data. Financial data providers supply funds primarily with raw financial market data, including security prices, trading information, and indices. The amount of data is dictated by the investment style. Nonetheless, most hedge fund managers are required to keep abreast of market developments and macroeconomic news.
Due to legal implications, directly marketing alternative investment vehicles can be problematic. One method of indirectly marketing private funds is to report a fund's performance to an index provider, especially if the fund's performance is attractive. Index providers compile indices of prices that assist fund managers in evaluating performance.
CONSULTANTS: Consultants may be hired by pensions, endowments, or high-net-worth individuals to provide a number of roles and services that center on advice, analysis, and investment recommendations. Clients rely on consultants to offer unbiased analysis of money managers’ investment performance, as well as advice on how to best allocate funds. Clients expect their consultants to help them lay out the parameters of their investment objectives by setting out a plan for allocating assets within the framework of their objectives and risk tolerance. Consultants work closely with their clients to monitor the performance of investments while continuing to play an advisory role in a client's choice of other service providers.
Consultants are increasingly being used to serve the role of chief investment officer in small organizations. The role of an outsourced chief investment officer (OCIO) ranges from performing all of the decision-making duties of an in-house chief investment officer to a reduced role of assisting staff with a subset of decisions.
Consultants have traditionally been compensated for their services in one or both of the following ways: fees from their clients, or compensation packages from the money managers for whom they generate business. This latter form of payment presents a conflict of interest on the part of consultants because it can detract from the ability to offer independent advice to clients. Further, the compensation that consultants receive from money managers is undisclosed and can be quite substantial. Some consultants waive their regular consulting fee, giving the impression that their services are free.
Consultants' integrity and expertise are vital parts of the consultant-client relationship because many clients rely on their consultants to set out the best investment plan for their purposes and hire the best money managers to oversee those investments.
A third compensation approach has emerged in which consultants use their expertise in manager selection and risk management to serve as fund-of-funds managers to their clients. This arrangement avoids explicit hourly fees to the investors for the consulting advice, and offers the potential that the consultants will act with substantial objectivity in the selection of managers.
DEPOSITORIES AND CUSTODIANS: Depositories and custodians are very similar entities that are responsible for holding their clients' cash and securities and settling clients' trades, both of which maintain the integrity of clients' assets while ensuring that trades are settled quickly. The Depository Trust Company (DTC) is the principal holding body of securities for traders all over the world and is part of the Depository Trust and Clearing Corporation (DTCC), which provides clearing, settlement, and information services. The National Securities Clearing Corporation is the DTCC's second major subsidiary in the United States. The DTCC also created the Fixed Income Clearing Corporation (FICC). The European Central Counterparty Limited (EuroCCP) is the major depository for clients in European trading markets, and offers European clients the same clearing and settlement services as those offered by the DTCC to American traders.
BANKS: A commercial bank focuses on the business of accepting deposits and making loans, with modest investment-related services. An investment bank focuses on providing sophisticated investment services, including underwriting and raising capital, as well as other activities such as brokerage services, mergers, and acquisitions.
Hedge funds may enlist the services of a commercial bank to facilitate the flow of both investment- and non-investment-related capital. In addition, hedge funds may use their commercial bank for loans, credit enhancement, and/or lines of credit. In the United States, the commercial banking and investment banking functions tend to be separated by regulation. Germany uses universal banking, which means that German banks can engage in both commercial and investment banking. Also unlike the United States, a large portion of German firms is privately funded and has two governance bodies: the Vorstand, or management board, and the Aufsichtsrat, or supervisory board.
Although the Japanese financial system seems superficially similar to the American system, banks are much more influential in Japan than they are in the United States, and cross-ownership is far more common. Japanese banks can hold common stock, and Japanese corporations can hold stock in other Japanese firms. A keiretsu is a group of firms in different industries bound together by cross-ownership of their common stock and by customer-supplier relationships. The 10 largest Japanese banks (known as city banks) are responsible for funding approximately one-third of all investments in the country. As in Germany, large banks play an active role in monitoring the decisions of the borrowing firm's management and have significant power to seize collateral, as both trustee and direct lender.
In the United Kingdom, there are two main types of banks: clearing banks, which are similar to American commercial banks, and merchant banks, similar to American investment banks. As in the United States, UK banks are not strongly involved in the firms with which they do business, and substantial stock ownership by banks is prohibited.
2.2 Financial Markets
This section provides an overview of the financial markets involved in alternative investments. A primary market refers to the methods, institutions, and mechanisms involved in the placement of new securities to investors. A secondary market facilitates trading among investors of previously existing securities.
2.2.1 Primary Capital Markets
New issues are sold in primary capital markets and distributed by an underwriter, who is responsible for the organization, risk bearing (during placement), and distribution (or sale) of newly issued securities. Investment banks serve as underwriters for the placement of traditional investments. For example, investment banks place new equity issues that originate either as new and additional shares in existing securities (secondary issues) or as first-time issues of shares not previously traded (initial public offerings, or IPOs).
In the modern global economy, firms often arrange to have their shares traded in foreign markets and denominated in the currency of the foreign market. For example, a German firm could list its stock on a U.S. exchange as an American depositary receipt (ADR) or a global depositary receipt (GDR). Foreign issuers must comply with all the rules that apply to domestic firms, as well as any additional regulations that apply to foreign issuers.
Another source of securities issued in primary capital markets is securitization. Securitization involves bundling assets, especially unlisted assets, and issuing claims on the bundled assets. The securities are registered and sold in the public market. Securitization can allow firms to divest illiquid assets such as accounts receivable to lay off risk and obtain cash. Various types of unlisted but liquid assets are also securitized, including various fixed-income securities such as mortgages. Exchange-traded funds are emerging as a major source of securitization, in which new securities are created, generally with underlying portfolios of listed securities.
Participants in alternative investments often create securities that are not subsequently listed. An example is when deal creators issue structured products, some of which are private (see Part 5). Private equity firms often use primary markets as exit strategies for their underlying investments. Large private equity firms hold substantial controlling positions in the companies. A goal of these private equity firms is to develop these companies to the point that they can be sold to the public through IPOs.
2.2.2 Secondary Capital Market
After their initial offerings, many securities are traded in secondary capital markets, which provide greater liquidity and a continuous flow of price information. In major markets, limit orders by market participants are maintained to buy securities (bid orders at bid prices) and to sell securities