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Starting A Fund - Biggest Surprise


AccentricInv
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For all you fund managers out there, what was the biggest surprise / hurdle that you had to face to get your fund off the ground.  Everyone knows raising money from friends & family, building a track record, etc is tough.  But is there anything outside of this caught you by surprise?  For those who started with a small amount of AUM, curious how you managed to pay your living expenses?

 

(Any and all advice for someone thinking of starting their own venture would be greatly appreciated!)

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For all you fund managers out there, what was the biggest surprise / hurdle that you had to face to get your fund off the ground.  Everyone knows raising money from friends & family, building a track record, etc is tough.  But is there anything outside of this caught you by surprise?  For those who started with a small amount of AUM, curious how you managed to pay your living expenses?

 

(Any and all advice for someone thinking of starting their own venture would be greatly appreciated!)

 

I'm actually wondering if it's possible to start a fund and being the only investor (yourself)? You can get the benefit of being taxed at 20% for all your income and potentially write off expenses as business expense..

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If you are married/have a gf/looking to get married, have a deep and long conversation with your significant other.  Having them onboard can be the difference between having to fold up shop versus having the staying power.  I'm very lucky in that aspect. 

 

Figure out whether you're going to set up a fund or use a RIA structure.  Starting a fund means minimum fund admin, auditing, legal etc cost.  RIA is much cheap, but you run the risk of aggregating 30-40 accounts that you have to trade in separately.  It's hard to scale RIA.  Frankly, if you have savings, I would look into fund structure.  If you dont' have much in the way of savings, go the RIA route.   

 

No one will probably talk to you in the first 1-2 years anyway, I was very surprised by this.  Things starts getting easier during the third year (mostly due to performance, proof of staying power etc)

 

You will be very surprised by who gives you money and who doesn't. 

 

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Not sure how big your project will be, but here are some quick points from my experiences:

A - how hard this game is - if it was easy everyone would be doing it successfully

B - the importance of governance

C - the importance of infrastructure (varies based on operational process, e.g. for systematic ctas/quantitative-based funds - algos and automation for entire execution and operational process, this needs to be in place from Day 1)

D - the need for experienced people (Everyone knows a thing or two about food, but there's a big difference between eating in a restaurant and cooking in the kitchen)

E -  Flexibility in your personal finances - a cash buffer (maybe 1 yr living expenses), a spouse that can bring home extra income - anything that helps you not tax the business too much in its first year of operation -

F - if you have a complex tax structure - then the importance of quality legal and tax advice - sometimes having a member/non-exec working for a top law firm or big 4 acctng can go a long way in negotiating fees

G - Importance of negotiating contracts with your service providers - all first drafts of service provider contracts will, at some level, make them non-liable for the very service you are hiring them for (Custodian, Prime brokers, Administrators, PMS providers, etc) - paying up for a good lawyer that understands this and negotiate on your behlalf can save you heaps in future.

H - the importance of planning

I - the importance of communication & culture

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Thanks everyone for the advice.  There's some good thoughts in here.  Would love to hear any other experiences others may have to share as well.

 

Regarding Bares Capital, I can't believe I've never heard of this guy.  I just listened to a couple interviews with him and am pleasantly surprised by how many similarities there are between our investment styles.  The manual of ideas interview is especially great. I just bought his book, and am looking forward to giving it a thorough read.

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Hating separate accounts more than I expected to is my biggest surprise so far. I started my RIA in February and it's certainly cheap and easy to get up and running, but separate accounts is not an ideal way to run an investment firm. If you have a couple million+ in starting capital I'd recommend a hedge fund.

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Hating separate accounts more than I expected to is my biggest surprise so far. I started my RIA in February and it's certainly cheap and easy to get up and running, but separate accounts is not an ideal way to run an investment firm. If you have a couple million+ in starting capital I'd recommend a hedge fund.

 

Just curious, why do you think it's been a bigger pain than expected?  (I'm planning to run SMA's also).  The biggest drawback I see is having to rebalance the portfolio for each new inflow to keep the accounts in-line, instead of being able to keep the inflow in cash and allocating that position to all investors as you'd be able to in a fund (ie you're able to raise the cash position from inflows, instead of having to sell positions to raise the cash allocation in a SMA structure).  But I figure the administrative burden of a fund structure and the benefits of transparency it offers outweighs this downside.

 

Are there any other critical drawbacks that I'm overlooking?

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Hating separate accounts more than I expected to is my biggest surprise so far. I started my RIA in February and it's certainly cheap and easy to get up and running, but separate accounts is not an ideal way to run an investment firm. If you have a couple million+ in starting capital I'd recommend a hedge fund.

 

Curious, why do you hate it? And what broker do you use? I know you can use 1 click trading through Interactive Brokers, so that eliminates the complication of having to make trades in multiple accounts. I suppose the other big negative of separate accounts is that your clients have access to real time trades - which means they can coat tail with a minimal investment and/or breathe down your neck.

 

I'm asking because I was thinking of starting off with the separate accounts route with $1-2 million in AUM, only because it's cheaper and therefore less riskier for me.

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I use IB (which I love btw) and one-click ordering is great but there's more to it than that. One problem is new clients coming in when positions have increased significantly. So I'm on boarding a new client here soon and my biggest position is up a lot this year. I'm perfectly comfortable holding the stock for now, but not wanting to buy more. So my new client will start with a pretty sizeable cash position since I won't be buying that stock for him. That client will also have a purchase date several months later than other clients in the rest of my positions. Alas, situations can arise when some clients are paying short-term gains and some long-term.

 

I only have a handful of clients but it's already annoying to make changes because one-click ordering just doesn't suffice much of the time. Don't get me wrong, SMAs are great for starting out but as soon as I get to the $4-5 million AUM range I will be transitioning to a hedge fund. I can't even imagine managing 20-30+ separate accounts. As BG said, this structure just doesn't scale that well.

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I use IB (which I love btw) and one-click ordering is great but there's more to it than that. One problem is new clients coming in when positions have increased significantly. So I'm on boarding a new client here soon and my biggest position is up a lot this year. I'm perfectly comfortable holding the stock for now, but not wanting to buy more. So my new client will start with a pretty sizeable cash position since I won't be buying that stock for him. That client will also have a purchase date several months later than other clients in the rest of my positions. Alas, situations can arise when some clients are paying short-term gains and some long-term.

 

I only have a handful of clients but it's already annoying to make changes because one-click ordering just doesn't suffice much of the time. Don't get me wrong, SMAs are great for starting out but as soon as I get to the $4-5 million AUM range I will be transitioning to a hedge fund. I can't even imagine managing 20-30+ separate accounts. As BG said, this structure just doesn't scale that well.

 

Thanks for the reply.

 

A couple of things; aside from tax reasons, isn't the true test of whether or not to hold - that whether or not you're willing to buy at the current price? I know this question is unrelated to the mechanics of SMA vs. hedge fund, but imo this would be a good test of whether I'm willing to hold something (whether or not I am willing to put a new client's money into it). :) On the other hand, if it's for tax reasons that you may not be selling something, I agree with you that one click can be a hassle.

 

I don't know that much about the tax structure of funds, but I'm guessing that taxes are pooled rather than individualized? Meaning if a new client comes in after hefty gains, they will owe a lot in taxes even though the gains didn't accrue to them?

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Also regarding the point about new clients... wouldn't you face the same issues with a hedge fund also though?  Say you have a new client that comes in at the market peak.  In a HF structure, they'd still be buying the fund at an all time NAV high (which is essentially the same thing as slicing the new client account at current prices to match the model portfolio wgts in a SMA structure).

 

I agree onboarding new clients at market peaks is definitely not optimal.  But I always figured it's the clients decision when they'd like to fund, and only the PM's responsibility what to do with assets afterwards.  To Mephitopheles' point, if you think prices are too high to purchase for new clients, why not sell the stake for existing clients as well?  If you're using new client's inflows in a HF structure to bring down your equity weighting, you could achieve the same goal by selling securities for all investors in a SMA structure.  The only difference is that in the HF structure you use new inflows to "dilute" the equity wgt, while in the SMA you have to actively sell (and suffer tax implications).  Let me know if this makes sense... I'm don't know if there are other tax implications also.

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- Raising money.

- going back and forth between investing and sales (money raising).

- meeting the client expectations

- being a good investor?  haha

 

I manage SMA's at this point with just under $40mm in AUM.  I'd consider starting a partnership at some point to focus more on growth through investments as opposed to managing clients money to their goals. 

 

You can be the best investor in the world but if you manage $100 then not much is going to happen.  If you have done sales in the past then at least you have that going for you.

 

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A couple of things; aside from tax reasons, isn't the true test of whether or not to hold - that whether or not you're willing to buy at the current price? I know this question is unrelated to the mechanics of SMA vs. hedge fund, but imo this would be a good test of whether I'm willing to hold something (whether or not I am willing to put a new client's money into it). :) On the other hand, if it's for tax reasons that you may not be selling something, I agree with you that one click can be a hassle.

 

I don't know that much about the tax structure of funds, but I'm guessing that taxes are pooled rather than individualized? Meaning if a new client comes in after hefty gains, they will owe a lot in taxes even though the gains didn't accrue to them?

 

I don't want to get too far off topic in reference to your first question, but in general I don't have that viewpoint. To take that viewpoint to the extreme, I heard another investor claim one time that you should only sell a stock if you're going to short it  :o I'm more of the opinion to let my winners run until I find something to replace them with (unless they get too overvalued of course). If a stock increases to fair value, I'm happy to keep it until I have something else to buy. And of course there are tax effects which do matter.

 

LP taxes are passed pro-rata through to the individuals.

 

If you're using new client's inflows in a HF structure to bring down your equity weighting, you could achieve the same goal by selling securities for all investors in a SMA structure.  The only difference is that in the HF structure you use new inflows to "dilute" the equity wgt, while in the SMA you have to actively sell (and suffer tax implications).

 

Correct. For all intents and purposes, HFs and SMAs are basically doing the same thing, HFs just make it easier. In SMAs, clients who open accounts (or added money) at different times are always going to have slightly different position weightings. It's always possible to rebalance, but those small differences often make simple one-click changes not really possible. When all money is pooled together in one fund the buying, selling, rebalancing, etc is much simpler.

 

My point was only that the SMA structure is more annoying than I expected, not that it's inadequate or anything like that  :)

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Thanks for the insights, Travis.

 

So for new clients/added cash, have you generally held cash and waited? 

 

Do you do any performance reporting on a firm-wide basis, and how have you managed that? (average across all accounts, used a model account, etc)

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So for new clients/added cash, have you generally held cash and waited?

 

Only in situations where a stock has increased quite a bit to fair-ish value but I'm not selling yet. As said before, taxes can be a major point here. If a stock is up a bunch and has reached fair value, but there's not long until long-term gains are reached, why sell?

 

Do you do any performance reporting on a firm-wide basis, and how have you managed that? (average across all accounts, used a model account, etc)

 

IB does all this automatically and yes, performance reporting is basically weighted averages from all client accounts. If a money manager reports 15% earnings in a year, there's a chance one of their clients is up 5% and another is up 25%--all depends on when they put money in.

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