7.01  Investment management is an arrangement whereby one party, the investor, entrusts a portfolio of investments to another party, the professional investment manager, so that the manager may manage the investment and reinvestment of the portfolio on behalf and for the account of the investor in accordance with an agreed investment objective. In doing so, the manager is expected to apply professional care, skill, and knowledge, and in consideration for such application, the investor will pay the manager a fee. Accordingly, the investment management service is characterized by three constitutive components. The first component is the manager’s duty to invest the investor’s capital in a mix of assets with certain risk and return properties. The second component is the manager’s discretion, using professional judgement, knowledge, and skill, to decide, subject to the applicable investment constraints, how to perform the investment duty, that is, how to construct the investment portfolio The third component is the investment manager’s agency authority to invest the investor’s capital in the selected portfolio of investments by entering into or arranging transactions for and on behalf of the investor. The three constitutive components must be aligned. The terms of the manager’s appointment need to be such that the scope of the investment discretion and the (p. 302) scope of the agency authority correspond to the scope of the investment duty. If either the scope of the investment discretion or the scope of the agency power is too narrow, the investment manager may not legally be able to perform the investment duty in the manner contracted.

7.02  The above notions are echoed in the definition of ‘investment management’ deployed in EU and UK regulatory legislation. The definitions suggest that an investment service does not constitute investment management for regulatory purposes unless the firm offering the service has the discretion to make, and the power to implement, investment decisions. The EC Court of Justice (CoJ) has had occasion to interpret the definition used in the Investment Services Directive (ISD),¹ which defined the service as ‘managing a portfolio of investments in accordance with mandates given on a discretionary client-by-client basis where such portfolios include one or more [financial instruments]’.² The CoJ decided:³

With regard, in particular, to the definition of managing portfolios of investments contained in Point 3 of Section A of the Annex to [the ISD], it comprises three elements. Firstly, portfolio management must be carried out in accordance with a mandate by which an investor authorises an investment firm to take investment decisions on his behalf. Secondly, the portfolios managed must include one or more of the instruments listed in Section B of the Annex to [the ISD], such as transferable securities. Finally, portfolio management must be carried out on a discriminatory, client-by-client basis. This last element implies, as the Commission states, that the investment firm may take discretionary decisions while respecting the investor’s strategic choices.

7.03  MiFID I and II are the successors to the ISD and both continued to define ‘portfolio management’ as ‘managing portfolios in accordance with mandates given by clients on a discretionary client-by-client basis where such portfolios include one or more financial instruments’.⁴ The UK’s legislative framework contains a similar definition for portfolio management and specifies ‘managing securities or (p. 303) contractually based investments of another person’ as a regulated activity if it involves ‘the exercise of discretion’.⁵

7.04  It is often suggested that an investment manager who may implement investment decisions only after obtaining investor approval is not providing investment management services because of the necessary discretion is lacking. That would be true if in the circumstances, the investment manager’s professional judgement is truly replaced by the investor’s judgement. In most cases, however, that conclusion will not be justified. For instance, the pre-trade approval may be motivated by the investor’s requirement to verify whether the proposed cause of action would cause any concerns that may not necessarily be investment related. The investor’s review may also be motivated by an operational reason, eg because the investor would like to see complete trading lists so that it is easier to monitor performance. Further, the constitutive parts of the investment manager’s process are, or ought to be, integrated because the execution process will invariably be informed by the decision process, and vice versa. In some circumstances liquidity of an asset or accessibility of a relevant market may be as important to the asset allocation decision as the expected return on that asset. The introduction of pre-trade investor approval as part of the manager’s investment process does not change that dynamic per se.

7.05  Nevertheless, if the manager merely makes proposals and the investor genuinely has the skill and ability to, and actually does, review and challenge the investment manager’s proposals, the shift of responsibility is such that the investor’s judgement prevails in relation to the investment decisions and the scope for the manager’s discretion is reduced to using professional judgement, knowledge, and skill in giving investment advice and executing investor approved transactions. In such circumstances, the investment manager—in regulatory terms—is acting as an investment adviser cum broker, and not as investment manager. Equally, if responsibility for execution has shifted to the investor so that execution is predominantly dependent on the investor’s skill and judgement—because the investor is selecting the trading venue and the time and manner of execution—the manager’s role in order execution can be said to have been reduced to mere reception and transmission of orders. Such shifts in reliance by the investor will necessarily limit the scope of the investment firm’s responsibilities, although the firm should be careful to ensure that the arrangements continue to be in the best interest of the investor.⁶

7.06  An investment manager is sometimes said to have the power to ‘manage a fund’ on behalf of another. In a general context, this terminology would imply that (p. 304) legal title to the assets comprising a portfolio of assets from time to time will vest with the person who has the management power, but that the other person, on whose behalf the portfolio is being managed (the beneficiary) has equitable rather than legal proprietary rights. To assert legal proprietary rights in specie, the beneficiary will have to be able to terminate the manager’s power and crystallize the fund. Whether or not the beneficiary has such power will depend on the terms and conditions upon which the fund was constituted.⁷ The fact that the investor has ‘entrusted’ the portfolio of assets to the manager and that the combination of discretionary and agency powers of an investment manager are referred to as ‘management powers’, however, should not be interpreted to mean that ownership of the assets is somehow transferred to the manager. An investment manager does not have the power of a trustee pursuant to a transfer of title to the assets that comprise the fund that is to be managed. Rather, funds and other eligible property that form part of the investment portfolio managed by the investment manager are credited to accounts maintained and administered by a professional custodian for the investor, subject to the terms of a custody agreement between that investor and the custodian.⁸ Accordingly, an investment manager’s insolvency does not leave the investor exposed as far as the property in the portfolio is concerned, as title to that property is defined in terms of the relationship between the investor and the custodian.

7.07  The investment manager will have been authorized by the investor to instruct the custodian to settle transactions the investment manager has executed with a market counterparty for and on behalf of the investor, or has instructed a broker to execute for and on behalf of the investor.⁹ The investment manager will perform all these tasks as agent of the investor and does not acquire any proprietary interests in the cash and securities accounts maintained by the custodian in the name of the investor. The custodian will operate the accounts and receive and transfer funds and securities for and on behalf of the investor, not the investment manager. Accordingly, the custodian’s account records constitute the definitive source of information about the portfolio holdings. Although the investment manager will maintain, and is under a regulatory duty to maintain, portfolio record-keeping systems that record all portfolio holdings, investment decisions, trade executions, and cash and securities movements, ultimately, an investment manager cannot know with certainty what the portfolio holdings are unless the investment management records have been compared with the custody records and all discrepancies have been investigated and clarified. That process is referred (p. 305) to in industry jargon as ‘reconciliation’. Reconciliation of portfolio records against the cash accounts maintained by the custodian will typically occur on a daily basis so that any discrepancies in trade settlements may be identified. Reconciliation against the securities accounts will occur on a less frequent basis, as cash reconciliations will usually reveal most discrepancies.

7.08  Investment management, as the term suggests, denotes a process. It includes all the steps that need to be taken during the term of the mandate to create and maintain a portfolio of investments in accordance with the investor’s investment objective and constraints.. The process includes reviewing and monitoring the portfolio, including performance measurement, to ensure continuous compliance with the investment objective and investment constraints.¹⁰

7.09  Investing is the process whereby a portfolio of investments is selected from a universe that contains both risk-free assets and assets that are not risk-free. Risk-free assets are assets that have an expected return over a certain period that will not vary much even if macro-economic and or other risk factors change, such as a short-term government bond. Risky assets, on the other hand, are assets that, over a certain period could have a range of different returns, or fail entirely, depending on the development of certain macro-economic and other risk factors. The concept of ‘risk’, as used in modern portfolio theory refers to the levels of dispersion of the anticipated returns of an investment, or a portfolio of investments, relative to the average, or arithmetic mean, return. The greater the variability of the spread of anticipated returns relative to the mean return, that is, the greater the ‘variance’ or ‘volatility’ of the anticipated returns, the greater the level of risk that is associated with that investment.¹¹

7.10  Modern investment theory assumes that investors are unwilling to invest in an asset that is not risk-free unless the mean return on that asset is above the return on a risk-free asset.¹² The seminal question for each investor, therefore, is in what proportion capital should be allocated, first, between risky assets and risk-free assets, and second, between the different categories, or classes, of risky assets. That decision-making process is called ‘strategic asset allocation’. Asset allocation decisions are driven by several factors, but particularly by the investor’s (p. 306) return requirements and risk appetite. Collective investment schemes, insurers that offer unit-linked life policies, and defined contribution pension funds function as intermediaries for the collective underlying investors. Accordingly, they will formulate generic risk–return requirements and make asset allocation decisions based for the collective investment pool on an asset-only modelling (AOM) approach. In an AOM approach, any impact of the underlying investor’s liabilities is expressed indirectly, that is, is implied in the expected return requirement.¹³ In contrast, return requirements may also be defined specifically with a view to expected future liabilities. Insurers, defined benefit pension schemes, and public institutions function as end-investors and hold the portfolio not for the collective benefit of underlying investors but to service a stream of uncertain future liabilities. These institutional investors will specify their return requirements by reference to their expected future liabilities, the calculation of which is a complex statistical exercise that is usually carried out with the assistance of professional actuaries. The asset allocation decisions are then formulated based on ‘asset–liability studies’, also referred to as ‘asset–liability modelling’ (ALM). ALM aims at determining the optimal strategic asset allocation that will deliver returns matching as closely as possible the institutional investor’s expected future liabilities. In each case, however, the investor will engage in forecasting of macro-economic developments and formulate expectations concerning risk and return prospects of asset classes, also called ‘capital market expectations’. The capital market expectations form the basis for strategic asset allocation decisions within the investor’s risk and return, that is, investment, objectives.

7.11  Normally, investors will be subject to certain constraints that need to be considered when setting risk and return objectives, and making strategic asset allocation decisions. These investment constraints may be driven by liquidity requirements investment horizon limitations, or tax considerations. Institutional investors may in addition be subject to ultra vires limitations and other constitutional restrictions, regulatory restrictions, and other special institutional concerns. Liquidity is a function of the ease and speed with which an asset can be sold in the market at a fair price. If the investor has high liquidity requirements, a substantial part of the portfolio will have to be held in cash or cash equivalents, that is, assets that may be sold at a fair market price without delay. The investment horizon is the length of time an investor seeks to invest the capital. Pension funds may take a longer view than insurance companies. Regulatory restrictions are typically applicable to regulated institutional investors, that is, banks, insurance companies, regulated collective investment schemes, or pension funds. Tax regulations may have an impact at investor level or at investment level. Depending on the type and structure (p. 307) of the investment, an investor may pay a different tax rate on investment returns. Equally, depending on jurisdiction and status of the investor, an investment may be subject to a different withholding rate at source. Tax matters may therefore limit the universe of assets that are eligible for the portfolio. Finally, an investor may face circumstances special to that investor and, on that basis, may place specific restrictions on a portfolio, such as a pension scheme that seeks to limit or avoid investment in the stock of the sponsoring employer. The AOM and ALM processes are strategic and result in the formulation of investment objectives and restraints, and a strategic asset allocation plan.

7.12  Historically, institutional investors appointed investment managers to deal with both the strategic asset allocation decisions and the implementation, in relation to each chosen asset class, of an appropriate investment strategy. An ‘investment strategy’ organizes and clarifies the principles that apply to the making and execution of investment decisions. It provides the practical basis for the selection of such investments as may be necessary to arrive at an optimal asset mix in the portfolio, that is, a portfolio that best meets the chosen risk and return objectives, in view of the chosen investment objective and the applicable constraints.¹⁴ In other words, the investment strategy is a methodology to achieve the portfolio’s investment objectives, while observing the investment constraints. Over time, the institutional investor’s approach to selecting and appointing investment managers changed in favour of appointing investment managers to carry out specialist investment strategies that focus on one or more specific, and often narrowly defined, asset class.¹⁵ Modern institutional investors operate an organizational framework that includes, at a minimum, an investment committee and some permanent administrative staff, who are able, with the assistance of independent advisers, to develop, approve, implement, and continuously review an overall investment policy and asset allocation process for the investor’s total investment portfolio, and select investment managers to carry out the implementation process. The manager selection in the context of an AOM-driven appointment may be based on the features of a certain generic proprietary investment strategy of the investment manager. Manager selection in the context of ALM-driven appointments may be based on the investment manager’s ability to design an investment strategy around certain core investment competences of the investment manager, specifically with a view to delivering a return that matches the investor’s expected future liabilities.

(p. 308) 7.13  An institutional investor may have a large-scale operation and may have chosen to employ portfolio management professionals who are able to develop capital market expectations, formulate investment strategies in-house, and invest the portfolio in accordance with the chosen allocations and strategies. However, even substantial institutional investors will not always be able to invest economically in the people, systems, and controls necessary to design and implement investment strategies that permit prudent and competent investment across a broad range of asset classes. It would require the employment of a great number of different portfolio management professionals who possessed a wide variety of skills and expertise in relation to all desired asset classes, as well as staff, controls, and systems necessary to enter into trading relationships with the relevant brokers and other market counterparties, to communicate with the custodian and the broker or other counterparty in relation to the settlement of transactions, and to keep a record of the executed transactions and the resulting changes in the investment portfolios. In addition, in the niche asset classes, even large sophisticated institutional investors may prefer to allocate the assets to an investment manager who has access to liquidity. Consequently, most institutional investors will appoint one or more outside professional investment managers to manage at least certain parts of the investment portfolio. Selecting external managers will allow the institutional investor to rely on the professional skills of the most successful investment managers from time to time, and at the same time diversify investment risk by allocating portions of the investor’s portfolio to different investment managers that operate independently and apply different investment styles and strategies.

7.14  In summary, the appointment of investment managers by institutional investors is predominantly driven by the ability of the investment manager to offer specialist investment strategies. The strategic asset allocation decisions that determine the parameters of the investment manager’s appointment will usually have been considered by the institutional investor’s in-house professionals or outside advisers, called ‘consultants’,¹⁶ not by the investment manager. The investment manager’s work is a component of the institutional investor’s overall portfolio process. That does not mean that the investment management industry does not offer advisory services aimed at assisting institutional investors with formulating capital market expectations and making strategic asset allocation decisions. But, investment advisory services have a purpose that is distinct and different from the purpose of investment management services,¹⁷ and should therefore be treated as separate and independent from investment management services. Notwithstanding, both types of services might very well be contracted for as part of a single relationship.

(p. 309) 7.15  The business of investment management is a scale business. Fees are commonly calculated by applying a certain rate specified in ‘basis points’ to the value of the assets under management. One basis point is equivalent to 0.01 per cent (1/100th of a per cent), or 0.0001 in decimals. Accordingly, if the management fee is set at, for example, 10 basis points per annum of the net asset value of the portfolio valued in US Dollars, the investment manager will earn a fee equal to $1 for a portfolio valued at $10,000. In that scenario, the investment manager would earn an annual fee of $100,000 if the portfolio has a value of $10 million. Typically, the fixed costs of the operations of an institutional investment manager – staff, offices, systems – is such that the manager cannot operate profitably unless individual investment portfolios have a value equal to several times $10 million. Retail investors who would like to take the benefit of specialist investment managers, or institutional investors that wish to invest smaller portfolios with a certain investment manager, therefore, will need to entrust their assets to that investment manager on a collective, or ‘pooled’, basis, which is discussed next, in section 3.

7.16  Many investment managers offer investment strategies via a collective investment scheme. Collective portfolio management permits the benefit of economies of scale so that individual investments that would be too small to be viably or commercially managed on an individual basis can be managed as a single collective portfolio. Each individual investor will need to contribute assets to a collective investment scheme that is operated by the investment manager or an affiliate. Collective investment schemes, or ‘funds’, are arrangements whereby the assets of different investors are pooled, administered, and invested on a collective basis.¹⁸ They are also called ‘managed’ or ‘pooled funds’. A fund may be established in closed-ended or open-ended form,¹⁹ and as a corporate vehicle,²⁰ or as common (p. 310) fund in the form of a unit trust if it is established under the laws of a common law jurisdiction,²¹ or otherwise in purely contractual form.²² The investors will invest in the fund in return for equity rights in the form of units or shares. The assets that the investors contribute to the fund will be held on a pooled basis subject to the terms of the fund, which will at a minimum comprise the investment objective and restrictions of the fund, and the terms and conditions on which the investment manager, the custodian and the other service providers of the fund will be appointed and supervised. The investors in the fund share pro rata in the returns and losses of the investment portfolio of the fund, as well as the costs associated with running the fund, principally the fees and expenses of the service providers..²³

7.17  The core operating functions of a fund are the transfer agency function (ie administration and settlement of dealings in units or shares of the scheme), the distribution function (ie the marketing of the fund), the fund accounting function (ie the net asset value calculation and share or unit pricing), and the investment (p. 311) management function. As noted, typically, these functions are outsourced in accordance with the terms of the fund to specialist service providers. This presents the various parties with a complex situation. The investor has rights against the fund, or the parties that constitute the fund, and, in the case of a common fund, usually a proprietary interest in the property held in the fund, but does not necessarily have direct rights against those who provide services to the fund, in particular the investment manager and the custodian. Yet the fund is merely a conduit to the investment capabilities of the investment manager and at the same time a medium to take advantage of the ability to pool investments with those of other investors. Questions concerning the scope of rights, responsibilities, and liabilities arising directly between the service providers and the investors in the fund can be very complex.

7.18  In many cases funds are established and operated, or ‘sponsored’, by financial services providers, typically large retail banks or retail insurance companies, which specialize in distributing collective investment schemes to retail clients. In that case, the selection and appointment of the investment manager by the fund is the responsibility of the sponsor.

7.19  Like all providers of professional services, investment managers specialize within their industry. In the case of the investment management industry, the specialization concerns differentiation of investment strategies. Usually, an investor will not appoint a manager to invest the investor’s capital in accordance with a strategy that has been developed by that investment manager, unless the strategy has been put into practice for a certain period, typically at least a year, so that it is possible to evaluate its performance characteristics properly. To that end, at inception of a new strategy, the investment manager will ‘seed’ it with its own capital, with the purpose of creating a performance record, or ‘track record’, for that strategy. Once the strategy has proved its value, external investors may be willing to invest, which will allow the investment manager to withdraw the seed capital.

7.20  The design, offering, and implementation of investment strategies by investment managers are subject to the MiFID II product governance requirements for manufacturers.²⁴ In addition to ‘investment advice’, Article 25(2) of MiFID II identifies ‘portfolio management’ as an investment service that would subject the investment manager to the suitability duty. It is not immediately obvious why the regulatory regime equates portfolio management to investment advice. Investment advice, by its nature, includes a consideration of the investor’s circumstances and purpose. The development, offering, and maintenance of a specialist investment strategy is, however, although in product governance terms will include a (p. 312) consideration of the target market, does not consider the circumstances of any specific investor. The purchase by an investor of an asset management product, be it in the form of an investment fund or discretionary mandate, is likely to be the result of investment advice. The practical implication of Article 25(2) of MiFID II for investment managers is that such firms are per se investment advisers in respect of their proprietary investment product. Consequently, the manufacturing investment firm must consider the risk and return properties of the selected asset management product in the context of the investor’s situation before executing the mandate. As discussed in Chapter 4,²⁵ this appears to be wrong footing the MiFID II regulatory system and is not in line with the position at law.

7.21  Investment strategies can be categorized in different ways, but the primary distinction is the category of investable assets, the asset class, that is the subject matter of the strategy. An asset class is a set of homogeneous investments that have similar risk–return characteristics. The universe of investable financial assets, as opposed to real assets, has traditionally been divided, broadly, into three different economic categories: equity investments, fixed-income investments, and money market investments.²⁶ In addition, currencies, or ‘foreign exchange’, may be considered as a separate asset class. Within these macro-categories, many subcategories can be discerned. Equity is broadly divided into geographical regions, ranging from countries to continents, and within the regional categories, into ‘large-cap’, ‘medium-cap’, and ‘small-cap’, denoting the market capitalization of the target companies. Thus, by way of example, an investment manager may develop a ‘UK Small-cap Equity’ strategy, or an ‘Emerging Market Equity’ strategy. Fixed income is broadly divided into currency zones, and within those, the asset class is typically defined first by reference to the maturity of the target fixed-income securities—that is, short-, intermediate-, and long-term—and second by reference to their credit quality. Credit quality is determined by an issuer’s status as a government or governmental agency issue, which is the highest credit rating, or as a corporate issuer, which may be further distinguished between regulated financial services firms and unregulated corporate issuers. In addition, issuers that are asset-backed schemes are treated as a separate issuer class.

7.22  The traditional asset classes may be contrasted with the risk–return characteristics of what are commonly referred to as ‘alternative investments’. The common alternative investment categories are private equity investments, real estate and infrastructure investments, and commodities. Except for commodities, these investments are characterized by relative illiquidity, and structural complexity of the investment transaction. In addition, certain categories of hedge fund investment universes as well as distressed securities have been described as separate alternative (p. 313) asset classes. In general, it may be said that alternative asset classes seek to invest in assets that exhibit risk–return characteristics that have a low correlation with the risk–return characteristics of the traditional asset classes. The investment management and risk measurement processes relating to investment in alternative asset classes, therefore, are of a different order to the investment management and risk measurement processes relating to investment in the traditional asset classes.

7.23  A further distinctive feature of investment strategies is the ‘investment style’, which denotes certain key risk-taking characteristics of an investment strategy. The universe of potential investment styles is infinite. However, a few basic categories may be distinguished. At the top of the pyramid, there is a distinction between passive, active, and semi-active, or ‘risk-controlled active’, styles. If an investment strategy is characterized as ‘passive’, it seeks to deliver the return of a certain market, typically expressed as a published financial market index, or a risk-free rate. For example, an ‘MSCI Europe’ passive investment strategy will seek to deliver the returns of the MSCI Europe Index by constructing a portfolio of investments that resembles the nominal MSCI Europe Index portfolio, closely. A strategy with an active investment style seeks to deliver an investment return that exceeds a risk-free rate or exceeds the return of a market or a portion of it, usually as represented by a financial index. The investment manager will carry out analytical research, formulate forecasts, and apply judgement and experience in making decisions on which investments to buy, hold, or sell. The objective of an active investment strategy is to returns that exceed the return on the applicable benchmark. For example, a ‘UK large-cap’ active equity investment strategy would seek to deliver a return that exceeds the expected return on the securities that comprise the FTSE 100 Index. A risk-controlled active strategy, also known as ‘enhanced index’ strategy, seeks to deliver excess returns within more narrow risk parameters relative to the chosen benchmark.

7.24  The single most important implication of modern portfolio theory is that an investment’s risk characteristics depend on the covariances of all the investments of the portfolio in which the investment in question is held. The division into active and passive styles is based on that principle of risk and return optimization through diversification and on the propositions of the Efficient Market Hypothesis (EMH).²⁷ Investment strategies that pursue an active investment style seek to discover and exploit market inefficiencies so that excess returns may be generated.²⁸ Passive investment strategies, on the other hand, do not try to generate excess returns but seek to select the optimally risky portfolio, that is, a portfolio that exhibits the benefits of Markowitz’s market portfolio. (p. 314) Following the emergence of Capital Asset Pricing Model (CAPM) and EMH, passive management, in particular index management, became a popular investment strategy during the 1970s and early 1980s, and indeed, have seen continued rise since. Today, economic theory does not subscribe to perfectly efficient markets, but to near-efficient markets in which active managers earn excess returns in pockets of inefficiency as a reward for gathering and acting on costly information. The continuing question at the door of the active management industry is whether active managers do in practice earn these excess returns for their investors.²⁹

7.25  The objective of a passive mandate is to seek a return that is as close to that of the relevant index, or composite benchmark, as is reasonably possible. The most common passive strategy entails the replication, or approximation, of a financial market index that serves as a proxy for the market portfolio. There are many published indices in all asset classes, each covering different markets, and within those markets, different segments. Obviously, in accordance with the basic principle of portfolio theory, a broader index represents better diversification and therefore lower residual risk. Further, there are differences between indices depending on whether the security weights are based on stock price, total market capitalization, free-float capitalization, or equal weighting, and further whether the return is calculated on a total-return basis that includes reinvestment of dividends, or on a net basis. Logically, the characteristics of an index may result in a bias of the nominal index portfolio towards a sector or category of issuers. Not all indices are constructed strictly passively. A truly passive index ought to be based solely on quantitative criteria, such as market capitalization. Some indices, however, may include a qualitative element, such as Standard & Poor’s indices, which are composed subject to discretionary criteria determined by a committee. The replication of an index portfolio typically requires a substantial portfolio. Only institutional (p. 315) investors, therefore, can economically invest in an index portfolio. If tracking a mainstream index, investment manager and custody fees will be low, as turnover in the portfolio will be minimal and the investment manager will not charge high fees for a pure ‘beta’ product.

7.26  In an index strategy, security selection decisions are foregone, except to the extent that a manager might not seek to replicate the index portfolio completely, on grounds that the return contribution of the smaller constituents is so immaterial that it does not warrant the trading and holding costs. Equally, portfolio composition decisions are foregone, as this is a function of the composition of the index. Each time the index is reset, the investment manager will be required to rebalance the portfolio accordingly. Enhanced index strategies at the core construct passive portfolios, but the investment manager varies the weights of individual holdings, within ex ante tracking error limits, to reflect an active view on the return prospects.

7.27  The objective of an active mandate with a relative return benchmark is to seek to outperform the relevant benchmark portfolio by a certain percentage. Absolute-return mandates, on the other hand, will set qualitative parameters. These return objectives are typically characterized by a reference to the investment period and to the intention to deliver capital appreciation or income in excess of a risk-free benchmark. The investment style of active equity strategies is typically distinguished depending on whether the selection methodology can be characterized as ‘value’,³⁰ ‘growth’,³¹ or ‘blended’, also referred to as ‘market-oriented’. Market-oriented styles are not restricted to either value or growth philosophies, although the style may have a bias to one or the other. A further distinction may be made between large-cap and small-cap styles. The style that underpins an active equity investment strategy may be identified by an analysis of the portfolio returns or of the portfolio holdings.³² Finally, a distinction may be made between ‘long-only’ styles, and styles that incorporate taking short positions, that is, selling securities or other market exposures either actually, by borrowing the securities at the time of the short sale to satisfy the short seller’s delivery obligation, or ‘synthetically’, by entering into a derivative transaction. The style of an active fixed-income strategy is typically dependent on whether the strategy relies on interest rate forecasting or on credit quality assessment. Variations and combinations of these basic equity and fixed-income active style categories, including a (p. 316) further consideration of industry sectors and geographic location of the issuers, allow for a myriad of investment styles for a certain asset class or combination of asset classes.

7.28  An active investment strategy very much revolves around the investment manager’s security-selection skills. The selection methodology may range from ‘fundamental’ research on issuers and industry sectors, to ‘quantitative’ model-driven selection based on various sets of economic data, ‘factor’, rather than review of individual issuers of groups of issuers. Depending on the applicable risk management requirements, portfolio-composition, that is, risk-modelling, skills also come into play. Effective risk modelling will depend on the availability of an appropriate benchmark portfolio. The benchmark portfolio should be representative of the investment manager’s opportunity set and should also exhibit systematic-risk characteristics that are similar to the risk characteristics of the managed portfolio.³³ Depending on the scope of a manager’s active discretion, accurate risk measurement and performance attribution may become challenging. Under a mandate that has specified the scope of the active discretion conservatively, the investment manager will not be permitted to leverage the portfolio, will not be permitted to take a short position, must invest the portfolio in constituents of the relevant benchmark portfolio only, and must ensure that at all times the portfolio is as fully invested as is practically possible, that is, market timing is not permitted. Market timing involves the shifting of capital allocations between risky and risk-free assets, such as cash. Under a mandate that has specified the scope of the active discretion liberally, the investment manager will be permitted to leverage the portfolio, take short positions, time the market, and spread the portfolio across several asset classes. Obviously, in practice, investor and investment manager will agree myriad variations along the conservative-to-liberal spectrum. If the investment discretion includes the ability to take a short position, leverage, and market-time the portfolio, the investment strategy will typically be referred to as a ‘hedge fund strategy’, regardless whether the investment strategy is actually carried out through a fund, or not. The only constraint that applies, usually, to liberal active investment strategies is that the investment manager is required to apply the investment style that underpins the investment strategy, consistently. For example, if an investment manager is hired as a value manager and, over time, shifts to investments that ought to be characterized as growth stocks, that investment manager can be said to be experiencing ‘style drift’.³⁴ It will be very challenging to measure risk and return accurately for portfolios that are managed subject to a liberal active discretion in particular, if the investment style is not applied consistently.

(p. 317) 7.29  The investment strategies discussed thus far are based on asset-only modelling. An investor may also ask a manager to design an investment strategy based on certain core investment competences of the investment manager, specifically with a view to delivering a return that matches the investor’s expected future liabilities. Insurers, defined benefit pension schemes, and public institutions, for instance, will face streams of uncertain future liabilities, and may have identified a future stream of liabilities that they would like to be able to match with cash flows from expected returns on an investment portfolio. Liability-driven investment (LDI) adds an extra element to the asset allocation equation. Rather than an absolute risk–return trade-off decision based on the volatility of the investment return only, the investment decision must also consider the volatility of the investment return relative to the volatility of the liabilities.³⁵

7.30  The return objective of an LDI mandate will typically state that the intention is to seek a return, as at the relevant maturity date, that is as close as reasonably possible to the value of the portfolio at inception, compounded by a certain rate. Typically, the target rate is a combination of a fixed interest rate and an inflation rate. The fixed rate will be set based on, among other factors, market valuations of forward cash benchmark rates,³⁶ and projected inflation rates prevailing at the time the portfolio was launched. The portfolio will be funded with a capital equal to the present value of the future liability, discounted by using the target interest rate. Equity investments by nature do not lend themselves to this type of investment strategy. Liability-driven investment strategies are carried out and implemented by specialist fixed-income managers.

7.31  Liability-driven investment strategies may also seek to match returns to investment liabilities, rather than to business liabilities. This is called ‘hedging’. A very common form is currency hedging. If the investor is based in a eurozone jurisdiction, but invests outside the eurozone, that investor’s investment return will depend not only on the return of the relevant foreign investment, but also on fluctuations in the exchange rate of the relevant foreign currency and the euro. To hedge that exposure, the investor may appoint an investment manager to implement a currency hedging strategy and sell that foreign currency against euros from time to time, thus locking in the exchange rate at regular intervals. A hedge could also be driven by an inability to, or decision not to, invest in assets that deliver a certain required return. For instance, an investor might have assets invested in money market instruments and other cash equivalents yet need to be exposed to a particular equity index, such as the FTSE 100 Index, and may not be willing, for whatever reason, to liquidate the cash equivalents to invest in FTSE 100 securities. This might prompt the investor to request the investment manager (p. 318) to manage the portfolio of cash equivalents and hedge the investor’s FTSE 100 exposure by purchasing FTSE 100 futures at regular intervals with a nominal value equal to the value from time to time of the portfolio of cash equivalents. These are all forms of liability-driven investment, although in industry jargon, the term ‘LDI’ refers to investment strategies that are designed to deliver a return that matches the investor’s exogenous liabilities, rather than indigenous portfolio market exposures.

7.32  The investor and the investment manager normally enter into a written investment management agreement, also known as the ‘mandate’,³⁷ under which the investment manager, in consideration for the management fee, undertakes as the investor’s agent to manage a portfolio of investments in accordance with, and subject to, agreed investment objectives and restrictions, if any. The terms of the mandate, therefore, are the primary source for the investment manager’s legal duties. Under the mandate, the investor appoints the investment manager as agent and undertakes to pay the investment manager a fee. In consideration of the fee, the investment manager undertakes to use professional judgement, knowledge, and skill, as the investor’s agent, subject to such investment constraints as may have been agreed, to construct and maintain a portfolio of investments with a view to attaining the agreed investment objectives.

7.33  The investment manager will be entitled to a fee that usually is calculated by reference to the average value of the assets under management measured over a certain period. The fee is either calculated on a fixed rate, or based on the investment performance, or a combination. A fixed-rate fee is relatively straightforward. The investor and the investment manager need to agree the rate, the base for calculation (eg based on the arithmetic average of the net asset values of the portfolio as at the end of each month), and how often the fee is calculated (eg quarterly). It is not uncommon to use a sliding-rate scale so that the investor pays a lower rate (p. 319) as the size of the portfolio increases. The calculation of a performance fee can become quite complicated. Often, the investor requires that, although the fee may be calculated periodically, performance is measured over a longer period so that only performance in excess of an earlier ‘high-water mark’ is rewarded. The performance is calculated relative to a performance benchmark, so that excess return may be defined as the return on the portfolio measured relative to the benchmark return, calculated cumulatively over a certain period (eg two years) on a net new high basis. There are several ways in which cumulative performance can be calculated, so that the investor and the investment manager need to take care to ensure that there is common intention as to the methodology.

7.34  The contract will typically be less clear about reasons for suspension or abatement of management fees. As a matter of general principle, an agent will not be entitled to remuneration in respect of any unauthorized transaction that is not ratified by the principal, or in respect of transactions in relation to which it is in breach of its fundamental duties as an agent.³⁸ As remuneration is usually calculated by reference to the value of the assets under management, it will be difficult to identify any single transaction as the source of remuneration, so a breach will rarely go to the whole client agreement. Breaches are not usually a matter of dishonesty, wilful neglect, or misconduct. Instead, they are typically due to involuntary mistakes, negligent as these might be. In those circumstances, assuming any loss to the investor has been repaired, there seems to be no reason not to pay the investment firm remuneration as would have been due in the absence of such breach.³⁹ In practice, investors who have been compensated for losses do not appear to seek abatement of management fees in the event of a breach of the client agreement by an investment firm. Compensation aims at moving the investor’s portfolio to the position it would have been in had the breach not occurred, so that the investor is restored on a net basis.⁴⁰ To abate fees in those circumstances would amount to a net profit for the investor and a penalty for the investment firm.

7.35  It is mostly self-evident that the cost of an investment firm’s general business operation is not one that should be reimbursed by the investor, unless agreed otherwise; that cost ought to be covered by the management fee. The cost of investment research has been an area of concern in this context. The investment process, in its most basic building blocks, consists of research, portfolio decisions, and trading. Broker-dealer firms offer a variety of investment research reports on assets that the house trades in. Traditionally, investment managers have been able to obtain (p. 320) investment research reports, including access to research specialists, by allocating a portion of dealing commissions to the purchase of investment research. That means that the investor is paying for what is arguably a cost of the investment manager’s general business operation. Following the superequivalence example set by the United Kingdom, MiFID II now curtails use of dealing commissions to pay for investment research.⁴¹

7.36  An agent has a right against its principal to be reimbursed for all expenses and to be indemnified against all losses and liabilities incurred by it in the execution of its authority,⁴² although the right to reimbursement of expenses will not apply if the expense in question should be covered by the remuneration.⁴³ The main source for potentially reimbursable expenses or indemnified liabilities is the dealings the investment manager has with counterparties and brokers. As the costs of trading, that is, any purchase price and any dealing commissions, are transferred by the custodian from the investor’s account at the time the transaction is due for settlement, the investment manager will not normally be called upon to pre-fund any reimbursable costs. However, in some circumstances, the investment firm could incur a liability that should properly be that of the investor; for instance, if the broker claims against the investment manager in connection with a failed settlement or other dispute in relation to a transaction instigated by the investment manager for the investor.⁴⁴ The implied right to be reimbursed or indemnified would not arise if the loss or liability is the result of an unauthorized act, is incurred solely as the result of the agent’s own negligence, default or breach of duty, or if the act in question is plainly unlawful.⁴⁵ Typically, the investment firm will seek to include express terms in the client agreement providing for indemnity rights.

7.37  Before appointing an investment manager, an institutional investor will seek to review that investment manager’s business and investment capabilities in some detail and, to that end, will often submit a questionnaire. In industry jargon, the questionnaire is called a ‘request for proposal’ (RFP). An RFP will typically request a description of the investment manager’s organizational structure, investment philosophy, and investment processes, the experience in the team of investment professionals, the past performance of the investment manager’s (p. 321) proprietary investment strategy, the investment manager’s reporting capabilities, and a fee proposal.⁴⁶ The investor will review the information as part of its decision to appoint the investment manager. Following review of the RFP, an investor may request the investment manager to give a presentation about its investment capabilities and the details of any proprietary investment strategy that has attracted the investor’s attention. To constitute evidence of an intention by the investment manager or both parties that there should be contractual liability in respect of a promise made, or the accuracy of the facts presented, in the pre-contractual information, each such statement (as opposed to a mere representation) is potentially capable of being treated as a term of the contract, or as having created a separate, ‘collateral’, contract. Whether a statement must be treated as a primary or a collateral term will depend predominantly on the prevailing circumstances at the time.⁴⁷ Therefore, general observations should be made with caution. It is suggested that, in normal circumstances, the parties to an institutional investment management agreement ought to assume that the written instrument constitutes proof of all the express terms of the agreement, and that written or verbal preliminary statements or assurances should be treated (if not as expressions of subjective intent) as representations rather than as a term of the contract or as a collateral term. This is because documentation or presentations prepared by the investment manager for the investor as a prospective client are typically intended as general informational communications, and accordingly, are usually discursive. Normally communications of this nature are not intended to be binding and ought not to be held up as such. This does not mean that a preliminary statement could not be proved to be a term of the mandate, whether primary or collateral. Where a preliminary statement amounts to a particular and specific assurance about a verifiable and reasonably certain fact or fact pattern, and it is, or ought to be, clear to the investment manager that the investor is relying on that assurance to enter into the investment agreement, and that reliance is reasonable, statements that are made as part of general informational communication could be classified as a primary or collateral term.⁴⁸ In this context, therefore, given the weight of importance that must be assigned to the nature and character of the investment manager’s proprietary strategy in the selection process, careful consideration must be given by both the investment manager and the prospective client as to their intentions in that respect. The practical importance may be limited as investment management agreements customarily provide that the written document containing the terms of the investment management agreement represents the ‘entire agreement’ of the parties.

(p. 322) 7.38  The principal terms of the investment management agreement are formed by provisions that set out the investment manager’s undertaking to use professional judgement, knowledge, and skill, as the investor’s agent, to construct and maintain a portfolio of investments for the investor in accordance with certain specified risk and return objectives, subject to the applicable investment constraints. These will be supported by subsidiary provisions that aim to cover the manner in which the investment manager, once an investment decision has been made, is expected on behalf of the investor to deal with brokers, counterparties, and the investor’s custodian, the manner in which the investment manager is expected to handle corporate actions and exercise voting rights, the investment manager’s permission to deal for the investor notwithstanding the existence of certain conflicts of duties or interests, the investment manager’s reporting obligations, the manner in which the investor may give further instructions, the manner in which the investment manager’s dealing authority and the agreement terminate or may be terminated, and the limitation of liability and mutual indemnities. ‘Boiler-plate’ matters, adding, inter alia, an entire agreement clause, a jurisdiction clause, and an applicable law clause, complete a typical investment management agreement. Strictly, there is no need to document substantive subsidiary terms, with the exception of conflict-management provisions that modify fiduciary duties.⁴⁹ This is because the investment manager is a quintessential agent, tasked with dealing with the investor’s property by deploying agency powers in a discretionary manner. The principles that apply to the work of agents and to the discretionary exercise of agency powers in relation to property which belongs to another have been well established, both at law and in equity. Consequently, in the absence of express terms, the core duties of an agent are broadly incorporated by implication of law.⁵⁰

7.39  The investment duty of the investment manager may best be described as a duty to use care, skill, and professional judgment to invest the investor’s capital in a mix of assets in accordance with the terms of the mandate, most notably the risk and return objectives, with a view to pursuing a certain specified return. The descriptions of risk and return objectives in mandates naturally will vary considerably depending on the investment strategy that the investment manager is asked to employ. It is quite common for an investment management agreement to include terms that provide that ‘no warranty’ is given in relation to the ‘performance of the portfolio’. This type of provision seeks to deny the investor the right to complain, with hindsight, that he had relied on certain assurances about the future investment return of the portfolio that have proven to be false. Under a properly drafted return objective, however, the investment manager is required to aim to deliver a certain return, not strictly to deliver that return. The investment duty is (p. 323) defined in terms of effort, not in terms of result. In addition, it ought to be clear, at least to the reasonable investor, that at the time of the investment manager’s appointment the return expectation is not a verifiable or reasonably certain target so that any pre-contractual statements made by the investment manager as to the likely performance of a certain investment strategy ought not to be relied on as particular or specific assurances that give rise to a collateral warranty or representation.⁵¹ Accordingly, assuming the terms of the investment duty are properly drafted, to include a provision that aims to confirm that the investment duty is not a duty to deliver a specific investment result would appear to be superfluous.

7.40  The terms of the mandate will normally not prescribe how the investment manager must use its investment discretion to perform the investment duty. The exercise of that discretion will be subject to the investment constraints, if any, prescribed by the mandate and the investment manager’s general duty to perform the investment duty with the requisite level of skill and care. The mandate may describe the essential features of the investment style characterizing the investment strategy that the investment manager will seek to employ. The reason is that divergence from the professed style, known as ‘style drift’, can change the risk and return profile of the investment strategy the investment manager is using, which might invalidate the reason for the original selection of the investment manager by the investor. The mandate may outline the key aspects of the investment style in an attempt to set limits on the investment manager’s discretion to change the investment strategy. The mandate may also be particular about the risk objectives, such as the limits applicable to the ex ante tracking error, or the value-at-risk (VaR) parameters to which a portfolio may be subjected.⁵² Prescriptive risk parameters will limit the investment manager’s freedom by requiring that the portfolio not be constructed in a manner that would cause the portfolio to breach those parameters. Prescriptive risk parameters will also require the investment manager to change the composition of the portfolio if market movements cause the portfolio to breach the parameters. Nevertheless, the mandate will mostly leave the investment manager with relatively broad discretion to make such investments as, in the investment manager’s professional judgement, may be conducive to the attainment of the return objective. The exercise of discretion will be subject only to the specified investment constraints, including any restrictions on the freedom to change the investment style and an enunciation of the risk objectives, and the investment manager’s duty to use skill and care.

7.41  The agency authority is the investment manager’s power to bind the investor to transactions with, or through, certain third parties.⁵³ The terms of the mandate (p. 324) should be drafted so that the scope of the investment manager’s agency authority corresponds to the scope of the investment duty. If the scope of the investment duty and the scope of the agency authority are mismatched, the investment manager might not be able to perform the investment duty in the manner contracted without breaching the mandate. A simple example may illustrate this. If the investment objective is to match the return of the FTSE 100 Index, yet the investment constraints provide that the investment manager does not have authority to invest in one or more major constituents of that index, the investment manager will not be able to match the return of the index through direct investment. The manager may seek to obtain the return through indirect investment, such as by way of a derivative transaction, but that might be a costlier way of obtaining exposure and, thus, will affect the return of the portfolio negatively relative to the return of the index. Consequently, the mandate must shape the scope of the agency authority so that the investment manager has the ability to invest in a range of investments (direct and indirect) that includes all types that the investment manager might need to hold to achieve the investment objectives. In addition, the scope of the authority should include an ability to execute the relevant transactions with or through such brokers or dealers, and in such markets, as the investment manager may need to select to obtain or dispose of a permitted investment.⁵⁴ The risk of a possible mismatch between duty and power is reduced, where the authority given to an agent other than by deed is interpreted liberally, having regard to the object of the authority, the usages of trade or business, and inferences that might be drawn from the conduct of the parties and the circumstances.⁵⁵ Equally, where the authority is conferred in ambiguous terms, an act reasonably performed in good faith, which might be justified within the ambiguous ambit, is deemed to have been within the scope of the agent’s express authority.⁵⁶ These principles demonstrate that the law assists principal and agent with a purpose-oriented, rather than a strict, construction of the agency authority.

7.42  In the absence of limiting words, the agency authority ought to be construed with a view to enabling the investment manager to perform the investment duty. For example, if the investment duty is to seek to deliver the return of the FTSE 100 Index, and the mandate does not include any terms that pertain specifically to the universe of permitted investments, brokers, or markets, the investment manager will have implied authority to purchase and sell all securities that are included in the FTSE 100 Index and may do so through such brokers and on such markets as is practical, reasonable, and usual. In addition, depending on the circumstances of the case, the authority may include an implied authority to invest in FTSE 100 futures. Obviously, the reverse is true, too. The return benchmark also limits the (p. 325) authorized investment universe. A manager who undertakes to deliver or exceed the return of the FTSE 100 Index, in the absence of special circumstances, would likely exceed its agency authority if it invests in securities that are not part of that benchmark.

7.43  It may be that the investment manager will need to use derivative contracts and collective investment schemes to achieve the investment objective. If, in the circumstances, there is doubt whether that authority may be implied based on the nature of the return objective, the mandate should include express terms permitting the use of the requisite type of investments. In that case, the mandate will also need to include an authority to use the assets or funds comprising the portfolio for collateral purposes, which may be an implied authority if it can be established that the transaction requiring the delivery of collateral is a permitted transaction.⁵⁷

7.44  It is self-evident that the mandate will need to include an authority to give such instructions to the counterparty to the transaction, or to the relevant broker, and to the custodian, as might be necessary to arrange for settlement of that transaction. This authority ought to be implied, but, often, a mandate will provide expressly how the investment manager is expected to deal with the custodian in relation to the portfolio.

7.45  At the heart of the performance of every investment mandate is the quality of the investment manager’s financial asset selection process. If the quality of that process passes muster, the investment manager has discharged the investment duty in accordance with the terms of the mandate, regardless of the realized investment return. Every professional agent acting for reward is under a duty to exercise such skill, care, and diligence as is usual or necessary in or for the ordinary or proper conduct of the profession. If the agent holds him- or herself out as possessing a special skill that exceeds that proper skill, the duty may be to exercise that higher degree of skill. The benchmark for the quality requirements that investment management services in general and the performance of the investment duty in particular must meet, therefore, is the skill, care, and diligence that may be expected of a reasonable investment manager who possesses an ordinary level of professional competence, taking into account the special skill that the investment manager professes to possess, and who is acting in like circumstances.⁵⁸ Proof of the applicable standard thus, foremost, requires proof of the standard that is ordinary in the profession, that is, proof of common practice among peers.

(p. 326) 7.46  Evaluation of the discharge of the investment duty requires an analysis of the investment manager’s conduct considering the purpose and the terms of the mandate, not an analysis of the realized investment return against the mandated target. In circumstances where the realized investment return is far less than the return objective, the investment manager might have discharged the investment duty perfectly in accordance with the terms of the mandate. The fact that another investment manager who invested in a similar investment universe achieved a better return is not proof of failure of the incumbent. Equally, the investment manager may have realized an investment return that is in line with, or in excess of, the mandate’s return objective, and nevertheless be in breach of the investment duty, although it would be difficult to prove loss in those circumstances.

7.47  In this context, the decision of the Court of Appeal in Nestlé v National Westminster Bank plc may serve as an example to illustrate the operation of the applicable principle,⁵⁹ that is, that the performance of the investment duty must be judged based on the conduct of the investment manager in light of the purpose of the mandate, not in light of the realized investment return, no matter how abysmal either relative to the applicable benchmark, if any, or the returns achieved any other investment manager acting in comparable circumstances.⁶⁰ The case concerned complaints by the holder of the remainder interest in a trust fund that was settled in the early 1920s at a value of approximately £50,000. In 1986, after the death of the last life tenant, the plaintiff became absolutely entitled to the remainder of the trust fund, which at that time had a value of approximately £270,000. At trial, expert witnesses established that, had the value of the trust fund kept pace with the cost of living, the remainder would have had a value of approximately £1 million. Equally, had the value of the trust fund kept pace with a certain broad UK equity index, the remainder would have had a value of £2.6 million. The plaintiff submitted that, at least from the early 1960s, the trustee should have allocated a larger portion of the trust fund to equities. Staughton LJ examined the various obligations that the trustee had to the life tenants over time and found that ‘it is apparent that the investments retained or made by the trustees fell woefully short of maintaining the real value of the fund, let alone matching the average increase in price of ordinary shares’.⁶¹ Nevertheless, he concluded that, although the investment processes of the trustee were far from exemplary, given the general duty of a trustee to act fairly and impartially in balancing the life interests and the remainder interests there was no loss arising from a breach of duty for which (p. 327) the trustee ought to compensate the trust fund.⁶² Although one might criticize the conclusion reached by the Court of Appeal on the ground that the duty of care and skill of a trustee acting in these circumstances ought to be of a different calibre,⁶³ it cannot be argued that the court’s approach, a determination of the trustee’s liability based on a standard of reasonable conduct, not of reasonable result, is incorrect. The fact that the trust fund significantly underperformed one benchmark, or the other is not proof of a failure to perform a duty of care.

7.48  The practice of portfolio investment has been the subject of extensive academic effort over the years, which has produced not only several Nobel laureates, but also a general theory of portfolio investment. Investment management is therefore very much influenced by academic theory, and although the variety of investment methodologies is infinite, there are certain basic academic principles against which investment processes may be measured. The ultimate implication of modern portfolio theory is that the risk–return characteristics of an investment are a function of both the investment’s individual risk–return prospects and the correlations of those prospects with the risk–return prospects of all other investments held in the portfolio. It follows that the aggregate risk-level of the portfolio can be less than the individual risk-level of any single investment included in it.⁶⁴ Accordingly, the exercise of investment discretion may be tested on two different skill sets. On the one hand, an investment manager’s method of forecasting return and volatility prospects of individual investments, sectors, and asset classes may be reviewed and considered. On the other hand, the investment manager’s risk management methods, such as the skill to estimate the correlations of the selected securities in a portfolio combination and assess overall portfolio risk before making investments, may be reviewed and considered.

7.49  Passive equity management does not require special skill and care in connection with the selection of securities, although a certain optimizing skill is required if the index is not fully replicated. A passive equity manager will select securities from the investment universe represented by the relevant index. A passive fixed-income manager will have to ensure that selected securities match the characteristics of the securities in the chosen benchmark. Thus, the security-selection skills required of passive fixed-income managers are of a more complex order than those (p. 328) of a passive equity manager. Mistakes could result in a failure to ensure that the selection includes securities that have the right benchmark characteristics.

7.50  Active investment managers need to apply considerable skill to the selection of securities, sectors, or asset classes, by formulating expected returns and volatility levels for individual investments with a view to identifying alpha opportunities or avoiding ‘lemons’. Forecasting and research methodologies vary and rely as much on experience as on science. If measured against principles of modern portfolio theory, active equity managers may be required to estimate beta coefficients, arrive at return forecasts based on fundamental, technical, or quantitative analysis, and select equity securities for purchase or sale while staying within the parameters of the applicable investment style. Active fixed-income managers need to estimate effective durations and key-rate durations relative to the applicable benchmark,⁶⁵ arrive at return forecasts based on interest rate analysis, fundamental credit analysis, or quantitative credit analysis, and select securities for purchase or sale with a view to mismatching effective duration, key-rate duration, sector and quality weights, or sector duration. An active investment manager will be in breach of the duty to apply skill and care to the security-selection process in any instance in which the chosen methodology is not reasonable, or the application of the methodology is of a substandard quality, for example because of inexperience or mistakes. What is or is not a reasonable security-selection methodology ought to be defined first, by reference to the terms of the mandate and second, by reference to common practice among investment managers that specialize in the same style of investment strategy.

7.51  Although the investment manager’s security-selection methodology will be incorporated into the investment strategy, the mandate will rarely be specific about the matter. Nevertheless, the investor will have reviewed the investment manager’s proposed investment strategy as part of the investor’s manager-selection procedure and, based on that, the investor might have had certain reasonable expectations in respect of the security-selection methodologies that the investment manager supposedly would use, and might have relied on these expectations when entering (p. 329) into the mandate. Such circumstances might give rise to a warranty or a representation, which would render the investment manager liable for losses caused by a failure to apply a security-selection methodology that conforms to those reasonable expectations. Further, in the event that the investment manager changes the essential characteristics of the security-selection methodology without due cause, a phenomenon known in the industry as ‘style drift’, the investor may have a valid reason to complain that the investment manager has breached a duty of care to ensure that the agreed investment strategy is applied consistently,⁶⁶ or, alternatively, that the investment manager breached a duty of care not to exceed the scope of the investment discretion. In the absence of specific terms or reasonable expectations, the investment manager will be held to a general standard of skill and care that may be said to constitute common practice; but such an absence from an institutional mandate ought to be rare because it suggests that the investor neither performed due diligence nor prescribed specific investment terms, although it could occur in the event of more secretive hedge fund strategies. To determine relevant common practice, regard must be had to the practice of investment managers that apply the same investment style, rather than a more general group of investment managers, as the investment style is the most important determinant of the risk–return characteristics of a portfolio.

7.52  In the context of the principles of modern portfolio theory, the purpose of portfolio selection techniques is two-fold: first, to ensure that, where reasonably and practicably possible, the portfolio’s overall active risk levels will not reach inappropriate levels; second, to aim to eliminate, where reasonably and practicably possible, idiosyncratic risks of individual investments for which the investor will not be compensated in the form of excess returns. The assessment of these matters needs to be conducted on an ex ante basis, that is, before the investment decisions are implemented. An investment manager may be in breach of the duty to apply skill and care to matters of portfolio selection if the implementation of the risk modelling methodology does not conform to the investor’s justifiable expectations arising under the mandate. Several considerations should be kept in mind in the context of assessing an investment manager’s process against principles of modern portfolio theory. Foremost, it should be noted that risk calculations are based on estimates of beta and other relevant risk-factor relationships. Therefore, at best, risk calculations can produce only indicative numbers that are subject to (p. 330) interpretation. At worst, risk calculations produce irrelevant numbers. Beta, as the key component of risk calculations, is only useful as a risk value if a benchmark index is used that reflects the primary risk characteristics of the investment strategy. If the benchmark portfolio is not a good proxy for the risk characteristics of the investment universe of the portfolio, the risk metrics are of little value.⁶⁷ If a mandate does not define the investment universe or the key attributes of an investment strategy well, which might be the case for certain hedge fund strategies, there may not be a readily appropriate benchmark to measure risk or performance, rendering risk calculations largely futile.

7.53  Passive investment managers are not required to limit idiosyncratic risk through portfolio construction. The index portfolio is presumed to be properly diversified per se. However, a passive investment manager may be in breach of the duty to apply skill and care to portfolio construction in any instance in which the ex ante tracking error measured over an appropriate time interval exceeds the limits set out in the mandate, or otherwise, exceeds such limits as might reasonably have been expected by the investor.⁶⁸ Ex ante tracking errors could occur in particular if the investment manager fails to rebalance the portfolio properly following a cash flow or a periodic reset of the index.

7.54  An active investment manager may be in breach of the duty to apply skill and care to portfolio selection if the chosen methodology to limit idiosyncratic risks through diversification is not reasonable in the context of the mandate, or if the implementation of the methodology is of a substandard quality, such as because of inexperience or mistakes. Like the standard that applies to the security-selection methodology, what is or is not a reasonable system of diversification ought to be defined first by reference to the terms of the mandate, and second by reference to common practice among investment managers that specialize in the same style of investment strategy.⁶⁹ As to the terms of the mandate, again these will rarely be specific about matters relating to limitation of idiosyncratic risks through diversification, but the investment manager might have induced reasonable investor expectations and subsequent reliance, so that a failure to limit idiosyncratic risks through diversification in line with those expectations could result in liability based on breach of warranty or on misrepresentation. Equally, a change in the portfolio-construction methodology without due cause might constitute a breach of the duty of care or a breach of the duty not to exceed the scope of the investment discretion. Conversely, an active mandate may not be prescriptive at all, that is, be ‘unconstrained’, which essentially leaves the investment manager free to select from the investment universe without specific risk (p. 331) constraints, although that should not permit the portfolio selection to become ‘speculative’.⁷⁰

7.55  An active investment manager may also be in breach of the duty of care applicable to portfolio selection if the chosen methodology to limit overall portfolio risk is not reasonable, or if the implementation of the methodology is of a substandard quality. Here, the terms of the mandate may be specific and prescribe certain maximum levels of overall ex ante risk. In that case, the investment manager will have to forecast risk levels and adjust investment decisions so that, on a projected basis, the portfolio will not exceed the given risk parameters, before implementing the investment decisions. The most common parameters are expressed either as an overall volatility value,⁷¹ as a VaR value,⁷² or as a tracking error value.⁷³ Additionally, an investor might prescribe limits on sector, issuer, or other exposures. Here, a conflict may arise between the requirement to eliminate unnecessary idiosyncratic risks through diversification, and the requirement to limit overall risks. The ability of the investment manager to optimize the idiosyncratic-risk elimination of the portfolio will depend on the scope of the investment discretion and may effectively be limited by restrictions on the permitted investment universe, the permitted portfolio composition, the permitted risk parameters, or by any other restrictions in the terms of the mandate. Certain restrictions on the investment universe and on ex ante overall risk exposures might limit the investment manager’s ability to eliminate the idiosyncratic risks of individual investments because the constraints may force the investment manager to be less diversified.⁷⁴ For instance, a mandate might prescribe an ex ante tracking-error limit. However, a high tracking-error portfolio might actually deliver lower risks and higher returns than those of the benchmark.⁷⁵ Nevertheless, should the mandate prescribe an ex ante tracking-error limit, and should the investment manager be found to have failed to comply with that limit, liability could arise for breach of the investment manager’s duty not to exceed the investment discretion. In the absence of specific terms, implied warranties, or representations in connection with risk diversification and overall risk levels, the investment manager will be held to a general standard of care that may be said to constitute common practice. To determine relevant common practice, regard must be had to the practice of investment (p. 332) managers that apply the same investment style, rather than a more general group of investment managers, as investment style is most important determinant of risk–return characteristics in a portfolio.

7.56  In the absence of a simple breach of an investment restriction, the claimant will have to show that the quality of the security-selection process was wanting, rather than the choice of any specific investment.⁷⁶ Litigation relating to a manager’s portfolio-selection process is rare as investment managers tend to settle disputes with institutional clients in private given the reputational risks involved with a public disagreement, and retail clients have different complaints procedures. Accordingly, judicial precedent is scarce, but there was one rather public disagreement in the early 2000s about the deficiencies of an institutional investment manager’s risk-management systems between a UK pension scheme and a UK manager, which, again, was ultimately settled.

7.57  The dispute was between Unilever Superannuation Trustees Ltd (USTL), and Mercury Asset Management plc (MAM). MAM was appointed by USTL to carry out an active balanced mandate that required allocation of the portfolio to various asset classes, including UK equities. The mandate specified a composite benchmark for the portfolio made up of various published indices, each relating to a specific portfolio component. The index relating to the UK equity component was the FTSE All Share Index. The investment objective was to outperform the composite benchmark by 1 per cent, subject to an understanding that ‘in normal circumstances the return will be expected to be no more than 3 per cent below the benchmark in any period of 4 successive calendar quarters’. Measured over the period from January 1997 to December 1997, as well as over the period from April 1997 to March 1998, the portfolio underperformed by approximately 8 per cent. USTL commenced proceedings against MAM in October 1999, complaining that MAM had breached a duty of care in relation to the UK equity component of the mandate, which had a target allocation of 60 per cent of the net asset value of the portfolio. The complaint alleged that MAM failed to manage the risk of underperformance. That allegation was based on two arguments. First, it was argued that, relative to the FTSE All Share Index, the UK equity component had a disproportionate concentration in the ‘general industrials’ sector, neglecting an allocation to the ‘financials’ sector. Second, it was argued that the UK equity component had a disproportionate allocation to a group of only twenty stocks.

7.58  Prima facie, USTL’s complaint had substance. If it is accepted that an active manager ought to select a portfolio such that the expected volatility of that portfolio remains within parameters that are acceptable to the investor, it is difficult to reconcile the specified maximum expected underperformance level of 3 per cent, which presumably was not construed as a warranty that the portfolio will not (p. 333) suffer losses exceeding 3 per cent of the benchmark in a certain period, with the high concentrations in the portfolio. It is probably reasonable to assume that, for such concentration levels, the ex ante tracking error of the portfolio consistently exceeded 3 per cent during the measuring periods. At trial, MAM countered that USTL had been receiving full reports about the portfolio composition and had never once raised a question or objected. It is not clear whether those reports included risk metrics; probably not, because it also emerged at trial that MAM did not operate any tangible risk-management programme in respect of the portfolio. It was clear that the portfolio manager in question was left with very wide discretion to select securities, and very little accountability. There is no indication that the 3 per cent metric, however it had to be interpreted, was ever considered by the portfolio manager in the context of the security selection process, let alone built in as a determinant. It also became clear that there was a discrepancy between the marketing representations made by MAM about its risk-management processes in general, and the practice applied in respect of USTL’s portfolio. Further, it emerged that there was a difference between the risk-management practices applied to USTL’s portfolio, or lack thereof, and the risk-management practice applied to portfolios managed by other MAM portfolio managers. In these circumstances, it would be very difficult for an investment manager to maintain that no breach of the investment duty occurred. The portfolio manager should have had regard, in some manner, to the risk parameters specified in the mandate.

7.59  It would, nevertheless, be difficult to establish with any measure of precision, what it is that could reasonably have been expected of the investment manager in the circumstances. The underperformance target limit of 3 per cent can be explained in many ways. To establish, on the balance of probabilities, what the investment manager’s most likely course of action would have been for assessing damages would require a complex reconstruction of the selection process that would have to be based on a range of assumptions.⁷⁷ In practice, the challenge for the investor to prove what the investment manager’s most likely course of action would have been will increase in proportion to the scope of the investment manager’s investment discretion. In the case of a passive mandate, the investment manager will have relatively limited discretion and it is less of a challenge to establish what the most likely course of events would have been. For instance, if the investment objective is to deliver a return as close as reasonably possible to that of the FTSE 100 Index, and the investment manager fails to adjust the composition of the portfolio in a timely manner following a reset of the Index, it will be a relatively straightforward exercise to establish what the investment manager would have done, but for the breach, and what the value of the portfolio would have been had it done that. However, if the mandate calls for an attempt to outperform the FTSE 100 Index and gives the investment manager relatively broad investment (p. 334) discretion, the investment manager could argue that, as it is unclear how the discretionary powers would have been used, the distribution of possible outcomes being too wide, it will apply the least onerous hypothetical manner of performance to the calculation of the opportunity cost. To refute that argument, the investor will have to establish that the investment manager, despite the discretion, would typically adhere to a certain investment process, so that the distribution of possible outcomes is much narrower. If the relevant investment strategy has been operated by the investment manager over a relevant period, past course of conduct ought to be a relevant factor, possibly tipping the ‘balance of probabilities’.

7.60  Once an investment decision has been made, the investment manager will need to arrange for execution of the appropriate transactions. To that end, the investment manager will have to employ a specialist staff possessed of the expertise and skill necessary to access a trading venue, select a suitable broker or dealer, and place an order with a broker or execute a trade with a dealer on terms that are in the best interest of the investor and meet best execution requirements.

7.61  Casual observation would lead to the conclusion that if an investment manager places an order with a broker, the investment manager must have delegated trading authority to the broker. However, this is not the case. The investment manager intends, and it is ordinarily so understood by the sell-side investment firms, to appoint the broker with the purpose of bringing about privity of contract between the investor and the broker. The broker provides the brokerage services to the investor, not to the investment manager. To say it differently, the broker is appointed as agent of the investor. The broker’s agency authority is created by the services contract made by the investment manager, as agent for the investor, with the broker. Thus, the broker is not appointed as a sub-agent whose agency authority derives from the delegated agency authority of the investment manager, but as co-agent. Where the investment manager cannot bring a transaction about directly, it is within the investment manager’s investment discretion and agency authority to discharge its duty to implement the relevant investment decision by selecting and appointing an appropriate broker for and on behalf of the investor.

7.62  That this is so, that is, that the investment manager has the authority to arrange for the broker to provide a service to the investor, follows from the fact that the concept of delegation presumes that the function that is delegated is a function the delegator could otherwise perform itself. The business of a broker, however, is entirely different from the business of an investment manager. It might be that an investment manager employs specialists who have the skill and knowledge to execute transactions directly with a counterparty acting as principal. That, however, does not mean that an investment manager is organized, or indeed, capitalized or regulated, to operate a brokerage business. A broker offers a skill set and execution (p. 335) ability that is different from the skill set and execution ability that is offered in the usual course of an investment manager’s business. Given that the investment manager cannot reasonably be expected to have undertaken, by the mandate, to offer a brokerage function, the investment manager cannot delegate that function to a sub-agent. Therefore, the services of a broker are contracted for separately by the investor, acting through the investment manager.

7.63  In the event of default of a broker or a dealer that was selected by the investment manager, the question may arise whether the investment manager is liable for losses. The ability of brokers or dealers to perform a contract made with or through them is a relevant factor in the context of the investment manager’s duty to take all reasonable steps to obtain best execution. The broker-dealer selection process includes both the ability of the broker-dealer to execute the trade, and the settlement risks. Thus, the investment manager needs not only to review the broker-dealer’s financial stability and standing, but also to consider such factors as the applicable trading terms, the quality of the operative payment and settlement systems, the quality of its delivery-versus-payment (DVP) processes, and any collateral movements. An investment manager might be liable if it failed to exercise the requisite skill and care in selecting, appointing, and (where appropriate) supervising the broker or dealer. However, as the investment manager acts as agent of the investor when instructing the broker or dealer, the instruction of the broker or dealer does not bring a service or transactional relationship about between the investment manager and that broker or dealer, but between the investor and the broker or dealer.⁷⁸ Accordingly, the investment manager is not liable for the acts and omissions of the broker or dealer as if these were the acts and omissions of the investment manager. The investment manager is liable only for negligent selection and instruction.

7.64  It is quite common for several individual investor portfolios to be managed in parallel, as a virtual pool, in accordance with the same investment strategy. If a trading decision is prompted by a signal from the investment strategy—rather than by a contribution or redemption to or from a portfolio by an investor, although both trading needs may be carried out in parallel—the investment manager will generate buy or sell orders for each portfolio that are in all respects the same, except for the quantity and potential individual portfolio restrictions. Rather than trading the orders one by one, the investment manager may seek to aggregate them and trade the orders as a single block. On occasion, individual orders might benefit from higher execution quality if executed separately, but if on balance orders that are part of the block are likely to enjoy the benefit of higher execution quality, aggregation is permitted under the applicable (p. 336) regulatory regime,⁷⁹ and by analogy ought to be a reasonable use of agency authority so as not to give rise to a claim from individual investors based on breach of a duty of care. Typically, the terms of the mandate will provide explicitly that aggregation of orders is part of the normal operating conditions of the investment manager, if only because the investment manager is under a regulatory duty to put the investor on notice that aggregation is part of its normal trading practices.⁸⁰

7.65  Ordinarily, where two or more persons give authority to an agent to make a single contract, it is presumed that the authority is to act for their joint account only, unless a contrary intention appears from the nature of the terms of the authority, or from the circumstances of the particular case.⁸¹ It is almost self-evident that investors who permit aggregation of their orders, so that these may be carried out as a single transaction, do not intend to become liable as joint principals on that transaction, but only as co-principals, pro rata to their share in the transaction. Accordingly, in the absence of express terms to the contrary, it ought to be assumed that, in the ordinary course of dealings, unless expressly disclaimed, sell-side participants may be regarded as willing to deal with the investors as co-principals, not as joint principals.

7.66  If the investment manager executes the transaction with a dealer, or with a matching agent by way of a cross, allocation will be implied at the time the transaction is executed.⁸² If the investment manager has placed the aggregate order with an execution broker, the broker might not be able to fill the order completely. Unless there is an express manifestation to the contrary, it could be assumed that the original allocation is not varied where the aggregate order is filled in part. If all else remained the same, the part-fill merely results in a pro rata reduction to the portion of each principal’s share in the executed transaction. In some circumstances, however, the allocation might have to be varied ex post execution for some reason, and a question might arise over what the legal position is. In particular, if it is assumed that the original allocation is not varied in the event that the aggregate order is filled in part, the basis on which reallocation may be effected after the transaction has been executed will be uncertain. In the case of a broker that makes a contract in its own name to the exclusion of (p. 337) the principal, the better analysis is to construe the internal relationship between the broker and each investor (as regards amounts due between them under the contract made) as a relationship of debtor and creditor, so that the obligations that result between each investor and the broker from the execution of a block transaction are not treated as arising under a distinct or independent contract between the broker and each investor that participated in the block, but as arising under the general agency relationship between the broker and each investor as mutual debtors and creditors.⁸³ If that is the position, then there is no objection to organizing the debtor–creditor relationship between each investor and the broker by implying a term that permits the broker to vary what is due between that broker and each investor in respect of that investor’s participation in the block on the instruction of the investment manager. In practice, the investment manager and the broker will have agreed—or this may reasonably be so inferred from the parties’ conduct—that, where it places an aggregate order on behalf of multiple principals, the investment manager undertakes to allocate the block trade definitively before the settlement date.⁸⁴ Where an execution broker makes a contract in his/her own name to the exclusion of the principals pursuant to a block trade, the concept of ‘allocation’, therefore, refers to the instruction of the investment manager ex post execution following which the broker will definitively determine what is due between the broker and each investor in respect of the investor’s participation in the aggregate-order contract. Where principals are not identified,⁸⁵ allocation will also have the effect of identification and there is nothing that bars the investment manager from disclosing whether it is instructing the broker on behalf of one or more principals. For the avoidance of doubt, it would not be permitted for an investment manager to instruct a broker if, at the time of the instruction, it has not specified for which investor or investors the trade is to be made, at least to some extent, in its books and records. Not only would this contravene the investment manager’s regulatory duties,⁸⁶ it would necessarily follow that the investment manager intended to act personally.⁸⁷

7.67  The excess return that a portfolio might earn if certain transactions are carried out may be eliminated by the costs that could be incurred because of those very transactions, which requires that an investment manager employs an appropriate trading- and settlement-cost forecasting methodology. These costs may be divided into direct and indirect costs. Direct costs include brokerage, exchange fees, taxes, settlement costs, and custody costs. Indirect costs include market-impact costs, opportunity costs, and the cost of delayed executions, including delayed or failed settlements. Therefore, the quality of the effort by the investment manager to execute transactions, or arrange for the execution of those transactions, depends on the extent to which it can minimize the trading and settlement costs in the circumstances. An investment firm that provides portfolio management services is subject to Article 27 (Best execution) of MiFID II when ‘executing an order on behalf of a client’, that is, trade (as the investor’s agent) with a dealer, and subject to Article 65 of MiFID II Delegated Regulation (EU) 2017/565 when ‘placing orders with other entities’, that is, instruct a broker.⁸⁸

7.68  As discussed in Chapter 6,⁸⁹ the factors that contribute to the quality of execution are complex. The investment manager’s trading desk will need to evaluate several constantly changing variables, such as the prevailing price and liquidity, and weigh the potential market-impact costs against opportunity costs, and price against the cost of delay of execution or settlement. Even if all else is equal, decisions may differ depending on the characteristics of the investment strategy. Opportunity costs may outweigh market-impact costs under one strategy, but not under another, so that, sometimes, the investment manager might seek to trade more speedily to avoid opportunity costs, though incurring higher market-impact costs, while in other circumstances trading more patiently. Adams concludes in relation to the duty of care of an investment manager who is seeking to execute in the context of an investment strategy:⁹⁰

All that can be done by fund managers is to ensure that the probabilities are weighed as favourably as possible in favour of the client, and this is done through the design of procedures that eliminate the more unfavourable aspects of the transaction that are susceptible to management. Such procedures typically involve assessing different execution venues for price, quality, liquidity and accessibility; assessing and selecting trading counterparties on thoughtful criteria not just once but continuously; managing conflicts of interest (such as in soft dollar trades); and checking execution (p. 339) quality. … Having appropriate discipline and protocols on the trading desk (large order limits etc) is also important in ensuring that the processes work well. … Over time, the diligent fund manager should be able to demonstrate that his execution quality is good, but trade by trade the quantum nature of the problem means that good fortune can play an inappropriately large part.

7.69  The investment manager’s portfolio management staff and trading desk will need to employ execution arrangements that consistently balance all relevant execution factors based on a continuous evaluation of the direct and indirect cost of trading through pre-trade analysis that includes the relevant factors per eligible execution venue, that is, market capitalization, daily trading volumes, average order sizes, volatility of the stock, and the correlation between the various categories of investment that need to be traded in the same period.⁹¹ Post-trade analysis of the quality of execution is also a necessary part of the execution arrangements. Although the measurement of execution quality on a trade-by-trade basis may not be meaningful as an independent data point, when execution characteristics are measured and analysed over time for markets with reliable and readily available comparative data, it can yield data that will assist the investment manager in improving the reliability of its execution arrangements.⁹² Choosing the correct pricing benchmark, however, may be the subject of debate.⁹³

7.70  Typically, investment managers seek to estimate trading costs by reference to implementation shortfall, which is the difference between the price of the investment on which the investment decision is based and the expected price. That is, implementation-shortfall methods imply the construction of a paper portfolio based on the assumption that, following an investment decision, trading is instantaneous and at no cost. The paper portfolio is then compared with the expected portfolio, that is, a probability-based projection of the portfolio after trading has taken place. A cruder method is to compare execution prices against the expected volume-weighted average price (VWAP) over the day, which measures market impact only crudely and misses opportunity costs completely. VWAP comparison simply ignores proposed transactions that cannot be executed.⁹⁴

7.71  The portfolio’s turnover ratio, expressed as a percentage of the portfolio’s holdings that have been sold and replaced with another holding during the measurement period, will vary depending on the asset class and the investment style. An equity (p. 340) portfolio will have a lower turnover rate than a fixed-income portfolio, as bond portfolios, whether managed passively or actively, will naturally have a higher replacement rate. Small-cap growth strategies will generally experience higher turnover than large-cap value strategies. Value strategies form a long-term view on selected investments so generally implement a buy-and-hold approach. All things being equal, investors should favour the lowest possible turnover ratios. High turnover ratios materially reduce portfolio returns. In addition, high turnover ratios may result in adverse tax complications. For example, tax-exempt investors such as pension schemes may be treated as operating a trading business if the turnover ratios exceed certain levels. Equally, taxable investors may incur adverse capital gains charges.

7.72  Market conditions change continuously and the changed conditions need to be reflected in the risk–return trade-off inherent in the portfolio. Accordingly, the active investment manager needs to employ a comprehensive and continuous monitoring programme that includes all the relevant macro-economic factors (such as inflation rates, yield curves, central bank policy, commodity prices), and measures the impact any changes in the key factors may have on the expected returns, volatility values, and correlations of the investments that comprise the portfolio. The result of these reviews may be that individual securities need to be removed, or, if the trends are long-term, that the asset-allocation ratios need to change. Every investment manager, active or passive, will also need to monitor the portfolio itself to ensure that, as market prices or indices change, the portfolio is restored to the intended asset-allocation ratios, with the aim of staying as close as possible to the investment manager’s optimized portfolio.

7.73  To deal with these matters, the investment strategy will incorporate a strategy for rebalancing. These are typically based either on time intervals, such as weekly or monthly, or on a percentage hurdle. Time-interval-based rebalancing involves the specification of intervals and requires the investment manager to execute the necessary trades each time an interval has elapsed. Percentage-based rebalancing involves setting rebalancing bandwidths or thresholds expressed as a percentage of the portfolio’s allocation values and requires rebalancing each time the threshold or bandwidth is exceeded. For instance, if a mandate requires a 50/50 allocation between certain risky and risk-free assets and specifies, such as , monthly rebalancing, the investment manager would have to rebalance the portfolio at the beginning of each month, regardless of the intra-month allocation fluctuation. If the mandate specifies that the portfolio must be rebalanced, such as , if it exceeds a 5 per cent bandwidth, the investment manager will have to rebalance the portfolio if the no-risk/some-risk split exceeds 45/55 or vice versa. A percentage-based rebalancing discipline requires regular monitoring. Investor and investment manager may want to add a time-interval element to the percentage-based rebalancing discipline, so that the investment manager can decide to let the portfolio drift on an intra-day basis. In the absence of an allocation specification, a mandate (p. 341) may require rebalancing if the portfolio exceeds a certain tracking error, on an ex ante basis. In the absence of any rebalancing specification, rebalancing will be informed by the investment manager’s general duty of skill and care. Note that rebalancing might also be triggered if the investor contributes additional capital to the portfolio. In making rebalancing decisions, again, the investment manager must keep taxes and the expected cost of trading in mind. If the cost of adjustment outweighs the opportunity cost, it may need to decide to postpone the adjustment.

7.74  A rebalancing programme will usually be implemented through the direct purchase or sale of the relevant investments. However, a manager may be able to reduce trading costs by purchasing or selling derivative contracts that reference the relevant asset. If a liquid market in the appropriate derivative contracts exists, the investment manager can construct the portfolio to achieve exposure to the relevant asset classes in the required asset allocation ratios using a mixture of direct investments and derivative contracts. The replication of market exposure through derivative contracts has a number of trading advantages. The transaction costs will generally be lower, as the brokerage commission is lower, the market-impact costs are lower, and there are no settlement and custody costs. Further, implementation will be more rapid as the market in derivatives is not dependent on the availability of the underlying securities. It is, in theory, unlimited in size. For instance, a manager with an active mandate that permits investment in constituents of the FTSE 100 Index who wishes to time the market and switch into cash speedily may choose to sell FTSE 100 Index futures instead of actually selling holdings in FTSE 100 Index constituents. The active investment manager can close out the futures positions as the allocation to equity is gradually brought back to the original ratio. Equally, a manager with a passive FTSE 100 Index mandate who receives a sizeable contribution from the investor and needs to invest immediately to ensure that the tracking error of the mandate is minimal, may wish to purchase FTSE 100 futures instead of the actual securities so as to avoid the market impact that would be involved with executing the entire trade in a single day. Later, the investment manager can gradually switch from derivative positions to directly held positions.

7.75  Trading costs are of concern in the event of a major change in the asset allocation in an investor portfolio. For instance, a pension scheme might seek to change the scheme benchmark following new insights as a result of an asset– liability study. Changes in asset allocation usually imply termination of the mandates of one or more existing investment managers, and the appointment of one or more new investment managers. If the investor replaces one equity manager with another in respect of a portfolio allocated to a FTSE 100 universe, the new investment manager should be able to accomplish the necessary adjustments as an ordinary rebalancing. If the new investment manager employs a different investment strategy with a different style, or the new strategy concerns (p. 342) a different asset class, the size and complexity of the rebalancing transactions might be substantial.

7.76  An investor might therefore consider appointing a transition manager to carry out the work. These are investment firms that specialize in restructuring large portfolios with a view to minimizing transaction costs and market risks.⁹⁵ The transition manager will obtain a ‘wish list’ from the new investment manager that sets out the target portfolio, and a ‘guaranteed list’ from the investor’s custodian that sets out the starting portfolio,⁹⁶ and then seek to implement such changes to the portfolio over an agreed period of time as may be necessary to arrive at the target portfolio. Key considerations for the investor in selecting a transition manager will be whether the provider of that service has the ability to access trading venues that permit it to minimize, in particular, the indirect transaction costs, that is, market-impact costs, opportunity costs, and the cost of delayed executions. Market-impact costs and opportunity costs can be minimized if the transition manager has access to an internal order-flow ‘pool’ so that trades may be crossed. Not surprisingly, therefore, transition management services are offered by investment firms with either substantial brokerage businesses or substantial index-management businesses, as these firms will be able to offer the benefit of internal crossing. Opportunity costs and delayed-execution costs can also be reduced if, during transition, the market exposure of the portfolio relative to that of the target portfolio is managed efficiently, for instance by using derivatives. The success of transition managers will often be measured by an implementation shortfall calculation, which takes market losses into account and therefore is also a function of the transition time horizon. Accordingly, a transition manager must have the necessary investment management skills so that the loss due to adverse market exposure of the portfolio during transition is minimized. Selection of a transition manager will thus be a function of that skill set also. Some transition managers will specialize in equity transitions, (p. 343) others in fixed-income transitions. If the transition mandate requires a transition manager to manage market exposure during the transition, it follows that transition management will necessarily involve the exercise of discretion and therefore qualify as the provision of investment management services. In that case, the provider will need to be authorized and be regulated as an investment manager.

7.77  Wealth management (WM) is the term used to describe a bundle of services designed to meet the needs and wants of affluent clients by providing a range of financial products and services. The bundle of WM services may range from banking and investment services and activities, to accounting, legal, and tax services, although many WM firms will be careful to exclude legal or tax services from the offering. In MiFID II and Capital Requirements Directive IV (CRD IV) terms,⁹⁷ the WM bundle may include the following:

1. (a)  Banking: deposit and savings accounts, payment services, foreign exchange services.⁹⁸

2. (b)  Custody services.⁹⁹

3. (c)  Investment advice:¹⁰⁰ advice can be provided either by the client’s ‘private banker’, or by expert ‘investment counsellors’ or product specialists on the trading desk. The client may also receive investment research and market commentary.

4. (d)  Brokerage and order transmission services: execution of orders on behalf of clients on trading venues,¹⁰¹ as well as receipt and transmission of orders, such as to an operator of a collective investment scheme.

5. (p. 344) (e)  Dealer services: dealing on own account to execute OTC spot foreign exchange transactions, and derivative or securities financing transactions.¹⁰²

6. (f)  Portfolio management services.¹⁰³

7.78  Like the fees charged by investment management businesses, WM fees are based on rates applied to the value of the transactions to which advice, execution, custody or portfolio management relates. Accordingly, WM cannot be viably offered unless the value of the investable assets of the client reaches a certain level. The client base of WM business, therefore, consists of so-called high net worth (HNW) individuals to ultra-high net worth (UHNW) clients.¹⁰⁴ UHNW clients hold their assets through (tax efficient) investment vehicles—typically ‘offshore’ investment companies, or trusts—which are managed by so-called family offices, which may be regulated investment firms in their own right, and may be represented by independent (investment) advisers.

7.79  The WM service is usually anchored in a central portal through which the client will be able to access the bundle of WM services. The central access point may be a ‘private banker’ or an expert ‘investment counsellor’, that is, an expert individual who is responsible for the client relationship. The role of the private banker or bankers is to respond to the client requests or needs and arrange for the required service to be provided. As discussed in Chapter 4,¹⁰⁵ if the investment service concerns investment advice or portfolio management, the investment firm is subject to suitability duties. All other services subject the investment firm to appropriateness duties. WM firms offer all services and the private banking team will need to construct and continue to update and develop a ‘know-your-client’ and suitability file that will consider the client’s: knowledge and experience per product and service; financial situation (meaning: capacity for loss, total/liquid net worth, and income and financial commitments); investment objective(s) and risk appetite; and investment horizon. The client file will need to be accurate, complete, and will need updating, including the recording of client interactions through call reports.¹⁰⁶ In the event of investment advice, ‘suitability letters’ will, where possible, have to be sent pre (or otherwise immediately post) the relevant (p. 345) retail clients implements the advice, setting out the investment product details and why it is suitable for them.¹⁰⁷

7.80  The WM firm will be subject to product governance requirements both as a manufacturer and as a distributer.¹⁰⁸ The bundle of services requires the WM firm carefully to consider, manage, and disclose all conflicts,¹⁰⁹ and the terms and conditions on which the WM services are offered will typically offer substantial and lengthy disclosure statements. Given the multi-faceted aspects of the WM offering model, the overriding duty to act in the client’s best interest will be paramount in guiding the conduct of the WM firm.

7.81  The pivotal question at the heart of the WM service model is, each time a client accesses a service in the bundle, whether the WM firm’s private banker, or, if the client is referred to the WM firm’s trading desk, whether the investment counsellor or product specialist on the trading desk was advising on the transaction in question.¹¹⁰ The WM firm is liable for failure to comply with appropriateness requirements in the event of non-advised transactions, and may become liable for failure to comply with the broader-reaching suitability requirements in the event that transaction qualifies as an advised transaction. As discussed in Chapter 4, the purpose and character of the professional service in the context of which information was provided by the investment firm are important factors to determine whether the transaction is advised or not: if the service is execution-oriented, that is, the investment firm is principally engaged to arrange a particular transaction or range of transactions and gives information in that context, the courts are reluctant to imply a duty beyond a responsibility not to make misrepresentations. This is true even in situations where the investment firm gave certain opinions on the desirability of a course of action. If the service is advice-oriented, that is, the investment firm is principally engaged by the investor to provide information about an investment or transaction based on a consideration of the investor’s investment (p. 346) objective and situation, the courts are more inclined to find an expanded scope of the responsibility, as the adviser must take reasonable care to consider all the potential consequences of the course of action that is the subject matter of the advice.¹¹¹

7.82  A person who provides information to another person would be giving investment advice within the meaning of MiFID II if the information is provided by way of a personal recommendation to an investor or potential investor, or an agent for that investor, in relation to a specific transaction or transactions in, or the exercise of rights attaching to, a financial asset. A ‘personal recommendation’ implies some form of consideration of the personal circumstances and purpose of the recipient in relation to a certain investment. There must be a relationship between the investor and the investment firm that justifies reliance by the investor on the fact that the investment firm would consider all material facts in the context of the investment service and inform the investor accordingly. This means that there must be a relationship that comprises more than generic communications about investment services and products, and is relatively specific about its purpose, that is, to include a determination of whether an investment is suitable, which means that execution-oriented services prima facie would not qualify.¹¹²

7.83  As discussed in Chapter 4,¹¹³ it is likely that the courts will find that the circumstances that bring the activities of an investment firm within scope of the regulatory concept of investment advice—that is, making a recommendation that represents either that the recommended transaction is suitable for the client or that it is based on a consideration of the client’s circumstances—and that trigger a regulatory duty to investigate the client’s situation and purpose to inform the firm’s suitability analysis, will give rise to a similar responsibility at law based on the notion of assumption of responsibility; and that the scope of the responsibility will depend on the scope of the permitted reliance, which in turn depends on the facts and circumstances, that is, without limitation, the nature and complexity of the investment product, the nature of the advisory relationship, the conduct of parties, the sophistication of the investor, and the documentation and information exchanged between them.

7.84  The responsibility of a regulated firm for the scope and quality of the advice, and the scope of potential losses was scrutinized by the Court of Appeal in Rubenstein v HSBC Bank plc.¹¹⁴ In 2005 Mr Rubenstein wanted to find a safe place for the proceeds of the sale of his home pending the purchase of another property. He wanted to find an investment, if possible, that provided a higher interest rate than a standard bank deposit, but without risking his capital. The prospective investment (p. 347) horizon would be no longer than a year, or so Mr Rubenstein stated. On the advice of his bank, he invested in a unit-linked life insurance product issued by an insurance company (AIG), an investment product that the bank had said had an investment risk profile that was comparable to a cash deposit in one of the bank’s accounts. The name ‘unit-linked’ is a reference to the units of a fund that serves as the reference value for pay-out calculations under the terms of the unit-linked life insurance product. There would have been a tax benefit to choosing a unit-linked life insurance product to investing directly in the fund itself.¹¹⁵ The chosen fund was AIG’s enhanced variable rate fund (EVRF), which was a fund that can be best described as an ‘enhanced money market fund’, that is, a money market fund that invests in slightly riskier assets and credit derivatives than mainstream money market funds. Although money market instruments are short-term debt instruments issued by banks and other financial institutions and in that respect comparable—ignoring potential deposit insurance—to fixed term cash deposits in terms of credit risk, unlike fixed term cash deposits, money market instruments do not necessarily have a stable value as they may be susceptible to market movements. The EVRF appears to have been investing in Structured Investment Vehicles (SIVs)¹¹⁶ as well as derivatives, further increasing the market risk. In 2005 it would not have been uncommon to consider the market risk of the EVRF very small and capital loss to be unlikely. Notwithstanding, the unit-linked life insurance product would still expose Mr Rubenstein to that risk, however small it was perceived to be,¹¹⁷ whereas the cash deposit would not. Mr Rubenstein was unable to find another home, so that he still held the investment three years later when the market turmoil which surrounded the collapse of Lehman Brothers in September 2008 occurred, which started with serious disruption to the money markets. When Mr Rubenstein ultimately was permitted to redeem his investment, he suffered a material net capital loss.

7.85  The judge in first instance found that Mr Rubenstein had relied on the bank’s advice and because there was to be no risk to the capital, that the bank had given that advice negligently as well as in breach of various conduct of business (COB) rules, which gave rise to breach of statutory duty. Interestingly, however, the judge also found that the loss suffered by the claimant was caused by unprecedented market turmoil and therefore was unforeseeable and too remote to be recovered.¹¹⁸ On (p. 348) appeal, Rix LJ considered that to be a wrong conclusion on the question of remoteness and he allowed the appeal on that issue.¹¹⁹ He said:¹²⁰

7.86  The WM relationship, given the personal nature of the relationship and the relatively frequent contact level, including the fact that the WM firm is fully aware of the client’s purpose and situation, presents a challenging factual context in which to bifurcate between advised and non-advised transactions. The WM firm will have to ensure it implements clear operating procedures for the private bankers, and the investment counsellors and product specialists on the trading desk that clarify as best as possible whether, in the event of a client trade, the client’s circumstances were considered beyond the level of appropriateness and to what extent that was communicated to the client. Depending on the level of interaction, the analysis may become nebulous. The duty to act in the client’s best interest will prevent, at least in regulatory terms, the firm from relying on standard disclosure letters that exclude or otherwise deny that a recommendation or other communication was based on a consideration of the client’s circumstances, although these might arguably be effective at law.¹²¹ However, if and when a recommendation for a transaction falls within the realm of investment advice so that the ensuing transaction qualifies as an advised transaction, the WM firm must ensure that the private banker, investment counsellor, or product specialist who made the recommendation considers the situation and investment purpose of the client very carefully before doing so. As Rubenstein shows, the courts will interpret the client’s investment purpose strictly. If the instruction is that there is to be no market risk, then a—in the circumstances considered to be—near risk free investment does not meet the test.

7.87  A further question for the WM firm is whether to offer advice on an independent basis or not. Article 24(7) of MiFID II provides that where an investment firm (p. 349) informs the client that investment advice is provided on an independent basis, that investment firm shall: (1) assess a sufficient range of financial instruments available on the market which must be sufficiently diverse with regard to their type and issuers or product providers to ensure that the client’s investment objectives can be suitably met and must not be limited to financial instruments issued or provided by (a) the investment firm itself or by entities having close links with the investment firm or (b) other entities with which the investment firm has such close legal or economic relationships, such as contractual relationships, as to pose a risk of impairing the independent basis of the advice provided; (2) not accept and retain fees, commissions or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients. In practice, most WM firms will choose not to offer advice on an independent basis because it will be difficult within the parameters of their business model to comply with these requirements.(p. 350)