Separately Managed Account Managers May Bunch Orders for Better Execution
One reason why the hedge fund structure is so popular with investment managers is that a single investment strategy can be implemented in one account. Separately managed account managers, however, often have multiple accounts and need to execute the same transaction in each of those separate accounts. Not only is this more time consuming than entering a single trade, there is the possibility that some accounts would receive poorer execution than other accounts (if the trades cannot all be executed for the same prices). To combat this problem, many brokers offer “bunched” orders which allow a manager to enter into a trade (or series of trades) and then allocate those trades to individual accounts pursuant to a pre-defined allocation method. In this way trades are allocated to accounts in what may be deemed a more “fair” way.
Types of Bunched Account Allocation Methods
In the event a bunched order is not filled at one total price (called a “partial fill”), there are two central ways to allocate trades to individual accounts from a bunched order – average pricing or high-low.
Under the average pricing method, the broker’s back end will add up all of the buys or sells at their particular price levels, multiply the trades by the number of contracts (or securities) at each particular price level, and divide by the total number of contracts (or securities) to determine an average price for the whole bunched order. The trades are allocated to the individual accounts and the price for the trade will reflect the average price.
Under the high-low method, the higher fill prices will be allocated to the higher account numbered clients for both buys and sells, and the lower fill prices to the lower account numbered clients for both purchases and sales.
Issues for CTAs and Investment Advisors
Generally, separately managed accounts fit within the realm of commodity trading advisors and investment advisors. However, many hedge fund managers are beginning to take on separately managed account clients as well. The central issue for any of these managers is going to be how the allocation process is described in the investment advisory brochure/contract, disclosure documents or offering documents. Managers will need to make sure that this issue has been discussed with both the attorney and the broker so that everyone is aware of the actual mechanics of the allocation. Additionally, I recommend that the broker’s back office review the disclosure documents to ensure that the allocation language is accurate and precise. If the offering documents state one method and the broker uses another method, there may be some liability for the manager. Additionally, if the manager is ever subject to examiniation by the SEC, NFA or state securities division, this could be a topic for review.
For hedge fund investors, part of your due diligence process should be to find out whether a hedge fund manager also manages separately managed accounts with the same investment program as the fund. If so, the investors should ask the manager to explain the allocation process for trades. While this should be disclosed in the offering documents I have a hunch that this issue is often overlooked by many funds – especially those funds which enter into the SMA agreements after the fund has been in business for a period of time.