I’m enjoying the preparations more as I make steps toward opening my business.? Today’s actions were ordering business cards, and sending out an RFP to firms that could be custodians/clearing brokers.? The latter of those two actions will prove to be important.
It is difficult to be a start up RIA.? Most custodians don’t want to deal with you unless you have something above $8 million, or even $35 million.? Yet, they are crucial to managing assets, because they provide security to investors, so that the investment advisors cannot misappropriate funds.? If Bernard Madoff had had a third party custodian, he would never have been able to defraud investors.
Now, my objective is to manage a large number of accounts such that they are broadly similar to the model account, which is my account.? I eat my own cooking.? Anyone investing alongside me should know four things:
- I have made a commitment to investors to keep at least 50% of my liquid net worth in my strategies.? For me that should be easy, at present, that amount is over 80%.
- I want all accounts, leaving aside differences for reasons of tax and ethical constraints, to get the same performance.? On any given day, when I trade for multiple accounts, all of my clients, including me, will get the exact same price.? It’s only fair.
- I am trying to minimize net cost for my clients; services that have no value for them I eliminate.? I aim for clarity in pricing, and so I plan to avoid soft dollars.? If I need resources, I will buy them myself.
- This also offers the possibility for small accounts (my minimum is $100,000) to get good execution and the equity markets.? But that brings up another issue: when talking about this to a friend of mine who wants to invest with me, he said, “But what if someone gives you a small amount of money?? Will you go out and buy a share here and share their in order to match your portfolio in percentage terms?”
That last one made me think.? In the short run, my solution would be to buy Spyders, and wait until I have enough critical mass from another capital contributor to do another group trade.? That might worsen the dispersion performance somewhat, but I don’t want my clients to be hurt by high commissions in order to enforce low dispersion.? The same issue would appear if someone wanted to withdraw a small amount of money.
I looked down on a lot of ideas that would allow me to run portfolios in such a way that I would have discretion in allocating trades.? Fairness is paramount.? Unless you can assure people that no one is getting an unfair advantage or disadvantage for your management, you’ll not be able to last as a manager in the long run.
Audits and Pseudo-Audits
I’m currently reading a book called, The Last of the Imperious Rich. Sometime in the next few months, you should see a review of it here.? But as I was on the train to New York, as I read about the part where one of the Lehmans met Goldman and Sachs, I commented, ?So that?s who Goldman and Sachs were.?
That started a conversation with the fellow sitting next to me.? It turned out that he was an accountant who dealt with registered investment advisors.? He told me that he was doing attestations for a number of his registered investment advisor clients.? I asked him what an attestation was, and he told me that it was verifying the accuracy of the performance figures of an RIA, but not to the level of GIPS level two, and certainly not level of a full forensic audit.
So I asked him how much the attestation cost, and it was remarkably reasonable.? So, my question to readers is this: how much credibility would you put into an accountant attesting to the accuracy of the performance figures that I have put forth, but not to the degree of a full audit?
Another way to think of it is this: clients have access to all my brokerage statements, together with a file that I have put together that reconciles all of them.? Personally, I think having the third-party look over my shoulder is valuable.? Even if you think I am an honest man, having someone else look over the figures, even if they are just comparing my brokerage statements and the Excel file that I produce is still valuable because it is another set of eyes looking at it.
One more question to all of my readers: are there other areas in separate account management where you think that if investment advisors might be unfair?? If so, please list them in the comments, because I am interested in knowing about that.
Again, thanks to my readers, who have been very helpful to me in the past.
as for trade allocation.. many platforms allow the advisor to run all trades through an average price account and allocate the shares based on the size of the accounts. This works well for opening positions, although for closing positions I favor the percentage-of-holdings option (where the platform automatically eliminates x% of exposure from every account with an open position). The reason for this is that stuff happens, some options get exercised and others don’t, some clients deposit/withdraw/liquidate. I just learned this one the hard way last week where I accidentally left an account short one share and an other one long one share because of a change in their size from other activities.. whoops. Thankfully it was a small mistake and I was able to correct it before the market moved. Close one!
Depending on how your platform bills trades, this could work or not. NFS, for example, charges every account a ticket which is not a trivial expense for small accounts (even in the 100k range), many do not (IB splits the commission evenly amongst accounts based on the number of shares allocated.. usually between $0.005 to $0.01 per share). With sufficient size, the only roadblock you should encounter is stocks with high share prices where the lack of fractionals makes even allocations difficult (google, for example) or positions that are a very small percentage of account values (say, investing 1% of the portfolio in security XYZ). Depending on what billing structure you have and the nominal price of the products you are using, allocation could go really smoothly or have a bit of a margin of error where some accounts have a higher % of total assets invested than others. It sucks, but it is what it is.
As far as review, I think it helps. Many people have trouble calculating returns–especially after deposits/withdrawals. It isn’t an easy thing for most people to wrap their head around, so I think that if an independent audit is reasonably priced, it’s a good value. It’s all about transparency and eliminating unnecessary time spent explaining to clients, one by one, details that can be communicated more efficiently through a single party who is independent.
You know. i can’t shake the feeling that one of the best ways to do advisory business (if you eventually had enough AUM and were using the same strategy for everyone) would be to have an open-end fund and have all your individual accounts invested in the fund. that way everyone gets the same sausage and you can take advantage of economies of scale for your clients. You could then either hold their money direct at the fund and collect the management fee or hold the product in brokerage accounts and sell them a special share class so that you get paid via the brokerage account platform. I don’t know much about the last option, but I imagine there must be someway to do it.
Independent Broker Dealer reps use the “direct at the fund” option a lot because it saves them the tickets that clearing BDs charge them.
I only mention this because you mentioned the idea in passing in the past. It’s nice that the funds probably have auditing infrastructure in place already. There’s a ton of small MF companies.. I’ve seen many funds that run on less than 10MM, so it shouldn’t be any trouble for you. Plus it’s nice that they handle things like PIP/SWP etc and could leave the door open for wide-spread distribution through their networks of wholesalers etc.
I guess there’s a reason you didn’t go this route. If you want to share, I’d love to hear it.
The main reason why I did not go this route is that running a small mutual fund is very expensive. Costs would be double or so what I am looking at now for clients.
I am looking at starting a mutual fund after I reach critical mass, so that I can have smaller accounts benefit, but it will be a money-loser initially. I can’t afford to lose money now.
David,
I think the attestation idea is a good one while you are just getting started. For small clients, that will suffice and will give them a sufficient degree of comfort. You obviously know this, but once you start to be interested in managing institutional accounts that are in the $5M+ range, then getting a full-blow audit from Ashland or Cipperman or some such firm will be critically important.
I applaud the use of no soft dollars. How are you planning to do the trading? Not a huge deal at a small size, but you’ll want to consider how you will evaluate the trade execution by the brokers at some stage.
I am planning on doing the trading through my clearing broker, who will likely allow me to direct trading to the NYSE, NASDAQ, and the ECNs.
The one area where investors are more nervous with separate account management than investing in a fund is: leverage.
If you use leverage, then investors in separate accts can potentially lose more than they invest. With a fund, thats impossible. So as long as you use no leverage I cant see the downside for investors in a separate acct scenario.