Trade allocation

Investment advisers who manage multiple client accounts have a fundamental legal duty to treat all their clients fairly. This duty becomes especially challenging when a firm manages both registered mutual funds and hedge funds at the same time. These different types of funds often have different trading strategies and fee structures, which can create pressure to favor one type over another.

The problem becomes more complex because advisers typically earn higher fees from hedge funds than from registered funds. This fee difference can create financial incentives to give hedge funds better treatment, such as access to the most profitable trades. Well-designed trade allocation procedures help prevent this favoritism and ensure all clients receive fair treatment.

naturally arise when investment managers serve multiple clients who have different or competing investment goals. When a manager oversees accounts that use similar strategies, conflicting strategies, or completely different approaches, the manager must still treat each client fairly. This means avoiding favoritism and distributing securities fairly among all accounts.

A manager violates their if they consistently allocate the best investment opportunities to certain favored clients while giving less attractive trades to others. This type of unfair treatment, sometimes called "," can result in significant regulatory penalties and lawsuits.

Most managers create written policies that govern how they distribute investment opportunities across their various funds and accounts. These policies aim to ensure fair distribution that aligns with each account's stated investment strategy.

However, simply dividing every trade proportionally based on account size—known as "pro rata allocation"—often doesn't work well in practice. This rigid approach can actually harm client interests in many situations. For example, a small trade might not be worth splitting among 20 different accounts due to transaction costs.

As a result, many managers develop more comprehensive allocation policies. These policies typically include standard procedures for most situations, plus defined processes for handling unusual cases. When managers need to deviate from standard allocation, they document their decision-making process and create audit trails that can be reviewed later.

For investments that cannot be easily divided among multiple clients—such as a single bond or a private investment opportunity—managers often use rotation systems. Under these systems, different accounts take turns receiving favorable treatment over time. This approach ensures fairness across extended periods, even though individual trades may benefit some accounts more than others.

Several specific circumstances create especially intense allocation conflicts that require careful management:

Different fee structures pose a major challenge. When certain accounts pay higher management fees or , managers face strong financial incentives to favor those accounts with the best trading opportunities.

High-water mark provisions create additional conflicts. Some hedge fund accounts include provisions, which mean managers only collect performance fees when the fund reaches new profit levels. Other accounts may not have these provisions. This difference can influence how managers allocate trades between accounts.

Fund lifecycle differences also generate conflicts. When one fund is growing and seeking new investments while another fund is winding down and selling positions, managers must balance competing interests in deal flow and exit opportunities.

Personal interests can unconsciously bias allocation decisions. For example, if a manager wants to raise additional capital from specific existing investors, they might unconsciously give those investors' accounts better treatment.

These scenarios highlight why managers must maintain detailed, written allocation policies and provide clear disclosures to investors about potential conflicts.

When managers allocate trades in ways other than simple pro rata distribution, they must implement protective safeguards. Managers typically choose one of two approaches:

First, they can require independent review and approval of certain transaction types by personnel who don't directly manage the portfolios. This creates a check on potential bias.

Second, they can require portfolio managers to prepare written explanations at the time of the trade decision. These contemporaneous documents must explain the reasoning behind the trading decision and why different clients received different treatment.

Beyond these preventive measures, managers should conduct regular post-trade analysis to identify suspicious patterns that might indicate abuse. This analysis might reveal, for example, that certain accounts consistently receive the most profitable trades while others consistently get losses.

The Securities and Exchange Commission uses sophisticated data analytics software during examinations to detect allocation problems that manual review might miss. This technology helps regulators identify cases where managers systematically direct profitable trades to favored accounts while allocating losing trades elsewhere.

Managers who operate multiple funds should regularly analyze their trading results to determine whether certain funds consistently receive better or worse treatment than others. This analysis should examine not just trade execution, but also exit opportunities—the ability to sell investments at optimal prices.

Exit opportunities include access to oversubscribed offerings like initial public offerings, as well as the ability to sell positions in the open market at favorable times and prices.

During SEC examinations, compliance staff evaluate whether managers maintain clearly documented allocation policies, keep detailed records of non-standard allocation decisions, and use systematic testing methods to verify fair treatment over time. These examination priorities reflect the SEC's ongoing concern about trade allocation abuses.

The SEC published a Risk Alert in June 2020 highlighting these concerns, and enforcement activity targeting cherry-picking schemes has continued since then.

Investment advisers must disclose their trade allocation policies in , which is their main regulatory filing. Additionally, both registered funds and private funds should include appropriate disclosure of these policies and their potential implications in their . This transparency helps investors understand how their trades will be allocated and what conflicts might arise.