategies, if the
fund is too large its trading models will become inexecutable. The fund’s assets under management (AUM) should
not represent a significant portion of the total capitalization of the market in which it is investing. Too many assets
may force managers to diversify into markets out of their skill set.

INVESTMENT MANAGEMENT INFORMATION

The hedge fund’s investment committee, which makes investment decisions, should have many years of relevant
experience and a good track record. Furthermore, the strategies and trading system employed to support trading

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decisions should be unique and innovative to give the hedge fund a competitive advantage. Trading strategies
should make intuitive sense and be repeatable, and the fund manager should have many years of experience
working with the trading system. If the system lacks an actual track record, a simulation should be verifiable and
encompass enough market cycles to prove reliable over time. If the system’s record is of actual performance, it
should be audited. If more than one system is used, the manager should be clear about which to use at specific
times and know how much money to allocate to the different systems.
As an advisor, you should know whether the hedge fund’s trading model is systematic, discretionary, or a
combination of the two. Systematic methods are better in that they remove emotion from trading; however, trading
is an art that cannot be captured solely by an algorithm. Ultimately, nothing can replace a manager’s experience.
Neither the systematic nor the discretionary model is preferable. Which one is used depends on the manager and
the system. If the system is good enough, it can perhaps run essentially on its own; if the manager has enough skill
or experience, a discretionary approach may be best.
The fund manager should have a systematic method of applying leverage, which should never be applied ad hoc
because the degree of leverage can make or break a fund. Managers might be right in their market expectations
but, because of price volatility, they could bankrupt the fund if leverage is excessive. The fund should have in place
controls on the use of leverage, including minimum and maximum levels, and leverage should be used only by
authorized investment personnel. If the fund has been established for some time, you can find out what its historical
maximum and typical leverage has been.
If leverage is applied to a hedge fund using OTC derivatives, the fund needs to have staff with expertise in trading
derivatives. The manager may need to get out of a position, either because the investment is not performing as well
as expected or because of redemption pressure. Because OTC derivatives are illiquid, the manager may not be able
to sell sizable positions at a reasonable price when necessary. This lack of liquidity increases the risk of giving the
buyer a big windfall. Besides liquidity risk, OTC derivatives subject the manager to the risk that the other side of the
derivative will default on the contract.

DID YOU KNOW?

Over-the-counter derivatives can be far more complex in their structure and pricing than exchange-
traded derivatives.

RISK ANALYSIS
Hedge fund managers must quantify and identify risk to control losses that might arise. Trading is such a
competitive endeavour that there are more ways to worsen performance than there are to improve it. Managers
should have various ways to manage investment risk, such as leverage maximums and position limits. They should
also stick to markets with sufficient liquidity. On the business side, the clearing and settlement functions of the
hedge fund operation must operate smoothly, without error and in a timely fashion.
Occasionally, the portfolio should be stress tested to ensure that the trading system and risk controls are working as
expected. Testing a portfolio means simulating security losses to determine the losses to the whole portfolio.

DID YOU KNOW?

Risk analysis becomes more difficult as transparency declines. Lack of timely and accurate information
will make your job as an advisor harder.

OPERATIONS
A hedge fund’s support operation is often under-scrutinized during the due diligence process. A reliable and
reputable team of service providers (e.g., the custodian, auditor, and broker) should make sure the hedge fund is

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running smoothly. The fund’s net asset value should be calculated by an independent third party, preferably the
administrator, to avoid any conflict of interest. Any past material changes to the fund’s service providers that
negatively affect the smooth operations of the fund (such as a change in service levels or buyouts) should be
noted.

FUND STRUCTURE
The format of a hedge fund offering (whether by prospectus, offering memorandum, or information statement) is
important because it determines the investor’s ability to withdraw from an agreement to purchase a fund. It also
determines whether the investor can rescind a purchase if there is a misrepresentation, or sue for damages if a
misrepresentation results in losses. Investors who need this protection should understand the offering structure of
the fund.

INVESTMENT PERFORMANCE
A hedge fund’s track record is usually the first item a potential investor looks at when considering a hedge fund
investment. But performance records are not always as they seem; for example, new funds publish pro forma
records. You should therefore consider how the records were produced. To be relevant, they should encompass
several years to capture at least an entire market cycle. Records of securities transactions should reflect purchases
made at the ask price and sales at the bid price, not at the last transacted price or the average of the bid/ask price.
Prices should also reflect the liquidity available.

EXAMPLE
If a simulated sale of 10,000 shares of a small-cap stock is recorded at the bid price, but the average daily volume
is 15,000 shares, the sale proceeds (and performance) are probably overstated.

Performance records should be audited to verify their integrity, and the audit should encompass the entire
performance record, not just a portion of it.
Performance attribution (essentially the sources of return) should be noted in the fund’s record. The manager
should display skill in all market conditions. Good performance based on a few short periods or lucky bets is not
sustainable over the long run. You should find out the three largest drawdowns in the fund’s history to get an idea of
the fund’s volatility and how well the manager dealt with adversity. A performance recovery may have resulted from
the skill of the manager, or the markets may simply have recovered. If the recovery took an unusually long time, the
manager should have remained true to his strategy and system through adversity. Furthermore, if the fund has been
successful, it may be the result of a large influx of new capital.
Depending on the markets in which it trades, the fund may be forced to diversify. Diversification is not always
a positive development because the manager’s initial success may have been based solely on a specialized
focus.
Finally, the hedge fund manager should provide the asset capacity of the fund’s trading strategy, and the fund
should not accept new money beyond this amount. If the fund continues to accept new investors, clients should
steer clear of it.

ACCOUNT STRUCTURE AND COMPOSITION

A hedge fund should avoid concentration risk by having a wide variety and significant number of clients based on
the fund’s AUM. The withdrawal of funds by a few large accounts could cripple the AUM and impair operation of the
fund as a viable business. The fund’s business viability is better if it can secure long-term assets with more staying
power from institutions or FoF companies. As an advisor, you should determine for your clients the proportion of
hedge fund assets held by the fund’s largest five to 10 clients.

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FEES
Hedge funds have either a hurdle rate or a high-water mark, and you should know which of the two is used.
A hurdle rate is the minimum return a fund must make before a performance fee can be taken. The high-water
mark is a contract provision preventing a hedge fund manager from collecting a performance fee until the highest
previous net asset value is exceeded. Therefore, the fund manager is prevented from collecting a bonus from positive
performance that merely recouped losses from previous years.
The hedge fund may have soft-dollar arrangements with brokers or other service suppliers. Soft-dollar arrangements
are services, such as analyst reports, that the fund receives in exchange for business rendered to its supplier. Because
the cost of the service from the supplier is borne by the investor, the service received by the fund in exchange should
benefit the client. However, that is not always the case, and it is a difficult principle to enforce. Advisors should be
aware of such arrangements and the potential for abuse.

HEDGE FUND SERVICE PROVIDERS

A hedge fund uses many different services in its day-to-day operations. The hedge fund manager, like a mutual fund
manager, relies on different organizations to offer investment services. Figure 23.1 identifies the service providers
and shows how they are linked together.

Figure 23.1 | A Hedge Fund and Its Service Providers

INVESTOR

Prime Broker Hedge Fund Hedge Fund

Manager

Custodian Administrator

Legal Advisor Accounting Firm

THE PRIME BROKER

A prime broker is an investment dealer or brokerage firm that supplies services to the hedge fund in the
implementation of trading strategies. The role of the prime broker has expanded in recent years. Originally, this
person was responsible mainly for three services:

• Trade execution
• Financing arrangements (i.e., providing leverage for long positions and executing short positions)
• Collateral management (i.e., ensuring that there is sufficient cash or collateral to cover the leverage used)

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Today, many prime brokers provide the following additional services:

• Providing market flow information

• Pricing
• Measuring risk
• Providing capital introductions to prospective new investors

A hedge fund manager may use more than one prime broker. Diverse brokers allow the fund manager to draw on
more sources of information, secure better execution for trades in a particular security or market, diversify pricing
sources, and diversify risk among service providers.

MARKET FLOW INFORMATION

Data and commentary on market flows are valuable sources of information to a hedge fund manager in trying to
establish how other market participants perceive the overall market or a particular security. A large prime broker has
an advantage in that it executes many trades and can pass a wealth of information to fund managers.

PRICING AND RISK MEASUREMENT

Prime brokers help the hedge fund manager determine the current value of positions and strategies by providing
pricing information. Pricing is important in establishing the value of the fund, as well as its performance results.
Many prime brokers also provide risk measures directly to managers or large institutional investors. These measures
usually go beyond those provided to investors by hedge funds or those calculated by hedge fund analysts. These risk
measures, which tend to be forward-looking or based on scenario analysis and stress testing, include the following
tests:

• Value at Risk
• Liquidity analysis (i.e., an estimate of the number of days needed to liquidate the whole portfolio)
• Portfolio concentration in specific sectors or industries
• Beta or market risk exposure (i.e., the degree of portfolio exposure to the overall market)
• Volatility estimates
• Sector shock analysis (i.e., the effect of certain shocks to a specific industry on the overall portfolio)
• Scenario analysis (i.e., the effect on a portfolio of a specific scenario, such as interest rate moves experienced in
2022, or the equity market decline in the first quarter of 2020)
• Stress tests (i.e., analysis of the effect of a predetermined portfolio event, such as a given interest rate increase
or drop in equities, on the overall portfolio)

CAPITAL INTRODUCTIONS
Most hedge funds are unable to advertise; instead, they must be introduced to prospective investors. Prime brokers
can use their contacts among high-net-worth investors and institutional investors to arrange meetings between
potential investors and the hedge funds.
Prime brokers may arrange events to connect hedge fund managers to high-net-worth individuals, institutional
investors, and funds of hedge funds. These events may focus on a specific hedge fund strategy, such as equity long/
short, fixed-income arbitrage, or convertible arbitrage. The prime broker benefits when the hedge fund attracts new
investors. The inflow of new money leads to additional trading, which further leads to additional revenue for the
prime broker.

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THE CUSTODIAN
The custodian is responsible for holding and tracking all of the assets and for transferring securities and cash to
and from the prime broker as required. The custodian works with the prime broker to ensure that sufficient cash or
securities are in the account to support financing activities such as leverage, borrowing, and shorting. Custodians may
also offer administrative services to clients, such as the production of account statements and end-of-year tax slips.

THE FUND ADMINISTRATOR

The fund administrator processes subscriptions and redemptions and calculates the hedge fund’s NAV.
To calculate the NAV, the administrator must verify the value of each security independently from the assessment
produced by the prime broker. Exchange-traded securities or derivatives are easy to price because they are marked
to market continuously. However, pricing for illiquid securities and OTC derivatives can be much more complex.
Pricing may involve “marking to model”, meaning that values are determined by modelling the security’s price
behaviour during periods between trades.

THE ACCOUNTING FIRM

The accounting firm provides an annual, independently audited report for investors. The report generally verifies
the securities held and the value of those securities as of the designated year-end of the fund. Accounting firms may
also be involved in due diligence work for potential hedge fund investors.

THE LEGAL ADVISOR

The legal advisor is primarily responsible for creating the offering documents (either an offering memorandum
or prospectus) for the hedge fund. This advisor may also help process fund and management registration with
securities regulators and assist in the due diligence process. The reputation of the legal firm often contributes to the
overall reputation of the hedge fund manager.

TRACING THE FLOW OF MONEY

The following steps outline the interactions among the investor, the hedge fund manager, and the various service
providers.
1. The investor places the funds in an account with an investment advisor.
2. The advisor’s firm processes the subscription form and wires the funds to the hedge fund’s custodial account.
3. The subscription forms are sent to the administrator, who accounts for the number of fund units the investor
is to receive and confirms the receipt of cash with the custodian.
4. The fund manager verifies receipt of the cash through either the administrator or the custodian.
5. The fund manager deploys the new capital by adding to existing positions or creating new trade positions.
6. The fund manager contacts the prime broker to advise him or her of the trade execution orders.
7. The prime broker confirms the trade orders once they are executed and monitors the cash and security
holdings. Thus, the broker ensures that sufficient funds are available to cover the leverage and short positions
on the overall portfolio.
8. At the end of the month, the administrator verifies the securities held and the prices to calculate the fund
NAV and unit holder price.
9. The NAV calculation is passed to the fund manager and unit holders of the fund through their monthly
statements.
10. At fiscal year-end, the accounting firm consolidates all of the trade positions and verifies prices to establish an
independently audited record. In addition, trades conducted during the year will be verified to ensure that the
reported returns generated by the hedge fund manager are accurately calculated.

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Figure 23.2 traces the flow of money from the investor.

Figure 23.2 | Tracing the Flow of Money

INVESTOR

Cash Proceeds Subscription Forms

Custodian Administrator

Cash from custodian Subscription confirmation

to fund to Hedge Fund Manager

Hedge Fund Manager Hedge Fund

Hedge Fund Manager Accounting firm audits

deploys new trades fund with verification from
with cash custodian and prime broker

Prime Broker Accounting Firm

HEDGE FUND SERVICE PROVIDERS

Can you identify the service providers for hedge funds? Complete the online learning activity to assess
your knowledge.

INCORPORATING HEDGE FUNDS INTO A PORTFOLIO

Assessing whether and how hedge funds fit into an investor’s portfolio involves four steps:
1. Assess investor suitability in terms of return–risk attitudes, time horizon, liquidity needs, and comfort level.
2. If hedge funds are suitable for the investor, assess the relative importance of hedge funds as a percentage of
the total portfolio, in terms of immediate needs and future needs.
3. Select a specific hedge fund or hedge funds and conduct due diligence, including learning about the hedge
fund managers.
4. Monitor performance over time using performance and risk measures.

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The question of investor suitability is important for hedge funds because they are less regulated than traditional
investments. The investor’s goals, objectives, and risk profile are key factors in determining the suitability of a
particular fund. Ask what clients hope to achieve with their portfolio, how much risk they are willing to accept, and
their risk capacity.
Hedge funds can be categorized according to level of risk and level of exposure to market risk. In general, hedge
funds that present less market risk tend to be less correlated with existing components of a portfolio and can
diversify away existing market risk in the portfolio.
Once an investor has identified the rationale for including hedge funds in a portfolio, there are two ways to treat the
funds in an asset allocation framework:

• As a separate asset class in the portfolio

• Integrated within existing asset classes in the portfolio

INCLUDING HEDGE FUNDS AS A SEPARATE ASSET CLASS

Hedge funds can be considered a separate asset class (like equities and fixed-income), to which a portion of
the portfolio may be allocated. In this way, the hedge fund allocation is part of the strategic asset allocation or
investment policy decision. In such a top-down approach, hedge funds are considered sufficiently complementary
to, and uncorrelated with, traditional asset classes to justify a long-term, stable allocation of the portfolio. Typically,
you and your client would determine a target allocation for hedge funds. You would then either build the allocation
gradually from new cash contributions to the portfolio or rebalance existing asset classes into hedge funds.
A typical role for hedge funds in a portfolio, from a strategic asset allocation point of view, is as a satellite in a
core-and-satellite configuration. In this portfolio set-up, the core of the portfolio comprises traditional, stable,
lower-volatility, lower-cost asset classes. An example would be either high-quality, actively managed equity and
fixed-income assets, or indexed traditional asset classes. The satellite represents a smaller, specialty-oriented,
alpha-generating, higher-cost portion of the portfolio that is designed to complement the core components. The
satellite is strategically managed to generate the alpha portion of the portfolio, and the core is managed to provide
the beta portion of the portfolio.

INCLUDING HEDGE FUNDS WITHIN TRADITIONAL ASSET CLASSES

Hedge fund managers are able to invest in a wide variety of securities; nevertheless, many trade stocks, bonds, and
other securities that traditional asset managers also trade. Therefore, referring to hedge funds as their own asset
class may not be appropriate if they are simply investing in securities that belong to other asset classes.
With this view, hedge funds can be integrated into an asset allocation framework by including them within the
allocation to traditional asset classes of stocks and bonds. In this role, hedge funds represent additional diversification
by creating market exposure within stocks and bonds, along a continuum from relative value to directional strategies.
Figure 23.3 shows how this within-class diversification of strategies by market exposure can work.

Figure 23.3 | Diversification of Strategies by Market Exposure

Hedge Fund Strategies Traditional Strategies

1 2 3 4
Relative Value Event-Driven Directional Long Only
Low Market Exposure High High

Low Volatility High High

High Probability of Consistent, Absolute Returns Low Low

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Depending on their objectives, risk profile, and other investing constraints, investors can diversify their equity
market exposure using any of the three hedge fund categories in Figure 23.3 by focusing on those funds that invest
in equity securities, as shown below:

Relative value equity Low market exposure strategies, such as equity market neutral
strategies

Event-driven equity Medium market exposure strategies, such as merger arbitrage

strategies

Directional equity High market exposure hedge fund strategies, such as long/short equity, global macro,
strategies emerging markets, managed futures, and dedicated long or short bias

Investors can similarly diversify their fixed income market exposure using hedge funds that focus on fixed income
securities, as shown below:

Relative value fixed Low market exposure strategies, such as convertible arbitrage and fixed-income
income strategies arbitrage

Event-driven fixed Medium market exposure strategies, such as distressed securities and high yield bonds
income strategies

Directional fixed High market exposure strategies, such as global macro, emerging markets, and managed
income strategies futures

FACTORS IN HEDGE FUND ALLOCATION DECISIONS

Some factors you must consider when making hedge fund allocation decisions are described below:

Volatility does not Many advisors assess the volatility characteristics of a hedge fund strategy to determine
equal risk whether hedge funds should substitute for stocks, bonds, or a combination of these
asset classes. However, the true risks of hedge funds are not reflected solely in their
volatility (i.e., their standard deviation). Hedge fund risks are multi-dimensional. Because
they include risks other than market risk, you must adequately analyze hedge funds to
determine their role and weighting in the portfolio.

Investment policy Consider the portfolio’s current asset mix and the investor’s objectives when determining
constraints must be how much to allocate to hedge funds and which asset classes to substitute. Determine
taken into account whether the client has portfolio constraints relating to liquidity or income requirements.
For example, if clients require a minimum income from their portfolio, it may be
inappropriate to substitute hedge funds for bonds.

Equity substitution You may reduce volatility by carefully substituting some of the equity component of the
may provide significant portfolio for a relative value equity strategy, such as an equity market neutral fund.
volatility reduction

Bond substitution may You may increase absolute returns from the portfolio and help protect it from falling
contribute downside bond prices by substituting some of the bond component with a fixed-income arbitrage
protection fund.

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FEES, PORTFOLIO TURNOVER, AND TAXES

8 | Discuss the impact of fees, portfolio turnover, and taxes on managed product returns.

Three factors that affect the return on a portfolio are management fees, portfolio turnover, and taxes.

MANAGEMENT FEES
For any managed product, management fees reduce the return on the investment. Management fees vary within
and among the various types of managed products. However, they should not be the only consideration when
choosing a managed product.
In general, management fees are lower on passively managed products, such as ETFs and index mutual funds, than
on actively managed products, such as closed-end funds and equity mutual funds. The higher fee charged by active
managers is compensation for, among other things, increased research costs associated with making investment
decisions for the fund. However, by investing in actively managed products, investors expect to achieve a return
greater than that of a passively managed investment.
Management fees have a relatively significant impact on the performance of index funds, fixed income funds, and
money market funds. There is a high correlation between low management fees and top-quartile performance.
Index and debt securities funds have less scope to add value to outperform their competitors. Therefore, most
of the difference in performance can be traced to a difference in management fees. The impact of fees is also
magnified by the fact that absolute performance on bonds and money market securities tends to be lower than for
equity securities.

PORTFOLIO TURNOVER
Portfolio turnover is roughly defined as the total value of securities bought and sold in relation to the overall net
assets of the portfolio. A higher turnover implies that more securities were bought and sold. Because trading costs
are ultimately paid by the fund’s investors, a higher turnover results in greater expenses and, all else being equal, a
lower return.

EXAMPLE
The turnover of Fund A was 120% and the turnover of Fund B was 85%. Therefore, Fund A has bought and sold
more securities, relative to its size, than Fund B. If the two funds were identical in all aspects except for their
turnover, Fund B would have a greater return than Fund A.

DID YOU KNOW?

Every Canadian mutual fund is required to disclose historical turnover rates in its simplified prospectus.
In addition, if a mutual fund’s turnover is expected to be more than 70% in future periods, the
prospectus must include a statement that explains how the tax consequences and trading costs
associated with the turnover may affect the mutual fund’s performance.

TAX CONSIDERATIONS
The taxation of investments is an obvious concern to any investor when the investment is held outside a registered
account, such as a registered retirement savings plan. In a non-registered account, interest income, dividends, and
capital gains are subject to varying levels of taxation in Canada. Unfortunately, with managed products—especially
with actively managed mutual funds and (to a lesser extent) passively managed products—capital gains can arise

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without the client selling the managed product. Realized capital gains minus realized capital losses equals net
capital gains. If this number is positive, the managed product will distribute the net capital gains to unit holders,
which is taxable.
A higher portfolio turnover may result in higher capital gains distributions to investors, given that securities are
bought and sold more often. After all, more active trading is supposed to result in more realized gains. Realized
gains, in and of themselves, are not a bad thing; investors simply need to be prepared for the tax consequences.
However, higher portfolio turnover in a managed product does not automatically signal higher capital gains
distributions. The higher turnover may be the result of the portfolio manager selling securities to realize gains
against realized capital losses in the portfolio. Alternatively, the manager may sell securities at a loss to offset
realized capital gains.
As an advisor, you should explain the impact of realized capital gains to your clients before making any investment
in a managed product, especially an actively managed mutual fund. Your clients should understand some basic
concepts. For example, if the fund increases in value by 25% over a January-to-December period, the gain is a
positive development, even though some securities may have been bought and sold to achieve it. A client who
bought the same fund late in the year, however, may not take the same view, especially if the fund had a negative
return for the latter part of the year. If the client owned the fund on the day of the distribution, then the client has
to pay tax on the distribution, even though the fund is worth less than the amount the client paid for it.
Index-linked managed products, including index mutual funds and ETFs, implicitly force investors to take capital
gains because of the rebalancing required to keep the fund’s contents and weights in line with those of the
underlying index.

DID YOU KNOW?

A 2003 study examined returns over a 10-year period for 343 equity and balanced mutual funds managed
by Canadian companies and marketed predominantly to Canadian investors.* The authors noted that
Canadian mutual funds do not have to disclose their after-tax investment returns. After making some
general assumptions about the tax rates of investors in the fund, the authors found that taxes reduced
long-term investment returns to a greater extent than management fees and brokerage commissions.
The authors also concluded that rankings of funds on a pre-tax basis differed significantly from the
rankings of those same funds on an after-tax basis. The article states that the average fund moved
28 spots (on a list of 343 funds) higher or lower in ranking, after taxes had been accounted for. Funds
that ranked near each other on a pre-tax basis had a 46% probability of having their ranking reversed on
an after-tax basis. In addition, the report found that, for an average fund during this period, an individual
investor in the highest marginal tax bracket would have lost approximately 15% of the annualized pre-
tax return to taxes on fund distributions.
* Amin Mawani, Moshe Milevsky, and Kamphol Panyagometh, “The Impact of Personal Income Taxes on Returns and Rankings
of Canadian Equity Mutual Funds,” Canadian Tax Journal 51, no. 2 (2003): 863–901.

OVERLAY MANAGEMENT

9 | Describe the skills required for successful overlay management.

Overlay management is a service that combines several managed investment products into a single account
controlled by a single authority. Conventional portfolio construction, unlike overlay management, merely combines
separate accounts for each managed product, which multiplies the administrative work.

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DID YOU KNOW?

The term overlay management is derived from the fact that the wealth manager overlays his or her
expertise over that of the investment managers of the managed products.

The use of overlay management among a large portion of the Canadian wealth management community came
about for two reasons:

• The challenge of beating the market return is more difficult now than in the past, and wealth managers now
acknowledge that certain investment decisions are best left to specialized investment professionals. The wealth
manager is now essentially a “manager of investment managers”. However, the wealth manager retains control
over the asset mix decision and even sector investment decisions.
• Managed products are viewed by many wealth managers as a method to reduce the amount of time spent
managing client portfolios. Instead, they can spend more time focusing on servicing current clients and
acquiring new ones.

SKILLS REQUIRED FOR SUCCESSFUL OVERLAY MANAGEMENT

Wealth managers using overlay management must have certain skills to succeed, which are described in
this section.

SELECTING INVESTMENT MANAGERS: DUE DILIGENCE

The wealth manager must be able to apply two main skills to the process of selecting an investment manager:

• The ability to understand and assess the investment manager’s pure investment-related skills and abilities
• The ability to assess and rate the non-investment-related aspects of the various managed products under
consideration

These aspects include any unique terms, conditions, and costs associated with each individual managed product.

ALLOCATING MANAGED PRODUCTS WITHIN AN ASSET ALLOCATION

The wealth manager must be able to apply asset allocation models correctly when creating and managing the asset
allocation for clients invested in managed products. Some managed products might have only a relatively short
time history, thus limiting the statistical validity when constructing an efficient frontier.

ACCOMMODATING OVERLAY MANAGEMENT IN INVESTMENT POLICY STATEMENTS

The wealth manager must be sure that the client’s investment policy statement (IPS) properly accommodates the
potential inclusion of managed products in the portfolio. The IPS should identify the specific role that managed
products will play and what types are permitted for investment.

ENSURING ACCURATE REPORTING OF PERFORMANCE NUMBERS

The wealth manager must be sure that the information regarding the client’s holdings in managed products lives up
to high standards of service and care. The relevant information provided by the managers of the managed product
should be complete and accurate, and it must be received in time to be consolidated into a single report form for
distribution to clients.

ASSESSING WHOLESALING SUPPORT

The wealth manager needs wholesaling support from the managed product manager in terms of specific materials
and assistance, as well as quality information provided post-sale.

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PROS AND CONS OF OVERLAY MANAGEMENT

Before implementing overlay management, the wealth manager must weigh the pros and cons of single security
selection in comparison to an investment in managed products. Some of the main points of comparison between
the investment management methods are shown in Table 23.2.

Table 23.2 | Comparison Between Single Security Selection and Managed Products

Aspect Single Security Selection Managed Products

Diversification No. Diversification is difficult to Yes. Managed product are usually
accomplish, especially with smaller well diversified.
portfolios.

Degree of control over investment Very high. None.

strategy by wealth manager

Ability to demonstrate security Yes. No. Managed products are generally

trading skills not designed to be traded.

Trading commission income Yes. Commission income depends None. The wealth manager’s income
on the amount of trading and is in the form of trailer fees, asset
degree of success. management fees, or a combination
of the two.

Ability to report on total exposure Yes. Client reports provide Yes. However, the wealth manager
to individual securities and investment details on a security- may not be able to consolidate this
individual market sectors and sub- level, sector, sub-sector, and asset information with any of the client’s
sectors class basis. other managed account investments
and individual security holdings.

Ability to apply tax loss harvesting Yes. To the extent that unrealized No. The wealth manager has no
(i.e., to control realized capital gains exist, capital gains and losses control over security-specific gains
gains and losses in a client’s total can be controlled. or losses.
portfolio on an annual basis)

Efficient use of the wealth No. The wealth manager must Yes (potentially). Less time and
manager’s time spend more time researching effort is spent researching individual
and trading individual securities, securities, which allows the manager
which reduces time available to to spend more time servicing current
service current clients and prospect clients and prospecting for new ones.
for new ones.

TRENDS IN OVERLAY MANAGEMENT

The first attempt at overlay management was with the use of separately managed accounts (SMAs). However,
wealth managers could never reference the decisions of other managers in the client’s account to ensure that their
decisions made sense in the context of the client’s overall portfolio. Therefore, clients were at risk of having higher total
exposure to particular markets, sectors, or individual securities than the investment guidelines permitted by the IPS.
Furthermore, clients could have a different tax basis, or cost, for each individual security they held in the various
managed accounts. Lack of information and lack of control over the managed account manager sometimes led
to poor results. The wealth manager was unable to control capital gains or losses in order to optimize the client’s
individual current income tax situation.

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The shortfalls of the SMA structure led to the development of unified managed accounts (UMAs). These accounts
are essentially software tools and data feeds. In a properly functioning UMA, the wealth manager is able to monitor
the client’s overall portfolio of managed accounts to the appropriate level of detail to ensure that all investment
guidelines are observed. Tax management can be controlled by including active loss harvesting.
The evolution and development of overlay management continues with the development of the unified managed
household account (UMHA). A UMHA provides all of the features, information, and controls afforded by a UMA.
However, the UMHA is applied to the client’s entire household, family office situation, or both, in some cases. It
incorporates all of the other considerations arising from the client’s household situation or family office situation.

SKILLS FOR OVERLAY MANAGEMENT

What skills does an advisor need to apply overlay management? Complete the online learning activity to
assess your knowledge.

OUTCOME-BASED INVESTMENTS

10 | Compare outcome-based investments to traditional investments.

Outcome-based investments are designed to achieve a specific client goal, such as principal protection, tax
management, or inflation indexation. According to findings by McKinsey & Company (in its report “The Asset
Management Industry in 2010”), growing interest in outcome-based investments has been fuelled by three factors:

• Poor relative mutual fund returns

• Selection from a large number of confusing investment styles
• Greater need for capital preservation and income generation

Over much of the lifetime of the mutual fund industry, the one central theme championed by industry supporters
has been relative performance. When a benchmark declined, the investment manager was considered to have
performed well if the portfolio lost less than the index benchmark. However, unlike the manager, the client cannot
benefit from relative performance. To the client, a loss is still a loss.
The philosophy of relative performance has supported the proliferation of style categories. If the manager could not
beat the broader indexes, there was probably a style sub-index that more suitably represented the portfolio.
Finally, an aging demographic is shifting its investment focus from savings and accumulation to more capital
preservation and income generation. A McKinsey Consumer Survey found growing interest among this demographic
in buying investment products that will mitigate the risks associated with advancing age.
These trends may signal a significant market shift in emphasis from relative performance managed products,
such as mutual funds, to more specific outcome-based products, such as principal-protected notes or target date
portfolios. We are seeing evidence of that growth already.

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MANAGING THE LEWIS-MAIER HOUSEHOLD’S INVESTMENTS

At the beginning of this chapter, we presented a scenario in which spouses Mark Lewis and Karl Maier wondered
what specific investments you would recommend to help them meet their goals. Now that you have read the
chapter, we’ll revisit the questions we asked and provide some answers:

• How can managed products be used to help the Lewis-Maiers’s achieve their goals? What aspects of these
products should you, as their advisor, be most aware of to ensure that their portfolio return is maximized?
• As advisor, you should understand the following aspects of managed products:
« Targeted managed products can be used to achieve substantial after tax cash flow and generate growth.
« Due diligence is required to select the right managed products.
« Wrap accounts are a flexible and convenient solution for some portfolio requirements.

• Your clients require significant cash flow from their portfolio. What else do they require? What specific managed
products can they use to ensure that their portfolios meet their investment goals?
• The Lewis-Maiers’s require growth in their portfolio. By adding ETFs as the core holding and hedge funds as
a satellite, the clients should be able to meet their growth needs. Both ETFs and hedge funds are suitable
options given their sizable portfolios, along with Mark’s sophisticated investment knowledge.
• As their advisor, what do you need to do to ensure that you are choosing the right managed products and
performing your role as an overseer of your clients’ portfolios? What evidence do you need to be assured that
the managers of the investment products you are recommending to your clients are meeting their mandate and
performance goals?
• You should make sure that the investment solutions you recommend have been well researched and
represent the best track records, competent fund managers, and lowest possible cost given the services
provided.
• Given their inherent complexity, you must choose hedge funds carefully based on their risk characteristics,
strategy, and structure. You must also pay close attention to their costs and liquidity constraints.

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SUMMARY
In this chapter, we discussed the following key aspects of managed products:

• Managed products are a pool of capital gathered and invested in a portfolio of individual securities according to
a specific investment mandate. The mandate is carried out and monitored by a professional money manager,
who receives a management fee for the service. Managed products include some types of managed assets that
were once offered only to wealthy clients but are now available to most investors.
• A mutual fund is an open-ended investment company that raises capital by issuing shares or units in its pooled
fund. The capital is used to purchase securities according to the fund’s investment mandate.
• Wrap products are portfolios of managed products “wrapped” together and sold as a single product. Wrap
accounts are accounts for which a qualified portfolio manager is authorized to select securities and execute
trades on behalf of a client.
• Exchange-traded funds offer cost effectiveness, liquidity, real-time transparency, and access a variety of
markets. In this chapter, we discussed four types of ETFs: synthetic, leveraged, inverse, and commodity ETFs.
Depending on their structure, ETFs are subject to specific risks, including risk of roll yield loss, risk of front
running, counterparty risk in derivatives, risk related to volatility and leverage factors, risk of short selling bans,
risk related to futures position and sizes, and credit risk in currency ETFs.
• Hedge funds are lightly regulated pools of capital whose managers have great flexibility in their investment
strategies. Some hedge funds are targeted toward high-net-worth and institutional investors, whereas other
funds and hedge fund-related products are targeted toward the retail market. Before recommending a hedge
fund, you should perform your due diligence, considering factors such as the fund’s track record, its risk
characteristics, return statistics, and tax treatment. You should also consider the structure of the hedge fund
organization and the skill of the fund’s managers. Of course, investor suitability is a major factor, in terms of risk
profile, time horizon, and liquidity needs.
• The return on managed products is affected by management fees, portfolio turnover, and taxes.
• Overlay management combines several managed investment products into a single account controlled by a
single authority. A successful overlay manager must be able to assess the skills of the investment manager and
rate the non-investment-related aspects of the managed products under consideration.
• Outcome-based investments are designed to achieve a specific client goal, such as principal protection, tax
management, or inflation indexation.

DISCUSSION BOARD

If you have any questions about this chapter, you may find answers in the online Discussion Board
for Chapter 23.

REVIEW QUESTIONS

Now that you have completed this chapter, you should be ready to answer the Chapter 23 Review
Questions.

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