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.
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.