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Offshore Mutual Funds. What is a Mutual Fund, Pooled Fund or Open Ended Investment Trust?

MUTUAL FUNDS

In recent years, mutual funds have become the largest growth sector in the investment industry worldwide. The increase in rates of investment into mutual funds has astonished even industry professionals. In this age of 24-hour global markets, program trading and market price volatility, the private investor has sought refuge in mutual funds. While the major investment houses have for many years offered a wide range of mutual funds, the present climate offers significant opportunities to small and medium sized investment managers, traders and brokers.

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BENEFITS OF AN OFFSHORE FUND

For an investment professional, a mutual fund is a vehicle that enables more efficient use of existing research and investment expertise and resources. As an additional product to market to one's client base, the properly structured offshore fund offers a number of features that distinguish it from a traditional mutual fund:

A lower level of regulation makes it easier to establish and administer the funds. Consequently, formation and operating costs are significantly reduced. Lower costs means funds can be offered at zero or low load and with competitive management fees from the investor's point of view. Furthermore, greater flexibility is generally available, in terms of both fund structure and the investment portfolio.

Tax exempt status in the offshore jurisdiction enables the fund to reinvest the approximately 30% taxes on profits and gains that would otherwise be payable in high tax jurisdictions, without the need to obtain investment company or similar status. Therefore, taxes may be deferred until the investor receives a return on his investment. (Tax advice should be sought in the jurisdictions of the sponsor/manager and each investor to determine any potential tax liability.)

No big back office operation is required, since all administration, execution and shareholder relations can be subcontracted out. Further, by having clients invest in a fund in which they buy and hold shares rather than, for example, a discretionary managed account, all of the contract notes, advices, statements and other client transaction paperwork may be dispensed with. Investors simply receive a monthly or quarterly NAV certificate and annual or semi-annual financial statement.

All of these features contribute to make an offshore fund a viable and attractive proposition for investment professionals in every field and of all sizes. The cost efficiency of offshore funds also means that a series of funds, custom designed for different client needs or profiles, may be easily created.

WHY THE BVI?

When choosing an offshore financial center in which to establish and administer mutual funds, there are a number of factors to consider both from the sponsor's and the investor's point of view:

The BVI IBC is accepted as the preferred choice for offshore corporate domicile.
Integrity is the key for both investors and sponsors investing millions of dollars in or through a perhaps unfamiliar jurisdiction. The BVI has a reputation second to none as a corporate domicile.
Regulation under the newly-in-force Mutual Funds Act 1996 ("the Act") supports the integrity of the Territory's financial services sector. The light handed regulatory scheme focuses on ensuring that only fit and proper persons are involved in any aspect of mutual fund operations in the BVI. Many offshore jurisdictions regulate only funds over a certain size or distribution and most do not specifically licence the professionals involved. The differentiated regulatory scheme under the Act covers all levels of funds but is in no way burdensome to the sponsor or the fund in its day-to-day operations.
Flexibility of structure is available, whether through an International Business Company ("IBC"), Limited Partnership or Unit Trust. The BVI has modern legislation governing each of these entities. The statutes reflect modern economic realities and market practices, for example: a) IBC's share capital can be denominated in any currency or in multiple currencies, b) There is no limit to the number, type or designation or rights of different classes of shares which can be created, c) There are no restrictions on borrowing powers or investment practices or policies, which are limited only by what sponsors indicate to prospective investors, d) minimum formality and speedy approval procedures allow funds to be created quickly, once the structure, investment criteria and prospectus have been finalised, and e) the US Dollar is the official currency of the BVI and there are no exchange control or other restrictions on the movement of funds.
Experienced, licensed professionals are available to undertake all aspects of the establishment and administration of the fund. This enables the sponsor to cost-effectively sub-contract all of the back office functions with confidence.
Total confidentiality of client affairs is maintained.
The BVI as a British Dependent Territory is politically stable.

STRUCTURE OF OFFSHORE MUTUAL FUNDS

The four principal elements that govern the structure of mutual funds include: a) the nature of the underlying investments in which the mutual fund intends to specialize, b) the way in which the fund intends to market its shares, c) the way in which investors earn their returns and realize their investments, d) the way in which the fund's manager and other professionals earn their fees. Each of these issues is briefly considered below.

THE UNDERLYING INVESTMENTS

Although most funds permit themselves the full range of investments, they generally specialize in a particular area, such as equities, bonds, currencies, or particular geographical areas or market sectors. Some funds may be hedge funds that rely to a greater or lesser extent upon the use of derivative instruments (i.e., options, futures and swaps based upon the underlying principal investment). In addition, some funds may rely heavily on the use of leverage or trade upon margin in order to boost returns. The latter are obviously the highest risk funds, in particular where these are also based upon derivatives.

Where the intended investments are relatively liquid, the typical fund will be an "open-ended" fund, in which investors can subscribe and redeem their shares for cash on a regular basis. If the intended asset classes are illiquid investments, such as real estate developments or film finance, then a "closed-end" fund may be more appropriate. With this type of fund, subscriptions are limited by reference to the number of shares or a specified offer period. Investors only receive a return of capital after a specified period or when management so decides, in both cases after the fund has liquidated its investment.

A fund may intend to invest in a variety of asset classes and to offer investors a choice of portfolio mix, with the option to switch between asset classes at minimal cost. A common structure is the "Fund of Funds" or "Umbrella Fund". Such funds work in one of two ways. The fund itself may establish a number of sub-funds in which investors can spread their investments. Subfunds may be for, e.g., equities, bonds or different currencies. Alternatively, the fund may offer a menu of third party funds from which investors can choose. This may give investors access on a pooled basis to funds to which they would have no access individually. A similar result can be achieved by creating a single fund with different share classes each representing a different type of investment (e.g. dollar, sterling and deutschmark denominated shares for investment in each currency).

A significant investor advantage that the larger of the umbrella (or 'family') funds offer is the relatively easy and inexpensive switching facilities offered by such structures. For a nominal fee investors may change the structure of their fund portfolio between sub-funds within the umbrella. This allows the investor to cheaply and easily move to different markets or risk profiles, depending on their preferences. This switching feature can be a useful marketing tool and can potentially be a real investment advantage to the private investor.

A master-feeder fund is a fund used to attract a specific interest group for onward investment into a central master fund.

You may also create a multi-manager fund, that is, a fund vehicle which selects different managers to invest a portion or portfolio of the funds assets. Normally, there is one investment adviser or manager which has contracted with the fund and is charged with the responsibility to allocate the fund assets between selected managers after studying their recent investment performance and techniques.

Side by side fund is normally an onshore and offshore fund utilizing the same investment strategy, but each fund is attractive or restricted to a different category or class of person. For example a promoter or fund manager may wish to start up an offshore fund, following the success of its onshore fund, utilizing precisely the same investment strategy, but the offshore fund may be limited to non-United States persons, owing to regulatory and or taxation issues which would otherwise arise.

It is generally thought that hedge funds, which employ sophisticated investment techniques, (often with varying degrees of leverage) constitute over fifty percent of the collective investment vehicles formed in the BVI. Other vehicles have been created with a view to investing in money market investments, interest bearing bonds or securities and stocks or shares. These vehicles are commonly referred to respectively as "Money Market Funds", "Bond Funds" and "Equity Funds".

METHOD OF MARKETING SHARES

Mutual fund structure is also affected by where and to whom the funds are offered. For example, will the fund be offered to the general public or only to "sophisticated professional investors"? (Normally, sophisticated professional investors are individuals with a net worth of at least one million dollars or institutions, including other funds.) In addition, is the fund marketing purely directed to the sponsor/manager's existing client base or discretionary managed accounts, or is it also directly or indirectly going out to other investors? Each of these will affect the various regulatory implications that need to be considered. At the end of the day, while there are some BVI regulatory requirements to be considered, regulations in the jurisdiction of the principal target markets will have the most bearing.

INVESTOR RETURNS

The typical fund is an open-ended fund that issues redeemable shares and is intended to achieve capital growth. There are no restrictions on the number of shares that such funds can issue and there is a potential flow of subscriptions and redemptions, as investors make and redeem their investments. After a fixed initial period (no more than two or three months) during which the shares are offered at a fixed price, all subscriptions and redemptions are at the Net Asset Value. Being a growth fund, dividends are typically not paid.

The frequency of redemption is governed by the liquidity of the underlying investment (i.e., how long the fund needs to realize cash to meet a redemption demand) and by the frequency of valuations. A fund can only redeem shares based on a formal Net Asset Valuation, so as to ensure proper pricing. Typically, redemption takes place on the last day of each month, following a Net Asset Valuation as at that date. With more liquid investments and if the fund is prepared to bear the administrative costs, valuations can be weekly or even daily. (The typical large institutional funds in the U.S. have daily valuations).

A closed-end fund may pay dividends after an initial period but will only return capital on an irregular basis after the underlying asset is sold. Consider, for example, a real estate investment. While the development is being constructed, there is no return to the investor. Once built, an income stream will develop from rent received from tenants. After a period, the building may be sold realising a capital gain.

Key Parties, their Fees and Expenses. Sponsor, management and administration functions and their remuneration typically follow the following patterns:

The Sponsor is the creator of the fund and will typically hold a number of voting shares (perhaps 100) in the fund, but these are not entitled to any distributions or share in the equity. All of the equity belongs to the investors, typically in the form of non-voting "preferred redeemable shares". The voting shares generally control management of the fund, apart from limited major decisions.

The Investment Manager. A manager is a person, not being an officer or an employee of a mutual fund which has delegated management functions to a person licensed under the Act, who:

For valuable consideration provides a mutual fund with management services either alone or together with investment advice; or
Is entitled to provide mutual funds with such services and facilities as provided in (a) above under the laws of a recognised jurisdiction.

The manager determines the investment strategy of the fund and makes the investment decisions. The manager earns fees in the range of 1 to 2% of the NAV per annum, calculated and paid on a regular basis. Typically, these exclude any brokerage commissions and trading expenses which are additional expenses of the fund. In addition, many managers take an incentive or participation fee, based upon any increase in the Net Asset Value. These may range from 6% to 50% of the profit or gain. Usually, there is some adjustment provision such that if the NAV goes down, the manager does not get any further fees until the NAV exceeds the previous high. Some investment managers take a percentage of each subscription as a commission, often up to 5%. This may be added to the investment or deducted from the net proceeds. Typically the fee is taken where the manager has to pay commission to other intermediaries.

To maintain a distance between the promoter, who may also act as the investment advisor, and the fund itself, an investment management company is often set up. For example, the promoter may hold the voting shares of the mutual fund company through a wholly owned management company, thereby retaining control of the fund.

This investment management company can be an International Business Company (IBC), and any management fees paid to it from the fund may be accumulated tax-free in the BVI (although tax implications should be discussed with a local professional advisor in the promoter's domestic domicile).

THE FUND ADMINISTRATOR

An administrator is a person who: for valuable consideration provides administrative services and facilities to a mutual fund; or is entitled to provide mutual funds with such services and facilities as provided in (a) above, under the laws of a recognised jurisdiction.

The functions of the fund administrator may vary but typically include:

The provision of the registrar and transfer agent for the investors' shares (which includes maintaining the fund's share register and processing the issue and redemption of shares);
Publishing the fund's net asset value (NAV) in accordance with the terms outlined in the prospectus or offering memorandum;
In some cases the preparation of the fund's annual financial statements and liaison with the auditors;
Dealing with general shareholder inquiries, etc.

Depending on the complexity of the fund, the administrator's fees could be as little as a few thousand dollars a year or as much as 0.5 to 0.65 % of the NAV per annum. Sometimes the administrator's fees are included within the management fee. In certain situations, the administrator subcontracts a part of the work, particularly the NAV certification, to the investment manager.

The Act requires any person who provides fund administration or fund management services "in, or from within, the British Virgin Islands" ("BVI") to be licenced under the Act. This section does not apply however, to persons who are not ordinarily resident or domiciled within the BVI, are licenced as a manager or administrator of mutual funds under the laws of a recognised jurisdiction, and have received written permission to carry on business as a fund administrator or fund manager. [s22]

The primary function of the custodian, which is usually an established bank, is to safeguard the fund's assets (i.e. the investment portfolio). The custodian bank executs securities transactions on the instructions of the investment manager, collects income and dividends on behalf of the fund, and provides the portfolio statements and schedule of investments to the administrator to calculate the fund's Net Asset Value (NAV).

In some cases and depending on the fund's objective, the custodian bank function may be split between various parties.

Commonly, part of the fund's assets are held by one or more brokers who execute trades on behalf of the fund. Custodial Fees can also be a fixed fee or a percentage of NAV. Where a broker acts as de facto custodian, it usually charges on a transactional basis.

In addition, the fund will also be responsible for all of its own legal, accounting and other administrative expenses, excluding overhead expenses of the manager, administrator, etc.

The auditor. Annual accounts need to be prepared, and public funds need to be audited by a licensed BVI auditor (or recognized outside the BVI). Five of the major accounting firms with extensive experience in this area are represented in the BVI.

There are also a number of smaller international accounting firms with a presence in the jurisdiction. Although there is no legal requirement to appoint an auditor for private or professional mutual funds, it is recommended that one be appointed.

Annual fees

An entity licensed as a mutual fund manager - $500
An entity licensed as a mutual fund administrator - $500
An entity licensed as both a mutual fund manager and administrator - $1,000
An entity recognized as a private or professional mutual fund - $350
An entity registered as a public mutual fund - $500

Annual fees for entities regulated under the Act are due on or before 31st day of March each year.Under section 38 (5) of the Financial Services Commission Act, 2001 the licence or certificate of a licensee that has not paid by that date must be revoked. Accordingly, funds, managers and administrators are all strongly urged to pay annual fees in good time.

REGULATION OF BVI MUTUAL FUNDS - THE MUTUAL FUND ACT 1996

The BVI Mutual Fund Act (as amended, extensively, by the Mutual Fund Amendment Act 1997) (together "the Act") is in force effective January 2, 1998. The purpose of the legislation was to provide for the regulation, authorisation and control of mutual funds, their managers and administrators carrying on business in or from within the British Virgin Islands and for related matters. The legislation is flexible and simple whilst providing the right degree of protection for the interests of those investing in mutual funds. From the definition of what constitutes a "mutual fund" as set out in the Act, the mutual fund vehicle must be established for the purposes of collecting and pooling investor funds and it must issue shares (or their equivalent in other vehicles) that entitles the holder to receive on demand an amount in value which is proportionate to the whole net asset value of the vehicle. The Act does not attempt to regulate closed end funds. Further a fund maintained by a group of family trusts for the purpose of facilitating family investments are exempt from the requirement to become recognised under the Act.

There are three main vehicles used in the BVI for collective investment purposes, namely limited companies, unit trusts and limited partnerships and each one will be looked at in turn.

LIMITED COMPANIES

By far the most popular vehicle for establishing a collective investment vehicle is a limited company, but in particular an International Business Company ("IBC") incorporated under The International Business Companies Act 1984 (Cap.291). The IBC has proved attractive because of its flexible nature, in particular the ability to create a flexible ownership structure with different classes or series of shares and additionally the ability to easily provide for the redemption of its shares. Moreover, share classes can be created with preferred or deferred voting rights and dividend or other participating rights. This legal entity is understood and accepted by international finance markets. The incorporation process is uncomplicated and essentially consists of filing customised copies of the Memorandum and Articles of Association with the Registrar or Companies, which are returned within 2 - 3 days together with a Certificate of Incorporation.

UNIT TRUSTS

Owing to the modern trust law existing in the British Virgin Islands, unit trusts are also a very popular form of collective investment vehicle. In such a structure, the investors or unit holders are the beneficiaries under the trust and pursuant to general trust principles, the trust can, at any time be brought to an end on the collective vote of all the unit holders.The formation of this vehicle is again, a fairly simple process, which normally entails the trustee and the fund manager executing a customized trust instrument. Flexible laws in the BVI allow the formation of an IBC to act as trustee, which will only require a restricted trust licence provided the company acts as trustee only of the trusts it lists in the application for the licence. The licence fee and annual fee is US $100.

PARTNERSHIPS

Following the introduction of the Partnership Act, 1996, international limited partnerships have been frequently used as collective investment vehicles, again because of their flexible nature. International limited partnerships are formed by a general partner and at least one limited partner executing Articles of Partnership and by submitting a Memorandum of Partnership to the Registrar of Companies (who doubles as the Registrar of Partnerships). The Articles of Partnership do not have to be filed with the Registrar but for all intents and purposes constitute the essential documents governing the inter partnership relations. Bodies corporate may be the general or limited partner and an international limited partnership may serve as the general partner of another international limited partnership. There is no legal requirement for an international limited partnership to have a local ("BVI") general or limited partner.

Under the Act, all mutual funds or collective investment vehicles are categorised as either "private", "professional" or "public". Private and professional funds must apply for recognition whereas public funds must apply for registration.

REGISTRATION OF PUBLIC FUNDS

A public fund is a mutual fund the shares of which are offered to the general public. Public funds must be registered, or have consent to registration under a pre-filing procedure, before carrying on business or engaging in any activity in the BVI. A public fund must issue and file a prospectus including the information required by the Act and must pro