Open-ended funds are so five minutes ago. Through the countless articles that slam such traditional investment vehicles in favor of the more liquid and less expensive exchange traded funds, or the more custom-tailored separate account, or even the less market-dependent hedge fund, it seems that regular ‘ole mutual fund shares are about as popular as a tractor pull in the Hamptons.

Of course, the blame falls squarely on the mutual fund companies themselves. The combination of high fees, poor performance, and self-dealing have painted many fund companies as poor fiduciaries, ones that are more concerned with their own bottom line than the upward trajectory of their fund’s net asset values. At the same time, lower-cost alternatives have given RIAs new ways to capture returns for their clients, and in many cases these new vehicles have done a fine job. But even with all the negatives, it may not be the time to completely write off traditional mutual funds. Indeed, some advisors are finding that pooling their clients’ money in their own funds is a better approach than using someone else’s off-the-shelf product.

A Fresh Start

Most of the bad reputation of mutual funds is guilt by association owing to their mishandling by old-guard fund operators. Like any for-profit concern, mutual fund companies require income, which has given rise to a fundamental dilemma: How does a mutual fund company balance its fiduciary responsibility to investors with its responsibility to itself to make a profit? Milton Friedman correctly theorized that many economic outcomes can be predicted by understanding the incentives involved. For big fund companies, the incentive to maximize their own revenues is often stronger than their altruistic mission to do the best possible job as their investors’ fiduciary.

The majority of mutual fund companies maintain a fee structure so high that sub-par performance is practically ensured. At the core are management fees, which encourage fund managers to grow assets far beyond the point at which a fund becomes difficult to manage without deteriorating performance. Then there are front-end sales loads, which are necessary to pay for the huge sales and marketing organizations that mutual fund companies and their broker intermediaries must maintain. In addition, Rule 12b-1 fees are charged annually in perpetuity to pay for marketing costs. As a final added insult to injury, underperforming mutual funds penalize investors for not staying the course by charging them for redeeming too quickly.

Behind the scenes, the practices of active trading and deal-making are intertwined, further contributing to the underperformance of mutual funds. Seeing the potential for significant commission generation, brokerages offer incentives to trade more often in the form of rebates paid as goods and services. This can result in higher-than-normal trading rates.

The active trading these practices encourage further damages mutual fund investors by creating excessive short-term gains that translate into greater tax burdens.

The result has been that only a small number of actively managed mutual funds beat their benchmarks. For fund companies, the quest for ever more assets and a symbiotic relationship with Wall Street brokerages explains most of the reasons why they may be ill-suited as fiduciaries for individual investors–and why advisor-managed funds may make more sense.

Putting the negatives aside, there are some positives in investing in open-end mutual funds. Funds allow investors to put relatively modest amounts of money to work in a very cost-efficient manner. There is also a tremendous array of funds available, offering far more choices than their exchange-traded brethren. Mutual funds also allow investors to compound their earnings and systematically invest each month. (These can also be accomplished through ETFs, but that would be more expensive.) Then there is the scaling. Simply put, it costs a lot less per unit to manage a large account than a smaller one, which means that if such benefits of scale are shared with investors, the whole mutual fund idea starts making sense to everyone.

This is also why some advisors are starting their own mutual funds, often with a little help from service providers.

Turnkey Approaches

Advisors who wish to run their own mutual fund have two choices. They can either start from scratch, which is an expensive and time-consuming process, or team up with a service provider that can do most of the heavy lifting. One such firm is Unified Financial Services, an Indianapolis-based service provider that has helped launch about 200 funds for advisors, fund managers, and other professional investors.

Like other service providers, Unified has an already existing investment company or series trust. Advisors who wish to start a fund would merely be another series of the trust. This entails a 75-day SEC filing and startup costs of around $40,000, according to Greg Drose, a regional VP of the firm.

Although that may sound high, opening a new series in an already existing structure is much less daunting than starting from scratch. “Starting a captive mutual fund is complex and cumbersome,” says Terry Gallagher, senior VP and director of compliance for Unified. “Most of our clients want to concentrate on managing money and marketing, not running a fund company. A series trust has the added benefit of shared expenses across all funds. Most notably, legal costs, insurance, and errors and omission insurance can be shared. Compliance represents perhaps the biggest savings. We currently charge about $5,000 per fund for the role of chief compliance officer; a firm that creates its own fund would likely pay at least $100,000 for a CCO.”

Advisors who decide to manage their own mutual fund should think hard about how they intend to market and distribute their product. According to Drose, the first milestone that should be considered is the point at which the fund’s expense ratio is covered by existing assets. That figures to be somewhere between $10 million and $18 million, depending on the type of fund. The second milestone is the point at which the advisor is able to reap the full management fee, which is somewhere between $28 million and $50 million. To get to that point, Drose likes the manager to be able to pay all the fund expenses out of his pocket for the first three years, if necessary.

Those interested in series trusts should also consider Gemini Fund Services, LLC. The Hauppauge, New York-based firm, has helped launch sixteen advisor-managed mutual funds. Eric Clarke, president of Orion Advisor Services, a sister company of Gemini based in Omaha, thinks that advisor-managed funds solve a number of thorny issues and will likely become more popular over time. “Some strategies are simply not practical in a non-pooled environment,” he says. “For firms that have a number of small accounts–say, under $100,000 — there is a significant challenge to implement investment strategies. New restrictions on holding mutual funds, for example, have become so draconian that exchange traded funds and other vehicles are being used more frequently. But these instruments bring with them operational challenges. Advisors who are running their own mutual funds have found that they are much more efficient, from both an operational and cost standpoint.”

Gemini offers a turnkey approach that includes back office, fund administration, CCO, and legal and prospectus filings. Fees vary, but expect to pay about $35,000 in up-front costs.

Gemini has teamed with Rydex Financial Services (RFS), the custody arm of Rydex Investments of Rockville, Maryland, to offer turnkey execution services to advisors wishing to launch their own funds. RFS is already the executing broker for another NorthStar subsidiary, CLS Investment Firm’s Amerigo and Clermont mutual funds. “RFS offers a complete, integrated trading solution, including the use of futures and other derivatives, which will be priced on a consolidated statement,” says Catherine Ayers-Rigsby, managing director of RFS.

Clarke sees a number of common attributes for a successful launch. Advisors, he says, “should have a good, marketable track record of three years or so and some sort of distribution strategy. We don’t generally like to launch a mutual fund with less than $15 million, and the real benefits of pooling don’t kick in until the fund reaches $20 to $25 million,” he says.

Both Ayers-Rigsby and Clarke agree that advisor-managed funds can be good for clients as well. “Active separate accounts can entail numerous statements to clients, which can be cumbersome and confusing,” says Ayers-Rigsby. “A pooled account also makes functions like portfolio rebalancing easier, and depending on the specific situation, the potential cost savings from trading one large account versus a number of smaller ones could be significant.”

For larger advisors, Potomac Funds, a New York-based fund family, is an option. While the firm generally will not open a fund for less than $25 million, when it does, Potomac pays all the upfront costs. “We look for A-list advisors with prospectus-quality track records of three to five years that are experiencing significant asset growth in their core business,” says Louis Flamino, regional director of sales and marketing for the firm. Potomac has done 15 funds so far, all in the $25 to $100 million range. “As assets grow in the funds, the costs go down, which is beneficial for everyone,” notes Flamino.

Another benefit to Potomac, according to Flamino, is potential distribution. “Our firm has selling agreements with about 200 broker/dealers, and any advisor-managed fund on our platform would be included in these arrangements,” he says. Flamino is quick to point out, however, that this merely “opens a door” for marketing. Indeed, all the series trust providers agree that the bulk of the marketing is up to the advisor.

After investigating its options, Portfolio Strategies Inc. (PSI), a $700 million advisory firm in Tacoma, Washington, chose Potomac to bring to market the Potomac PSI Calendar Effects Fund, which PSI sub-advises. “We had the ability to bring a sizable chunk of assets for the launch,” says John Williamson, PSI’s managing partner, “which enabled us to negotiate no upfront costs.” But the real benefit, according to Williamson, was enabling his firm to lower the advisory fees charged to PSI clients who invest in the fund. “If we used an outside fund, our clients would pay our standard advisory fee to us and the fund management fee to the underlying fund investment.” With the PSI Calendar Effects Fund, PSI gets 75 basis points of the management fee of the fund as sub-advisor, which the firm passes along to the client by lowering its advisory fees. “By sub-advising the Potomac fund,” says Williamson, “we have eliminated the middleman.”

Going It Alone

Even with all the difficulties involved with starting a fund, there are some legitimate reasons to start from the ground floor. For Marc Nicolay, president of Boulder, Colorado-based Agile Funds, Inc., creating a fund company fit in well with the firm’s other proprietary fund-of-funds products. “When we started the process in late 2002, there were not as many opportunities to partner as there are presently, so we decided to launch our own fund company,” says Nicolay. Agile looked to start a fund for many of the same reasons as others do, operational simplicity being the most important. This was especially relevant given Agile’s emphasis on risk management. “What we were really looking for was a way to give our smaller accounts access to absolute return strategies, which is impossible to do on a separate account basis.” The solution was the Agile Multi-Strategy Fund (AMSRX), which gives non-accredited investors the opportunity to gain exposure to absolute return strategies in a mutual fund wrapper. The firm’s asset base enabled Nicolay to launch with about $30 million. “It has given us significant flexibility and complete operational control,” notes Nicolay, though he warns that “one should not underestimate the regulatory issues.”

Another advisor that decided to go it alone is Personal Mutual Fund Management (PMFM), Inc., a Bogart, Georgia-based firm with about $700 million under advisement. The size of the organization allowed President Don Beasley to launch PMFM’s fund family a few years ago. “When we started using ETFs to express our views in the market, the next logical step was to pool our accounts. This has served to maximize our investment flexibility.”

For most advisors, starting a mutual fund represents a sizable investment in the future. The reason for this is clear: Taking $10-$20 million of fee-paying assets and rolling it into a fund is a bet that may not pay off, especially in the short run, since the bulk of those fees will now be covering fund expenses. It will result in an immediate drop in income to an advisor, so there should be some sort of overall plan that allows for higher assets in the future.

Indeed, according to Potomac’s Flamino, the quality of advisors who want to start a fund is rising. “Most advisors who start funds do not see it as a way to get into the high-margin business of mutual funds. They see it as a way to gain distribution of a defined market strategy that lends itself to a pooled account structure.”

Contributing Editor Ben Warwick is CIO of Memphis-based Sovereign Wealth Management, and writes the monthly Searching for Alpha newsletter, available at www.investmentadvisor.com. He can be reached at ben@searchingforalpha.com.