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Wednesday, April 27, 2011

Eight Simple Steps to Starting Your Own Mutual Fund Family

Reported by Sean Hanna, Editor in Chief

Mutual funds have been around since 1940. Actually, investment pools from which today's mutual funds are descended date back even further than that. Yet, there remain opportunities to build a successful business in the mutual fund space even today. Not only are there new products such as ETFs opening doors, a mature infrastructure has also grown up over the past decade to support entrepreneurs entering the mutual fund business. Yes, one would think that a business with more than 700 players and $10 trillion of assets under management would be mature, but new firms continue to make their way into the market and create viable and valuable franchises.

After covering the mutual fund market for more than a decade as editor in chief of The MFWire.com, it occurred to me that there are few, if any, resources to help budding mutual fund entrepreneurs on their way. Rather, the industry has operated as an "old boys network" with many new entrants being created by executives at existing fund firms. When I have interviewed those who are altogether new to the industry, they typically describe a process that lasts a year or more and can cost more than $1 million. The process need not be that long and expensive. In that spirit, I have had our editorial staff leverage our industry contacts and years of information gathering to create this simple eight-step primer on the basics of getting into the mutual fund industry. Our intent is to introduce you to the players in the industry and provide a quick guide to who's who and what are the key decisions a new entrant will face.

Step 1: Develop a Strategy
Step 2: Hire Expert Counsel
Step 3: Recruit Directors for the Fund Board
Step 4: Hire a Transfer Agent
Step 5: Hire a Custodian
Step 6: Distribution
Step 7: Hire a Fund Accountant
Step 8: Getting Noticed

Step One: Develop a Strategy

While new fund firms are opening seemingly on a weekly basis, few that we interview have a strong sense of strategy out of the gate. Rather, many shops are driven by an "artisanal' mindset rather than that of a business person. The drivers of the new fund shop are typically investment professionals who are at the top of their game and have decided to create a mutual fund to satiate what they see as growing demand. In some cases, this may be an institutional asset manager whose pension clients want an investment strategy added to their 401(k) program, or it may be a registered investment advisor that wants to offer clients a mutual fund package for tax or simplicity reasons, or it may be any one of another hosts of reasons.

What few of these creators of new firms often realize is the extent to which their initial decisions will affect the course that their fund will take. Some of those initial decisions include: pricing, whether to include sales loads and 12b-1 fees, the fund's branding and positioning, the corporate structure of the family, and what partners to rely on. Founders also need a dash of luck.

Jack Bogle, undeniably one of the titans of the fund industry and the founder of the Vanguard Group, recently told a gathering of senior industry executives that he owed his firm's success to a series of breaks, including being fired from Wellington Management after that firm's sales fell off in the 1970s bear market.

Bogle seized the opportunity of his firing to try an idea he had been studying since his college days in the 1950s and thought on his feet to alter course as he ran into the inevitable hurdles of starting a new business. It was three initial ideas that he had that created Vanguard's DNA and created what is today the industry's largest firm. Those ideas were: subadvisors, mutual ownership and indexing.

While in college at Princeton, Bogle wrote a thesis on the possibilities for indexing as a way to manage money. Fifteen years later, that concept stuck with him, despite his having cut his teeth on active management at Wellington. Bogle saw his new shop at Vanguard as an opportunity to put this idea into practice and offer a unique product to investors.

He also envisioned a second, and still-unique concept: the mutual fund shareholders would own the fund advisor. This concept would be similar to that of a mutual life insurance company where the policy holders owned the insurance company in proportion to the value of their policies. At Vanguard, each of the funds would own a stake in the Vanguard Group, aligning the interests of the investment advisor and the advisor more directly than ever before.

Bogle did have an immediate problem, however. Having been fired by Wellington, his firm had no assets to manage and nothing to offer investors. To solve this issue, Bogle pitched Wellington on being the subadvisor to his initial fund. They agreed and the Vanguard Wellington Fund was born, as was the opportunity for Bogle to launch his first index fund.

Those three decisions laid the groundwork for Vanguard's market leadership today. By choosing a mutual structure for Vanguard Group, he ensured that Vanguard would have a stake in being a low-cost provider since there was no "profit" for the advisor to rake from the fund; the use of subadvisors allowed Vanguard executives to make arm's length decisions on hiring and firing the investment professionals and on deciding what to pay them. Meanwhile, indexing allowed Vanguard to simplify the investment management process and create a compelling story to share with investors.

After covering the industry, the importance of those three factors -- corporate structure, replication and consistency of the investment process and the ability to communicate a compelling story for the fund firm's existence -- have surfaced again and again as key reasons that the most successful firms have succeeded.

Bogle also made one other key decision, and as he relates the story in 2011, it was the marketplace that drove him to it. After Bogle created the first index mutual fund in 1974, he did what every new fund firm CEO must do: he walked the streets of lower Manhattan seeking distribution through the broker-dealer community. Bogle says that many potential investors saw the compelling story of indexing -- match the market, don't try to beat it and lose, and save, save, save in fees -- only to ask an inconvenient question: Why, if fees are so important, should I pay my broker 8.5 percent in commissions? Needless to say, few of those questioners wanted to buy the fund.

For Bogle, the market provided a compelling reason for him to put the final piece into place. Vanguard would offer its funds without a commission on a no-load basis directly to shareholders.

Bogle was not the last fund founder to discover after his fund was launched that fee structure matters. And it matters a lot.

That decision is now much more complicated than whether to sell through brokers and offer funds with loads or to sell directly to investors with no commissions. A host of intermediaries and sales channels have arisen that complicate the decision. In each channel, fees have a "natural" level. Some channels use loads, some shun loads. Each also has different costs and challenges.

Since some vendors have different strengths and weaknesses as do potential employees, the earlier in the process these strategic decisions are made, the less costly the efforts should be, both in money and mistakes.

So, who is your customer? A broker, the end investor through a financial advisor or directly, an institution or corporation? Each of these has different cost and compensation expectations that need to be considered when creating a fund.

The broker-dealer channel: Mutual funds sold through this channel must carry commissions to pay the broker, though the growth of fee-based accounts at the four wirehouses and regional brokerage firms now mean that many fund sales are made on a fee-basis or through those firms' mutual fund wrap programs. For a mutual fund to be sold on these firms' platforms, the fund must have a selling agreement in place and pay platform fees and revenue sharing.

The wirehouses no longer focus primarily on distribution of their own funds and two of them have dropped proprietary asset management altogether. This development has opened the door to other fund firms.

Key players:
  • Bank of America Merrill Lynch
  • Morgan Stanley Smith Barney
  • UBS
  • Wells Fargo

  • Raymond James Financial
  • Edward Jones

    Clearing firms for smaller B-Ds:
  • National Financial
  • Pershing

  • LPL
  • Commonwealth

    Turn-key asset manager platforms offer mutual fund wrap accounts and separately-managed accounts (SMAs) to many financial institutions and smaller brokerage firms.
  • Envestnet
  • PNC Capital Management
  • Brinker Capital

    The RIA and fee-based channel. Since Charles Schwab created the first mutual fund supermarket in 1992, an increasing proportion of individual investors have chosen to buy and sell mutual funds through supermarkets. In the past decade, most of the mutual fund supermarkets have also built custody capabilities to handle back-office work for fee-based financial advisors and planners. There are now some 25,000 advisors that use these custody platforms for their client assets.

    Key Players:
  • Charles Schwab (OneSource)
  • Fidelity Investments (FundsNetwork)
  • TD Ameritrade

  • E*Trade
  • Scottrade (fund custody outsourced to Schwab)

    There are a number of consulting firms that help fund advisors develop strategy and make key decisions. Some of these firms and their key contacts include:

    Strategic Consultants:
  • Casey, Quirk Acito (Ben Phillips)
  • Bain Consulting
  • McKinsey Consulting

    Distribution Consultants:
  • Strategic Insight (Avi Nachmany)
  • kasina (Steven Miyao)
  • Fuse Research Network (Neil Bathon)

    Sales Consultants
  • Sincere & Co. (Richard Sincere)

    Editor's note: This article is part of The MFWire.com's eight-step primer for starting a mutual fund family. Be sure to see the other steps mentioned above.  

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