The following is a guest post from an industry expert who prefers to remain anonymous in sharing these insider tips with us. While I’m still not exactly crying tears for big name fund managers, it does shed extra light on the hurdles faced by small, innovative entrants who want to bring us new funds.
After exhaustive research you have finally decided that none of the funds available to you as a private investor do exactly what you want. Moreover, you are sure that your concept is a blinder, and that other people will throw money at you to invest in your new concept.
Clearly, you need to start your own fund.
The financial press is full of stories about how much money fund management companies make. If it has such high margins surely it must be a great business to get into, right?
Sure, there will be fees – whether it is active, strategic, dynamic, low risk, income or even, horror of horrors, passive. The basic legal and regulatory framework applies to all investment vehicles. On top of that the normal business issues of promotion and marketing are still relevant, and have associated costs, whatever the product.
So how do you establish a retail investment fund from scratch?
Assembling your team
Your first step is to find someone qualified to run it. Ideally that will be you but if you have not got the requisite experience and qualifications you will need to employ someone to fill what is known by the Financial Conduct Authority (FCA) as the CF 30 role. This is someone who it judges has sufficient experience and knowledge, either from having passed exams or spent enough time in the market, to have the necessary skills.
Remember that this is not like a driving licence, where you have to pass a specific test. After all, Fred Goodwin was allowed to run a bank even though he had no banking qualifications.
Fine, you have your CF 30 function. But you or employee will want holidays or may fall ill so you need another one to act as back-up. Alternatively, you can ask a suitably qualified mate to act as a locum to fill when you are on your yacht. So that is two staff already.
You will also need a Compliance and/or Money Laundering Officer, a CF10 function.
This usually falls to the person who was most inebriated in the pub when it was discussed, as he or she won’t really know what they are committing to. But he or she will of course be the person to blame if it all goes pear shaped and the FCA comes knocking on the door.
You will also need a Compliance Officer. This usually falls to the person who was most inebriated when it was discussed.
Fortunately there are lots of people who don’t quite understand all the ramifications of filling in a seemingly endless stream of forms, so these positions are quite easy to place.
Set up your fund management company
Next step is to form a company via Companies House in the normal way. This is probably the easiest part of the process.
In addition you need an office, a computer, oh and a BCP (business contingency plan) in case the office blows up. You will probably also require some data feeds for news and price information on whatever securities you will be investing in. And you need a broker who will need to do some DD (due diligence) on you to make sure you are legit and not some Trashcanistan money laundering scheme.
You might think banks would be keen to open a new account for you, but don’t bet on it. Lawyers, accountants, and book keepers are also on the shopping list of service providers.
What is a problem is writing a business plan to explain to the FCA how the business will work. Lots of spreadsheets, writing and business speak. This then has to be endorsed by a qualified accountant (more fees) before being submitted to the FCA by a lawyer (yet more fees).
All being well the FCA will grant permission and give you a designation such as BIPRU50K. This is not your password but your classification for regulatory purposes. It also means your company has to have 50,000 euros of Tier 1 Capital. That means about forty grand of shareholders equity that you can never ever use. It might be more if the FCA judge that the company’s running costs for 13 weeks will exceed that.
You see it wants to ensure that if it all goes badly wrong the company can survive for a quarter of a year while you return funds to investors.
Prepare the company coffers
Your little company now needs working capital to get going on top of the regulatory capital that you can’t use. And of course it can’t be debt because that would affect the Tier 1 capital.
So dig into you pockets, again.
Now, here is where it starts to get more complex. To run a fund you need to take money in from the public, keep it in a separate account, keep track of the investments you make, any dividends received, deduct your costs and any others, and write to the investors on a regular basis to keep them updated.
To ensure that is done properly the FCA insist that you appoint a depositary. A depositary actually consists of two roles: a trustee and a custodian.
A trustee doesn’t actually do any of this stuff, they just make sure it is done, and properly. So, yes you guessed it, more fees.
A custodian actually holds the cash and securities on your behalf. And guess what? The banks that do this are not charities and will want to paid for their services.
The banks are not charities and will want to be paid for their services.
All this assumes that your little company will keep track of the beans. If you do, the FCA will say that increases the risk and will increase your Tier 1 capital requirements.
An alternative is to find another company to provide the services of an Authorised Corporate Director (ACD). It will essentially do all the back office stuff, for a fee.
How to reach Other People’s Money
Everything is now in place and all you need to do is get the public to give you money. How hard can that be, when we read how many boiler room scams there are easily fleecing the public of hard earned cash?
Actually it is not easy at all because, rightly, the public is very suspicious of people asking for your money.
Recent events with Northern Rock, RBS, HBOS, Bradford & Bingley, and even the Co-Op have only served to increase public apprehension about trusting even the most long established organisations. So asking someone to invest money in something established last week is a whole lot harder than it used to be.
There is one other hurdle to overcome. As a manager of a financial product you are not allowed to approach the public to solicit business. Normally, fund managers do not have FCA approval to give financial advice, simply because they are not familiar with all the other products on the market or, more importantly, the financial circumstances of the individual.
To sell your financial product you therefore have to enlist the services of an intermediary, either an IFA or a platform. Not surprisingly, neither of these two types of businesses do anything for free.
Time was when the fee structure of funds allowed IFAs to take trail commission to encourage them to recommend funds. The more recent trend to fee based advisers, encouraged by RDR, has made it more difficult to provide financial incentives to IFAs to promote certain funds.
But it hasn’t ended.
Fancy a ticket to that international match? How about a track day at Silverstone? The range of promotional events provided by the big fund managers is mind-boggling. For the new kid on the block, offering a glass of wine and some sandwiches at the nearest Harvester is simply not going to cut it, not when the intermediaries are used to being taken on a three day cruise to the Channel Islands.
The range of promotional events provided by the big fund managers is mind-boggling. Offering a glass of wine and some sandwiches at the nearest Harvester is not going to cut it.
It is true that some managers have offered off-site ‘educational’ seminars to introduce so called new-fangled concepts like behavioural finance, the efficient market hypothesis (EMH) and modern portfolio theory (MPT). (Though to be fair some of these ideas are now 50 years old and you can also get a Nobel prize for saying they don’t work.)
However, the golden rule still applies. The intermediaries don’t pay for anything. That is the privileged role of the product provider.
Then there are the platforms. If you consumers think they are complex for you, they are even worse for fund managers. This is another mouth that needs to be fed from the annual management charge (AMC).
There are a few exceptions but in general the platforms want several features before they will host your fund. These include a minimum size, a track record of at least three years, expressions of interest from a number of IFAs, a guaranteed level of flow in the first year, oh, and sometimes an upfront fee. How expensive can it be to enter SEDOL codes into a spreadsheet?
All this can be regarded as the “plumbing” of the distribution network. This is just getting the infrastructure in place to enable investors and intermediaries to actually invest in the fund.
Of course there is no guarantee that a platform will actually host the fund. Just like any shop they do not have to offer every single fund that is available. They will only offer what they think they can sell. If they do not want to put your fund on their shelf there is nothing you can do.
The problem of self-promotion
Buyers of your fund will either be intermediaries investing on behalf of their clients or investors acting on their own behalf.
Remember that because of FCA rules, fund managers are not allowed to promote their funds directly to the public. Providing advice can only be done by someone qualified to do so who has assessed the risk profile of the client and who has a full appreciation of his or hers financial situation.
Because of this, all that product providers can do is create ads showing mountains, happy people, and other such generic images.
They cannot run ads that say this fund has a TER of X%, a beta of Y, an alpha of X, or any other specific data such as you might find in an ad for a car or a mobile phone that might be as advice. In other words you can’t do a lot of specific advertising to create demand for your new fund, even if you want to spend the cash.
IFAs might be a more fertile ground. First though they want a three-year track record. Not much use to a business start-up. Even if that is not a pre-condition they usually insist on a minimum size – say £10m or even £100m if they want to be awkward.
The reason they usually quote for this is that they have so many clients, they are worried they would put so much money in that they would end up owning too much of it. Their rules prevent them from holding more than 10 or 20% of any investment.
They may also insist that the fund is rated by one of the agencies. How do you qualify to get rated? See the beginning of this paragraph and repeat.
Even if those hurdles can be overcome they then hit you with the killer challenge. No one in their IFA firm will be allowed to invest unless it is on the recommended list. How do you get on their recommended list? Go back to the top of the previous paragraph and repeat.
Running your own fund
Amongst all this administration and marketing activity you still actually have to run the fund. And it has to perform otherwise no one will buy it.
Here the logic can get tricky. No one wants to buy a fund that is bottom of the heap relative to others. Equally, few investors are keen to invest in something that has recently gone up more than its competitors.
Amongst all this administration and marketing activity you still actually have to run the fund…
Either way, performance is usually measured against one of the main established indices we see and hear quoted everywhere. But that data is proprietary to the company that owns and calculates it, so if you start reproducing its data and quoting it in your marketing material it will expect some financial recognition for its intellectual property.
That means – yes, you guessed it – more fees.
These days fund managers are also expected to exercise corporate governance. That doesn’t just mean voting for directors. It also means understanding pay packages and deciding if they are appropriate or not. And, to be honest, most public disclosure on these is so obtuse as to make the exercise virtually meaningless.
Nevertheless, politicians and the press want you to vote. That is fine, except that in these days of nominee holdings you need to do that through a third party. And guess what, they charge each time you do.
In reality running a fund is not really much about picking securities. Just as with Tesco Lasagne or any other consumer product, as long as it is true to its label, then it is far more about distribution and keeping on the right side of the legislation.