There is a saying in aviation that all airplanes are compromises. If you want the fastest plane, it likely burns a lot of fuel so the cost per hour and cost per mile goes way up. That can be a very expensive hour, or even less, saved. A more fuel efficient plane might not get you where you need to go without taking most of the day. A large plane can carry a lot of people and luggage, but might not be able to land on a short runway. And if your typical trip is less than 200 miles, a large plane might never get to the altitude where it is efficient.
So there is really no such thing as perfect scenario for a particular type of fund, no ideal, no situation where there is no compromise. There can be, however, situations that clearly lead to one solution or another, and finding the solution that fits the most criteria should be the goal.
So here are some scenarios where the solution seems evident:
Over our thirty year history, the most successful scenario for a firm starting a traditional mutual fund has been when an investment advisory firm:
- Has grown quickly and successfully, and as a result has ended up with more accounts than can be administered effectively without adding staff and systems,
- Has accepted a number of smaller accounts from friends and family, and friends and family of larger clients, and those smaller accounts can benefit from better diversification and trading costs by being combined,
- Wants to accept qualified retirement plan assets or rollover IRAs from existing or potential clients, and needs a vehicle that can accept such accounts seamlessly,
- Has the ability to put $20mm or more into a pooled vehicle rather quickly, and has distribution relationships with wealth managers or the brokerage community interested in referring additional assets into the firm’s program.
Traditionally firms that meet these criteria have built a successful mutual fund business as part of their overall business plan.
The criteria for when it is a good scenario for establishing an ETF is very similar to a traditional mutual fund. The difference and when an ETF may be a better solution than a mutual fund include when the investment advisory firm:
- Expects to have consistent incoming demand for the fund, since an ETF needs to show consistent activity in order to encourage and motivate market makers and APs willing to make a market in the shares and create new units for the ETF,
- Has marketing relationships with wealth managers that prefer to use ETFs in their client asset allocations, and
- Does not need the client reporting and other services that have traditionally led many advisors to hold their accounts on the larger platforms like Schwab, Fidelity, LPL and others.
Closed end interval funds have a rather specific purpose, and ideal scenario that makes an interval fund the best solution. That scenario typically exists when the investment advisor:
- Has an investment style that includes illiquid securities,
- Has underlying investment options that can only be priced and redeemed periodically, such as a hedge fund that limits purchase and redemptions to monthly,
- Has a client base that wants or needs a publicly registered fund, such as qualified plans or institutional investors with investment policies requiring the use of 1940 Act registered funds.
The least expensive and most flexible option to create a pooled vehicle is a hedge fund, which we prefer to refer to as private fund since only a portion of private funds actually employ hedge strategies. Regardless of the semantics, a private fund has significantly less regulatory requirements and as a result the expenses are lower, which makes the economics to the investment advisor more attractive.
There are very clear and somewhat narrow circumstances under which a private hedge fund is the best solution, however. This typically occurs when the investment advisor:
- Has clients that are either accredited or qualified investors, as defined under either the Investment Company Act of 1940 or the Securities Act of 1933, or both,
- Wants to receive an incentive based investment advisory fee which is outside the limitations defined in the Investment Company Act, or
- Does not intend to raise assets that would exceed 25% of the total fund from qualified retirement plan investors.
In each of the scenarios above, the best solution does not necessarily have to meet ALL of the criteria for the solution to be the best option, but in each case those issues represent the key questions that need to be raised.
We enjoy having conversations to sort through these options, so please reach out and we will be happy to discuss.