Compliance Solutions for Investment Advisers

FAQs — Sub-Advisors

 

Why do some investment advisers use a sub-advisor?

The use of a sub-advisor allows an investment adviser to provide an investment focus or objective beyond the expertise of the adviser’s staff.

Is an investment adviser that uses sub-advisors required to develop specific policies and procedures?

Advisers that use sub-advisors should develop and implement compliance policies and procedures that address the selection, retention and monitoring of sub-advisors.

What types of supervision should an investment adviser exercise over a sub-advisor?

Supervision of sub-advisers typically falls into five general categories:

  • Due diligence and pre-qualification;
  • Monitoring adviser qualifications;
  • Monitoring portfolio operations;
  • Monitoring other operations; and
  • Reporting and disclosures to clients.

What are some due diligence actions that an investment adviser should undertake vis-à-vis the use of a sub-advisor?

Before entering into a sub-advisory arrangement, an adviser should utilize one or more of the following due-diligence and pre-qualification activities:

  • Review the sub-adviser’s Form ADV Part 1 and Part 2A;
  • Review Schedule D and other information for principals;
  • Check SEC, CRD and other records for any disciplinary or other matters;
  • Review sales literature and other brochure material;
  • Obtain and review any completed due diligence questionnaire provided by the sub-adviser;
  • Check references;
  • Identify “style” and area of specialty;
  • Review performance record;
  • Review financial statements;
  • Review client agreement and other client documents;
  • Identify internal portfolio management procedures;
  • Review IT internal system and interface;
  • Review compliance procedures; and
  • Check errors and omissions coverage.

Is an investment adviser required to monitor the sub-advisor’s qualifications?

As part of its agreement with the adviser, each sub-adviser should be required to agree to update its information whenever there occurs a material change, such as a change in management personnel, change in style or overall performance, financial change, claims or litigation, etc. At least once a year the adviser should review all sub-advisory arrangements to evaluate whether to keep or modify the relationship.

Is an investment adviser required to monitor the sub-advisor’s portfolio operations?

Each sub-adviser should be required to provide portfolio composition, transaction, and other reporting information to the adviser. This information should be typically supplied on no less than a quarterly basis.

What types of reporting and disclosure should an investment adviser that employs the use of sub-advisors make to clients?

Clients are entitled to certain levels of disclosure associated with the provision of sub-advisory services. These disclosures include, among other things:

  • A copy of the sub-adviser’s Form ADV Part 2A;
  • A client disclosure document as to referral or other fee sharing;
  • An annual offer for an updated version of these documents; and
  • Reporting on at least a quarterly basis as to account assets, performance and fees.

What types of records will the SEC request during or prior to an examination?

The Staff of the SEC may request some or all of the following documents and information pertaining to sub-advisers:

  • Any sub-advisory agreement executed with other investment advisers.
  • A description of all business activities (e.g., securities lending, client referrals, principal trades, etc.) between the adviser and/or its affiliates and the money managers and/or their affiliates recommended by the advisory firm to manage client portfolios.
  • A list of all money managers recommended by the adviser that effect securities transactions or conduct any other types of business with the advisory firm’s affiliated broker-dealer.
  • Documentation that substantiates the advisory firm’s due diligence reviews used to select and monitor money managers recommended by the advisory firm.
  • A list of clients that have requested that the advisory firm use underlying managers to utilize a particular broker-dealer.
  • A list of all underlying managers registered with the SEC.

What are some potential compliance risks associated with the use of sub-advisors?

An investment adviser that uses sub-advisors may be at risk if the adviser:

  • Fails to establish internal controls to ensure that the use of sub-advisers is consistent with regulatory requirements, best practices, firm policies and disclosures.
  • Fails to review the sub-adviser’s disclosure documents (e.g., Form ADV Part 1, Form ADV Part 2A).
  • Fails to check online records for any disciplinary or other matters involving the sub-adviser or any of its associated persons.
  • Fails to review the sub-adviser’s sales literature, marketing material, performance records and errors and omissions coverage.
  • Fails to check the sub-adviser’s references.
  • Fails to enter into a contractual relationship with the sub-adviser.
  • Fails to monitor the performance of sub-advisers.
  • Fails to monitor the qualifications of sub-advisers.
  • Fails to exercise your firm’s discretionary authority to hire and fire sub-advisers when warranted by the circumstances.
  • Fails to obtain client authorization to use sub-advisers.
  • Fails to adequately explain the dual fee structure of a sub-advisory arrangement to clients.
  • Fails to disclose the use of sub-advisers.
  • Fails to substantiate that your firm obtained all information related to sub-advisers in a timely, accurate, and complete manner.

What are some compliance tests an investment adviser can conduct to determine whether the adviser’s policies and procedures adequately address the use of sub-advisors and reflect the firm’s actual practices?

Tests an adviser can run include:

  • Determine whether internal controls ensure that the use of sub-advisers is consistent with regulatory requirements, best practices, firm policies and disclosures.
  • Review the sub-adviser’s portfolio management to ensure that client accounts are managed in accordance with agreed-upon objectives.
  • Determine whether sub-advisers have adequate policies and procedures to protect clients’ nonpublic personal information.
  • Request a copy of the sub-adviser’s annual compliance review report or SAS 70 report in order to review and assess the status of the sub-adviser’s compliance program.
  • Request compliance checklists, deficiency letters and quarterly compliance certifications in order to review and assess the status of the sub-adviser’s compliance program.
  • Check the IARD web site for information on the sub-adviser and any portfolio managers associated with the sub-adviser to see if any disciplinary actions have been disclosed.
  • Review your firm’s disclosure documents to ensure that it has adequately disclosed the use of sub-advisers.
  • Substantiate that your firm obtains all information related to sub-advisers in a timely, accurate, and complete manner.

 

Important Information

The information contained in this Frequently Asked Questions is only a summary and is not intended to be a comprehensive analysis of the rules and regulations applicable to registered investment advisers. It is not intended to constitute legal or compliance consulting advice or apply to any one investment adviser’s particular situation. For more information, please see our Terms of Use.

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