Risks due diligence and structures - Fund structures and reg...

Learning Outcomes

This article explains core investment fund structures and their regulation, including:

• the main legal vehicles for pooled investment (companies, trusts, partnerships, contractual funds) and how liability, governance rights, and tax treatment differ;
• the distinction between open-ended and closed-ended funds and the implications for liquidity, pricing, and suitable asset types;
• how regulatory objectives such as investor protection, market integrity, and system-wide risk reduction translate into authorization, disclosure, reporting, and oversight requirements;
• the roles of key independent parties—custodians, depositaries, administrators, boards, and trustees—in asset safekeeping, valuation, and operational control;
• how regulation shapes fund risks, including operational risk, conflicts of interest, leverage or gearing, and liquidity management challenges;
• the content and purpose of core fund documents, especially the prospectus or offering memorandum, in setting out strategy, risks, fees, and dealing terms;
• how liquidity rules, borrowing limits, and eligible-investor criteria constrain product design and influence risk for different investor types;
• practical application of these concepts to exam-style due diligence tasks, such as checking whether a fund’s structure, service-provider framework, and redemption terms are consistent with regulation, align with the portfolio, and reveal any structural red flags.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the basics of fund structures and their regulatory context, which provide the groundwork for risk assessment, suitability, and operational due diligence, with a focus on the following syllabus points:

• Identify common legal forms of pooled investment vehicles (funds).
• Explain the concept and objectives of fund regulation.
• Describe the regulatory requirements for investor protection, reporting, and oversight.
• Understand how regulation impacts fund risks and operational due diligence.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Why do many regulations require a fund’s assets to be held by an independent custodian?
   1. To guarantee that the fund never loses money
   2. To segregate client assets from the manager and reduce misappropriation risk
   3. To ensure that the fund can freely borrow against its assets
   4. To allow the manager to avoid regulatory supervision
2. Which pair correctly matches a fund legal form with a key characteristic?
   1. Limited partnership – all investors have unlimited liability
   2. Trust – assets are held by a trustee for the benefit of unit-holders
   3. Open-ended company – fixed number of shares that never changes
   4. Closed-ended company – must redeem shares at net asset value daily
3. Under fund regulation, the primary purpose of a prospectus or offering memorandum is to:
   1. Provide daily trading tips for investors
   2. Disclose strategy, risks, fees, and operational arrangements to investors
   3. Set the exact future performance of the fund
   4. Replace the need for any additional reporting or financial statements
4. How can regulatory liquidity requirements influence the risk of an open-ended fund?
   1. They remove all market risk from the fund’s portfolio
   2. They encourage the fund to hold more illiquid assets for higher returns
   3. They limit holdings of illiquid assets, reducing redemption pressure under stress
   4. They force the fund to pay a fixed return to investors at maturity

Introduction

Investment funds pool money from multiple investors and invest according to a defined strategy. To assess fund risks and perform appropriate due diligence, CFA candidates require a clear understanding of standard fund structures, the key regulatory requirements that apply, and the reasons regulation exists.

Funds take on legal form to channel investor and managerial rights and obligations. Regulation of funds aims to protect investors, support market stability, and reduce system-wide risk. It imposes obligations on managers and fund vehicles, including reporting, oversight, and operational controls.

Key Term: Collective investment scheme
A broad term for any arrangement that pools investor money to invest in financial or real assets on a collective basis, with each investor entitled to a proportionate interest in the pooled portfolio.

Key Term: Net asset value (NAV)
The total market value of a fund’s assets minus its liabilities, usually expressed on a per-share or per-unit basis and used as the reference price for subscriptions and redemptions in open-ended funds.

Although investors can sometimes invest directly in assets (for example, buying a building or a private company stake), retail and many institutional investors usually access markets through fund investing. In alternative investments, two additional routes may appear:

• Co-investing: investing alongside a main fund in a specific deal.
• Direct investing: owning the asset directly.

The choice among fund investing, co-investing, and direct investing affects control, required skills, and liquidity:

• Fund investing gives investors with limited resources or experience access to professionally managed, diversified portfolios.
• Co-investing allows experienced investors to participate in specific deals with the main fund, often at reduced fees, while still benefiting from the manager’s due diligence.
• Direct investing offers maximum control but also demands the most specialist knowledge and resources and typically involves the least liquidity.

This article focuses on pooled fund structures, but awareness of these methods helps you understand why the legal and regulatory structure of the vehicle matters so much when assessing risk. Compared with direct investing, pooled funds introduce additional layers of structural, operational, and legal/regulatory risk. These layers can either mitigate risk (for example, independent custody, diversification) or create new vulnerabilities (for example, liquidity mismatch, leverage, or complex fee arrangements).

For Level 1, your task is not to memorize each jurisdiction’s detailed rules but to understand the general logic:

• What is the fund legally?
• Who owns what?
• Who controls decisions?
• How are investors protected if something goes wrong?

Once these elements are clear, many due diligence and risk questions become straightforward.

Common Fund Structures

Investment funds may be organized using different legal types, with the choice affecting liability, tax treatment, governance, and regulation.

Collective Investment Schemes

Funds that pool investor money are known generically as collective investment schemes. Their structures include several recurring concepts.

Key Term: Open-ended fund
A type of fund that issues and redeems units at net asset value on demand (or at specified dealing dates), allowing investors to enter and exit the fund at prescribed intervals.

Key Term: Closed-ended fund
A fund with a fixed number of shares or units; investors typically buy and sell these on a secondary market after the initial offering, and the market price may differ from net asset value.

Key Term: Limited partnership (LP)
A common private fund structure where at least one general partner manages the fund and has unlimited liability, while other partners (limited partners) provide capital but have liability restricted to their investment.

Key Term: Trust
A legal arrangement whereby assets are held by a trustee on behalf of beneficiaries, commonly used for some fund structures to separate ownership and management.

Key Term: Investment company
A fund structure where the pooled vehicle is set up as a separate legal company and investors hold shares in that company, which in turn owns the investment portfolio.

Typical vehicles used in major markets are:

• Open-ended investment companies
• Unit trusts
• Limited partnerships (especially in private equity, venture capital, and hedge funds)
• Common contractual funds or mutual funds
• Closed-ended investment companies (for example, investment trusts or listed closed-end funds)

In practice, these legal vehicles are used to package a wide range of strategies:

• Traditional mutual funds that invest mainly in listed equities and bonds for retail investors.
• Hedge funds that may use leverage, derivatives, and short selling.
• Private equity and venture capital funds investing in unlisted companies.
• Real estate and infrastructure funds investing in illiquid real assets.
• Funds of funds that invest in other funds rather than directly in securities.

The same strategy could in principle be offered through different legal forms. For example, an equity strategy might be implemented as an open-ended mutual fund for retail investors and as a limited partnership hedge fund for professional investors. The suitability of each legal type depends on the investment strategy, expected investor base, desired regulatory profile, and tax considerations.

From a due diligence standpoint, you should always relate the strategy to the structure. Long-horizon, illiquid strategies (such as private equity) are usually housed in closed-ended or partnership structures with limited redemption rights. Highly liquid strategies (such as large-cap index equity) are typically offered through open-ended corporate or trust-based mutual funds.

Corporate, Trust, Contractual, and Partnership Forms

Regulated funds are often structured using one of four broad legal approaches. Each has implications for who owns the assets, how investors are protected, and how decisions are made.

• Corporate funds (investment companies):

  • The fund is a separate legal company; investors become shareholders.
  • A board of directors or equivalent body has fiduciary duties to shareholders.
  • Shareholders typically have limited liability: their loss is limited to their investment.
  • Shares may be redeemable (open-ended) or listed on an exchange (closed-ended).
  • Distributions (dividends) and voting rights are governed by company law and the fund’s articles.

• Trust-based funds (unit trusts):

  • A trustee holds the fund assets on trust for the unit-holders.
  • The trustee has legal title; investors have beneficial ownership rights.
  • The trust deed sets out investment powers, income distribution, and unit-holder rights.
  • This form is common where trust law is well-developed and may offer tax benefits.

• Contractual funds (common contractual funds, some mutual funds):

  • Investors enter into a contract or set of rules rather than owning shares in a company.
  • The fund itself may not be a separate legal person; the manager acts on behalf of investors.
  • These funds are often tax transparent, meaning income and gains are taxed at investor level.
  • Contractual funds are widely used for pension schemes and cross-border poolings where avoiding a separate tax-paying entity is beneficial.

• Limited partnerships (for alternative funds):

  • The general partner (GP) manages the fund, makes investment decisions, and bears unlimited liability for the partnership’s obligations.
  • Limited partners (LPs) contribute capital, benefit from limited liability, and are usually passive; they must not take part in day-to-day management.
  • Capital is often committed up-front (for example, a 10-year private equity fund), but drawn down over time as the GP identifies investments.
  • Distributions follow a waterfall specified in the partnership agreement, often including performance-based allocations to the GP (a form of carried interest).
  • The partnership agreement can be highly tailored, specifying roles, reporting, investment limits, and conflict-of-interest controls.

In alternative investments, partnership structures are popular because they allow:

• Flexible allocation of profits and losses between managers and investors.
• Detailed contractual rules on capital calls, defaulting investors, and recycling of capital.
• Long-term commitments that match the time needed to source, manage, and exit illiquid investments.

From a due diligence viewpoint, you should always identify:

• Who is the legal owner of the assets?
• Who controls investment decisions?
• What is the maximum loss an investor might face (limited versus unlimited liability)?
• How are decisions made and challenged (company law, partnership agreement, trust deed, or contract)?
• What happens in default or distress situations (for example, investor failing to meet a capital call, or manager being removed)?

Recognizing these features helps you interpret exam questions that provide short fund descriptions but expect you to infer key characteristics such as liability, control, and likely investor protections.

Open-Ended versus Closed-Ended Funds

The open-ended or closed-ended nature of a vehicle is fundamental to its risk and liquidity profile.

• Open-ended funds:

  • Issue and redeem units at NAV per share, usually daily, weekly, or monthly.
  • Investors subscribe to and redeem from the fund itself; the fund’s capital rises or falls with net subscriptions and redemptions.
  • The manager must maintain sufficient liquidity—cash and readily saleable securities—to meet redemption requests on each dealing day.
  • Net asset value must be calculated frequently and accurately, using up-to-date prices.
  • These structures are common for mutual funds and UCITS-type funds (typically daily dealing), and for many hedge funds (often monthly or quarterly dealing).

• Closed-ended funds:

  • Raise a fixed amount of capital at launch and issue a fixed number of shares or units.
  • The fund normally does not redeem shares on demand; instead, investors trade shares with each other on a secondary market (for example, a stock exchange).
  • The trading price is determined by supply and demand and may deviate from NAV. Shares may trade:
    • at a discount to NAV (price below NAV), or
    • at a premium to NAV (price above NAV).
  • The manager can keep the portfolio fully invested without worrying about meeting daily redemptions, making these funds suited to illiquid or long-term investments.
  • Some closed-ended funds have limited life spans and may liquidate or offer periodic liquidity events.

For exam purposes, remember:

• Open-ended funds are generally more suitable for liquid portfolio assets (listed bonds, equities, money market instruments).
• Closed-ended funds are often used for illiquid assets (private equity, real estate, infrastructure, distressed debt) because the manager does not have to fund daily redemptions.
• A closed-ended fund’s liquidity for investors comes from the marketability of its shares, not from redemption at NAV. Poor secondary-market liquidity can result in persistent discounts.

Open-ended and closed-ended structures can also be combined with different legal forms. For example, an open-ended investment company and a unit trust might both offer broadly similar equity strategies but with different governance and tax treatment.

Worked Example 1.1

A fund is structured as a limited partnership with a general partner (the manager) and several limited partners (the investors). The general partner invests 2% of the capital and manages the fund. The fund’s assets are held by a third-party custodian as required by regulation. Why is the use of an independent custodian important here?

Answer:
The independent custodian holds the assets on behalf of all partners, segregating them from the manager’s own assets. This arrangement reduces operational risk, protects against misappropriation, and increases investor confidence because assets cannot be unilaterally accessed or pledged by the manager. It also facilitates accurate record-keeping and simplifies recovery of assets if the manager becomes insolvent.

Worked Example 1.2

A closed-ended real estate investment company and an open-ended property fund both invest in similar commercial buildings. The open-ended fund offers monthly redemptions at NAV, while the closed-ended company is listed and its share price often trades at a discount to NAV. Which structure is more likely to face liquidity pressure during a market downturn, and why?

Answer:
The open-ended property fund is more exposed to liquidity pressure. If many investors request redemptions in a downturn, the manager may need to sell properties quickly or impose gates or suspensions. Buildings cannot be sold monthly without price impact, so there is a liquidity mismatch. The closed-ended company does not have to meet redemptions; its investors trade among themselves, and liquidity pressure shows up as wider discounts to NAV rather than forced property sales.

Overview of Fund Regulation

Fund regulation is primarily designed to protect investors, ensure proper disclosure, reduce fraud, and bolster market confidence. It also aims to support fair and efficient markets and to reduce system-wide risk from highly leveraged or interconnected funds.

Regulations typically require:

• Fund registration or approval before marketing to the public.
• Clear disclosure of strategy, fees, risks, and conflicts of interest in a prospectus or offering document.
• Appointment of independent service providers (such as administrators and custodians) to safeguard assets and facilitate independent valuation.
• Regular reporting to investors and regulators (for example, audited annual financial statements, periodic performance and risk reports).
• Ongoing oversight via directors, trustees, or depositaries, and robust internal compliance and risk-management systems at the manager.

In many jurisdictions, there is both:

• Product regulation (rules that apply to the fund vehicle itself, such as diversification, eligible assets, and liquidity), and
• Manager regulation (rules applying to the investment manager or adviser, such as capital requirements, competence, and conduct of business).

Understanding which entity is regulated helps you interpret exam scenarios where, for example, a fund may be domiciled in one jurisdiction while the manager is regulated in another.

Key Term: Custodian
An independent firm appointed to hold a fund’s assets in safe custody, maintain records of ownership, and ensure that assets are segregated from those of the manager.

Key Term: Depositary
In some regimes, a party with enhanced oversight duties that must both safekeep assets (directly or via sub-custodians) and monitor that subscriptions, redemptions, and valuations are carried out according to regulations and fund rules.

Key Term: Fund administrator
A service provider that typically calculates the fund’s NAV, maintains the shareholder or unitholder register, and produces investor statements and financial reports.

Regulatory frameworks often distinguish between:

• Public or retail funds:
  Heavily regulated products that can be sold to the general public. They face tighter rules on:
  • eligible assets and diversification,
  • liquidity and redemption frequency,
  • use of derivatives and leverage,
  • disclosure (including simplified investor information documents).
• Private or alternative funds:
  Often offered only to professional or sophisticated investors. Regulations may be lighter on product rules but marketing is restricted, and minimum investment sizes can be higher. Investors are expected to perform more detailed due diligence.

Regulators typically focus on substance over form. Labeling a product as a “fund” or “note” does not avoid regulatory scrutiny if it functions as a collective investment scheme. In exam questions, if you see a structure that pools capital and is managed as a whole, you should think in terms of fund regulation principles even if the label differs.

Worked Example 1.3

A regulated open-ended fund is required to redeem units at the next published net asset value. How does this requirement affect risk and investor due diligence?

Answer:
The promise of liquidity at NAV gives investors confidence they can exit the fund at a fair value, but it also requires the fund to maintain a liquid asset base and careful risk management to avoid forced sales or gating during stress events. In due diligence, investors must check that the liquidity of the portfolio assets and the use of leverage are consistent with the redemption frequency. A daily-dealing fund heavily invested in thinly traded securities is a structural red flag.

Investor Protection and Due Diligence

A core regulatory objective is to protect investors, especially retail investors. This is achieved through a combination of disclosure, governance, segregation of assets, and conduct-of-business rules.

Disclosure and Offering Documents

• Disclosure: The fund must present investors with comprehensive, clear, and accurate information about its objectives, investment strategy, fee structure, risks, and conflicts of interest. This is done through the fund’s prospectus or offering memorandum and may be supplemented by shorter key information documents and regular reports.

Key Term: Prospectus
The main legally required disclosure document for a public fund, detailing objectives, investment strategies, risk factors, fees, dealing arrangements, and operational practices, and normally filed with or reviewed by the regulator.

Key Term: Offering memorandum
A detailed disclosure document used for private or alternative funds, similar in content to a prospectus but typically aimed at qualified or professional investors rather than the retail public.

Typical sections of a prospectus or offering memorandum include:

• Investment objective and policy.
• Eligible assets and markets.
• Risk factors (market, credit, liquidity, leverage, operational, legal).
• Fee structure (management fees, performance fees, other expenses).
• Dealing procedures (subscription and redemption dates, notice periods, settlement).
• Valuation rules and pricing sources.
• Use of derivatives and borrowing.
• Governance and service providers (manager, custodian, administrator, auditor).

From a due diligence standpoint, the offering document is the primary source for verifying whether the fund’s actual behavior (for example, use of leverage or derivatives) is consistent with its formally stated policy.

Valuation and Asset Safekeeping

• Valuation and Asset Safekeeping:
  Regulation often requires regular, independent valuation of fund assets, and mandates the appointment of a depositary or custodian to hold fund property apart from the manager’s assets. This reduces the risk of fraud, errors in pricing, and conflicts of interest if the manager also trades the assets.

For liquid, exchange-traded securities, valuation is typically based on last-traded or bid prices from recognized markets. For illiquid or complex instruments (private equity, unlisted debt, bespoke derivatives), valuation may rely on models or third-party appraisals. Regulators may require:

• documented valuation policies,
• use of independent valuers or committees, and
• controls to avoid the manager marking its own book without oversight.

Weak or overly discretionary valuation practices increase the risk that NAV does not reflect realizable value, which is a key due diligence concern.

Oversight and Governance

• Oversight: Funds must have independent oversight bodies (such as boards, independent trustees, or depositaries) to supervise compliance with both the law and the fund’s own rules. These bodies monitor the manager’s adherence to the stated strategy, investment limits, and conflict-of-interest policies.

Key Term: Independent board or trustee
A governing body or individual(s) separate from the fund manager, responsible for overseeing the fund’s operations and safeguarding investor interests.

Independent directors or trustees should, in principle:

• Approve key service-provider appointments.
• Challenge the manager on performance, risk, and significant changes to strategy.
• Review conflicts of interest (for example, cross-trading between related funds, allocation of deals among funds).
• Oversee valuation and distribution policies.

Due diligence questions may ask you to recognize the difference between a fund with strong independent oversight and one where the manager effectively supervises itself.

Fair Treatment and Dealing Rules

Investor protection also relies on rules for fair treatment and dealing:

• Equal treatment of investors holding the same share class (no preferential pricing for certain investors within the same class).
• Clear rules on pricing, subscription, and redemption cut-off times (late trading and market timing abuses are prohibited).
• Policies on handling errors, trade allocation across client accounts, and use of soft commissions or research paid by the fund.

For example, if an order arrives after the cut-off time, it should be processed using the next dealing day’s NAV, not the already-known price. This prevents late traders from exploiting price-sensitive information.

From a due diligence angle, a candidate should be able to:

• Identify whether the fund is regulated and, if so, under what general regime (retail versus professional).
• Check that the fund uses recognized, independent service providers (custodian, auditor, administrator).
• Assess whether the disclosures about strategy, risks, fees, and liquidity are consistent and realistic.
• Spot potential conflicts of interest (for example, the manager acting as both adviser and principal, or frequent related-party transactions).

Worked Example 1.4

An investor is assessing two funds with similar equity strategies. Fund A is a regulated retail fund that publishes a full prospectus and semi-annual reports. Fund B is an unregulated offshore fund that provides only marketing slides and a term sheet. What regulatory and due diligence concerns arise with Fund B?

Answer:
Fund B lacks the detailed, legally required disclosure of a prospectus and may not be subject to strict rules on custody, valuation, or oversight. There may be no independent board or depositary, and marketing documents may not be subject to regulatory review. This increases information and operational risk for the investor. The limited documentation is a due diligence red flag, especially for less-sophisticated investors, and would typically be acceptable only for professional investors capable of negotiating additional protections.

Core Regulatory Themes

Key regulation-related concepts relevant for risk due diligence include liquidity rules, leverage and derivatives, eligible investors and marketing rules, and liquidity management tools.

Liquidity Rules

• Open-ended funds must hold sufficient liquid assets to meet redemption obligations.
• Many regulations set:
  • Minimum proportions of highly liquid assets.
  • Limits on illiquid or hard-to-value holdings.
  • Requirements for liquidity risk management frameworks, including stress testing and contingency plans.

Key Term: Liquidity mismatch
A situation where a fund offers more frequent or generous redemption terms than the liquidity of its portfolio assets justifies, increasing the risk of forced sales, gates, or suspension.

A typical regulatory approach is:

• For daily-dealing retail funds: strict limits on illiquid assets and requirements for diversification.
• For less frequent-dealing or professional funds: more flexibility but with a requirement to document and monitor liquidity risk and to disclose the use of tools such as gates or suspensions.

If a fund offers daily or weekly redemptions but invests heavily in private or thinly traded assets, regulators and due diligence analysts will question whether the liquidity promise is sustainable. In stress conditions, such a fund might need to:

• sell liquid holdings first (increasing concentration risk),
• widen bid–offer spreads and face worse execution, or
• suspend redemptions to protect remaining investors.

Matching asset liquidity to redemption terms is therefore a central structural consideration.

Borrowing, Gearing, and Derivatives

Leverage can magnify both returns and risks.

• Borrowing limits: Regulations may restrict borrowing by funds, especially retail funds, to limit risk and protect investors from excessive gearing. Borrowings may be capped as a percentage of NAV.
• Gearing through derivatives: Even without borrowing, derivatives can create economic leverage. For example:
  • a futures contract on an equity index requires only margin but provides exposure to the full notional amount;
  • options can create asymmetric exposure relative to invested cash.
• Regulatory regimes often:
  • Require measurement of global exposure using methods such as the commitment approach or value-at-risk.
  • Impose caps or require disclosure of gearing levels, including synthetic leverage.
• Short selling and securities lending: These activities may be restricted or subject to additional risk controls and disclosure. Collateral management and counterparty risk become important.

Key Term: Gearing
The use of borrowed funds or derivative positions to increase a fund’s exposure to portfolio assets relative to its equity capital, magnifying gains and losses.

For due diligence, you should:

• Check whether gearing is permitted under the relevant regulation and fund documents.
• Understand how gearing is generated (bank borrowings, margin loans, derivatives, or securities lending).
• Assess the impact of gearing on:
  • volatility of NAV,
  • liquidity (need to meet margin calls), and
  • potential for rapid losses in stressed markets.

Worked Example 1.5

A hedge fund’s documents state that it may use leverage up to 300% of NAV, primarily through futures and swaps. The fund offers monthly redemptions with 30 days’ notice. What additional risks does this create compared with an unleveraged fund, and what should due diligence focus on?

Answer:
Leverage via derivatives means the fund can lose more than an equivalent unleveraged portfolio would, and margin calls may force asset sales at unfavorable times. Monthly redemptions add liquidity pressure if performance deteriorates. Due diligence should focus on the fund’s risk-management processes (margin monitoring, stress testing, liquidity of portfolio positions), the quality of collateral management, and whether redemption terms (notice periods, gates) are adequate given potential volatility.

Eligible Investors and Marketing Rules

Investor protection also relies on defining which types of investors may buy certain products.

• Retail investors: Typically have access only to heavily regulated funds that meet strict diversification, gearing, and disclosure standards. These funds are marketed through regulated channels, often with standardized risk warnings.
• Professional, qualified, or accredited investors: Considered more sophisticated and better able to bear losses and conduct due diligence. They may invest in more lightly regulated alternative funds, such as hedge funds, private equity funds, and private credit funds.

Key Term: Professional or qualified investor
An investor who meets specified income, wealth, or experience criteria and is therefore permitted to invest in certain complex or lightly regulated products not available to the general public.

Marketing rules determine:

• Where and to whom the fund can be promoted.
• Whether a simplified disclosure document (for example, a key investor information document) is required.
• What risk warnings must be provided (for example, capital at risk, illiquid, long lock-up).

For exam purposes, focus on the principle: more complex, less regulated products are usually restricted to investors who meet higher eligibility criteria. If a very complex, illiquid fund is described as being widely marketed to unsophisticated investors, that should raise a regulatory concern in an exam question.

Liquidity Management Tools

When many investors want to redeem at once, even a well-managed fund can face stress. Regulations and fund rules may permit several tools to manage this risk.

• Suspension of redemptions: Temporarily halting redemptions to avoid forced sales and ensure fair treatment. Usually allowed only in exceptional circumstances (for example, market closures, breakdown of pricing systems, or extreme illiquidity).
• Redemption gates: Limiting the percentage of the fund that can be redeemed on any one dealing date, with excess redemption requests carried forward.

Key Term: Redemption gate
A mechanism that restricts the total amount investors can redeem on a dealing day, usually expressed as a percentage of the fund’s NAV, to protect remaining investors and avoid fire sales.

• Side pockets: Segregating particularly illiquid or distressed assets into a separate sub-portfolio so that remaining liquid assets can still support redemptions for other investors.

Key Term: Side pocket
A separate sub-portfolio used to hold illiquid or hard-to-value assets, with specific rules governing redemptions and valuation for investors exposed to those assets.

• Swing pricing and anti-dilution levies: Adjusting the dealing price or charging a fee when there are large subscriptions or redemptions, so that transaction costs are borne by transacting investors rather than diluting remaining investors. (Terminology may vary by jurisdiction.)

These tools can reduce market-wide risk but also limit investor liquidity. In due diligence, it is important to read the prospectus or offering memorandum to see whether such tools exist and under what conditions they may be used. The absence of any liquidity management tools in a fund investing in moderately illiquid assets may itself be a risk indicator.

Worked Example 1.6

A fund offers weekly liquidity but invests in assets that can only be sold after several months. The prospectus mentions the ability to impose a 10% redemption gate in “exceptional circumstances.” What regulatory concern might arise, and how does the gate help?

Answer:
A mismatch between the fund’s redemption terms and the liquidity of its assets could violate regulatory requirements and increases the risk of forced asset sales (“fire sales”). The 10% gate provides a mechanism to slow down redemptions, reducing pressure to sell assets quickly and helping protect remaining investors from dilution. However, regulators and due diligence analysts would still question whether weekly redemptions are appropriate at all for such a portfolio; the gate mitigates but does not fully solve the liquidity mismatch.

Exam Warning

Regulation varies by jurisdiction, and the detailed requirements for fund approval, disclosure, liquidity, borrowing, and custody are not identical worldwide. Some regimes are more rules-based (with detailed quantitative limits), others more principles-based (emphasizing outcomes such as “fair treatment” and “suitable liquidity management”).

In the exam, focus on core legal and risk-management principles:

• asset segregation and independent custody,
• independent valuation and transparent pricing,
• appropriate liquidity relative to dealing terms,
• reasonable limits on leverage and derivatives,
• adequate disclosure and governance.

Do not worry about memorizing jurisdiction-specific acronyms or minor procedural details.

Revision Tip

When assessing risk or performing due diligence in CFA exam questions:

• Identify the fund vehicle’s legal and regulatory form (company, trust, partnership, contractual fund; retail versus professional).
• Check whether client assets are segregated and held by an independent custodian or depositary.
• Look at investor eligibility criteria and marketing restrictions.
• Examine redemption terms and compare them to the liquidity of portfolio assets and the use of leverage.
• Note any liquidity management tools (gates, suspensions, side pockets) and consider whether they are appropriate given the strategy.

If a fund offers generous redemption terms while investing in highly illiquid assets or using high leverage, this is likely to be a structural red flag.

Summary

Understanding core fund structures and regulation equips you to perform fundamental due diligence and risk analysis. Legal form determines who owns the assets, who controls decisions, how disputes are resolved, and how far investor liability extends. The open-ended or closed-ended nature of a vehicle shapes liquidity, pricing, and suitability for different asset classes.

Effective regulation:

• establishes operational controls and governance;
• requires clear disclosure and ongoing reporting;
• mandates segregation of assets and independent valuation; and
• sets limits on leverage, eligible assets, and liquidity to reduce risk to investors and the financial system.

Independent custodians, administrators, and oversight bodies reduce operational and fraud risk. Rules on liquidity, gearing, and eligible investors aim to align product design with investor protection, so that retail investors are exposed only to risks they can reasonably understand and bear, while professional investors can choose more complex products with appropriate disclosures.

In an exam context, you should be able to read a brief description of a fund, identify its structure, infer the key regulatory protections or gaps, and recognize red flags such as liquidity mismatch, excessive gearing, unrealistic dealing terms, or weak independent oversight. These structural observations complement security-level analysis and are central to assessing overall investment risk and suitability.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the primary legal structures used by investment funds, including companies, trusts, contractual funds, and limited partnerships, and how they allocate ownership, control, and liability.
• Distinguish between open-ended and closed-ended funds in terms of issuance, redemption, liquidity, pricing, and suitable asset types.
• Identify main regulatory objectives (investor protection, market integrity, system-wide risk reduction) and how they translate into concrete requirements for authorization, disclosure, reporting, governance, and oversight.
• Describe typical investor protection mechanisms, including independent custody, valuation oversight, and required disclosure through a prospectus or offering memorandum.
• Recognize regulator-imposed limits on liquidity and borrowing in fund vehicles and how these relate to gearing, liquidity risk, and redemption pressure.
• Understand how marketing and investor eligibility rules differentiate retail from professional-investor products and why more complex structures are restricted to sophisticated investors.
• Explain the purpose and operation of liquidity management tools such as suspensions, redemption gates, and side pockets.
• Apply these principles to operational due diligence in the CFA exam context, spotting mismatches between a fund’s structure, strategy, leverage, and redemption terms, and identifying structural red flags.

Key Terms and Concepts

• Collective investment scheme
• Net asset value (NAV)
• Open-ended fund
• Closed-ended fund
• Limited partnership (LP)
• Trust
• Investment company
• Custodian
• Depositary
• Fund administrator
• Prospectus
• Offering memorandum
• Independent board or trustee
• Liquidity mismatch
• Gearing
• Professional or qualified investor
• Redemption gate
• Side pocket