a broker helping with investments

Third Parties Often Involved With Investment Events

There are many third parties that are deeply involved in the investment process (the investor and the investment manager being the first two parties). The three most important third parties are the broker, the administrator and the auditor. We disseminate why these three complex figures, often found in financial management firms, work tirelessly for consumers around the country.

Brokers

Brokers are responsible for the custodianship of assets and, in many cases, provide lending and research services to managers. In terms of custodianship, brokers are federally regulated entities in North America, so their assets are insured by their respective federal governments. All the major banks and many smaller institutions provide brokerage services. Unfortunately, even federally insured brokerage firms can fall victim to fraud. In 2011, for example, MF Global, one such brokerage firm, went into bankruptcy and revealed that client assets held under custodianship had been mishandled. Frankly, there is very little one can do to avoid such a situation except to try to diversify across managers who use different brokers.

Investors need to be weary of arrangements between managers and brokerage firms in the form of “soft dollars”. Soft dollar arrangements occur when a manager directs business towards a certain brokerage firm in exchange for the brokerage firm providing services to the manager. Sometimes, the services provided to the manager have nothing to do with the investors (i.e. paying the operating costs of the manager) but the costs, often in the form of higher trading commissions, are borne directly by the investors. Ideally, soft dollar arrangements should be entirely avoided. In some cases, where soft dollars are unavoidable, investors must make sure that services provided to the manager from brokerage firms directly benefit the investors (i.e. improving investment research) rather than just the investment manager.

Administrators

Administrators are responsible for keeping track of all the assets under management. The administrator calculates the net asset value (NAV) of the fund and enforces rules and regulations for asset valuation. Even though many people are unaware of the administrator’s role, it plays an integral role in the investment process. One stark example illustrating the importance of researching a manager’s administrator was in the case of one of the largest investment frauds in history.

Bernard Madoff, the hedge fund manager whose Ponzi scheme defrauded investors of tens of billions of dollars, was his own administrator. As a result, there was no one to provide a check against his alleged investment returns! Many “sophisticated” investors piled into Madoff’s fund, foregoing due diligence on his administrator, and lost their invested capital as a result.

Auditors

Auditors provide an integral part of the investment process which is similar to that of administrators. The auditor will validate (or invalidate) the information provided by the administrator and provide a professional opinion on not only the investments but also the operations of the financial management firm, or solely the investment manager. Needless to say, auditors need to be reputable and capable.