With 2017 coming to a close, it's time to start looking at what you'll need to prepare in the first quarter for 2018. One of the major priorities for early in the year is Form ADV. If your fiscal year ended in December, you're aware that you'll need to file your Form ADV amendment by the end of March to remain compliant with the SEC.
A concern of many investment advisers is whether they are properly reporting their relationships with external managers. Using an outside money manager can be an effective way to increase efficiency, and the structure of that relationship needs to be noted on the Form ADV. Two of the more typical structures are to either utilize sub-advisers, or third party asset managers (TPAMs), or both. However, differentiating if your relationship is a sub-advisory relationship or a TPAM arrangement can be difficult.
These two types of relationships are separate and distinct, but which one would work best for you? Should you change the arrangement in 2018? Are you reporting your relationship accurately and completely on your Form ADV?
The following information should help you understand the distinctions between the two, as well as whether or not you need to update your filing information for 2018.
Can you, as the investment adviser, hire or fire the external manager?
A key differentiating factor between a sub-advisory or TPAM relationship is who has the control over hiring and firing the external manager. Typically, if you can hire or fire the manager yourself, then you have a sub-advisory relationship. Conversely, if only the client has the authority to hire or fire the external manager, then it's typically a TPAM relationship.
This matters in regards to performance, management, and the relationship with the client. In a sub-advisory relationship, the adviser can hire or fire external managers as they see fit in relation to how investments perform. The adviser can negotiate all terms, fees, and services to be provided on the client's behalf - something that some clients may prefer, as they don't need to be heavily involved.
In the sub-advisory relationship, the adviser is the main point of contact with the client throughout their relationship. The adviser has more flexibility to adapt to changes in the market through how they utilize external managers, as well as adapt to changes in the client's goals.
Conversely, in a third-party asset manager relationship, the client directly entered into a relationship with the external manager. The client retains control over what they communicate to their TPAM, and retains control over hiring and firing that manager as well. As the investment adviser, you can make recommendations to the client based on performance, which the client can choose to follow or ignore as they prefer.
Contracts, Disclosures, and Documents
Another key differentiating factor between sub-advisory relationships and a TPAM is who has responsibility for maintaining the contract terms, disclosures, and other documentation.
In a sub-advisory arrangement, you are responsible for contracting directly with the sub-adviser. You are also responsible for ensuring that all disclosure documents (both yours and the sub-adviser's) and contracts are properly delivered to the client. Further, you'll need to be sure that all the matters related to the sub-advisory arrangement are properly reflected in your firm's policies and procedures manual.
When utilizing a TPAM, while the investment adviser may be asked to initially review the TPAM's contract terms on behalf of its client, once the contract is signed with the TPAM, the referring adviser typically cannot amend or modify the contract on the client's behalf. The TPAM has a distinct and separate relationship with the client, and as such, they are directly responsible for client disclosure documents, reports, fact sheets, and maintaining other documentation.
While retaining control over the ability to manage the team involved with a client's portfolio can be an attractive reason to maintain a sub-advisory relationship with external managers, it can also be tempting to not be responsible for the third-party's compliance documentation.
Neither one is necessarily better than the other, but the benefits or drawbacks to each do require careful consideration.
Managing Client Expectations and Updating Your Documentation
Regardless of whether you're using a sub-adviser or TPAM to manage some or all of your client assets, you want to be sure that the client is made aware of the existence of such relationships. Further, you want to be sure that you are accurately describing the relationship in your disclosure documents and contracts. As seen above, there are distinctions between the two arrangements. These differences can affect client fees, billing practices, contractual considerations, custodial and brokerage relationships, plus additional matters for which the client must be notified. It's important to be clear with your client from the start, and set client expectations regarding how they (and you) will interact with external managers.
There's no forgiveness from regulators if you improperly report your relationships, however, so it's essential that you understand the difference between them as you revise and file your Form ADV amendments.
Need help with your Form ADV revisions before the due date next year? Click here or click the button below to schedule time to talk with a member of our team. We'll help you determine if a sub-advisory or third-party asset manager arrangement works best for your situation.
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