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.

Bonds, huh! Yeah. What are they good for? Absolutely nuth– hang on, that’s not quite right.

Despite the exciting Bond Crash Apocalypse Now scenarios available from your local financial media outlet or multiplex cinema, bonds still have a place in the portfolio of any investor whose risk profile questionnaire doesn’t bear the name “Indiana Jones”.

Below I’m going to trot through the main kinds of bonds and quickly sketch out the part they each have to play in a diversified portfolio.1

But before I do, it’s worth remembering that bonds are meant to be the counter-weight to shares in a portfolio. They are the stabilising influence that tempers the turbulence. Equities are from Mars and bonds are from Venus, if you will.

• The key to (most) bonds is they aim to pay you a fixed income until a certain date, at which point you get your initial money back.2

• That is very different to equities, which offer no such certainty of income or capital returns.

• When equities crash we look to bonds to limit our losses.

• When equities underperform, we hope that bond returns can pick up the slack.

• When equity valuations are in the dumpster we rebalance from bonds to take advantage of cheap share prices.

• Bonds reduce volatility and increase our chances of getting the outcome we want.

The cost of these benefits of bonds is a much lower expected return than equities (though things don’t always turn out that way) and, in most cases, a vulnerability to inflation.

Here’s a couple of other bond basics that will help make sense of what’s to come in the rest of this article:

Maturity refers to the length of time (usually years) before the issuer must pay back the loan that the bond represents.

The longer a bond’s maturity, the more risky it is. That’s because there’s a greater chance it will fall prey to rising interest rates and inflation.

The duration of a bond tells us two things:

1. The impact of changing interest rates on a bond. For example, a bond with a duration of seven years will lose around 7% of its market value for every 1% rise in interest rates. Equally if rates fell by 1% then the bond would gain 7%.

2. How long it will take for a bond to recover its original value as its interest payments are reinvested at a higher rate. If you hold a duration seven bond for seven years then you won’t lose your original stake.

Bonds or bond funds? Most of the characteristics described below apply equally well to individual bonds or bond funds. If in doubt, assume I’m talking about bond tracker funds and ETFs, as they are the simplest, most cost-effective way for most investors to hold fixed income assets.

Here’s a handy new-fangled infographic that lays out the bond landscape:

Short-term gilts

If you are haunted by fears of spiraling interest rates then short-term gilts are the place to be.

Short-term gilt funds hold conventional3 UK government bonds that are due to mature in 0-5 years, which means:

• They are high quality assets. The risk of the UK Government defaulting on its debts is very remote.

• Volatility is low because the maturity date of each holding is short. In other words, if interest rates rise, it won’t be long before the old bonds mature and the money is reinvested in fresh bonds that reflect the new rate.

• Returns are very low because you’re taking about as much risk as a royal nanny popping Prince George into a bubble-wrap onesie.

• Currency risk is off the table, assuming you’re an investor who spends most of their dosh in the UK4.

Who for: If you’re vulnerable to interest rate hikes, have a high fixed-income allocation, and have little need for growth then short-term gilt funds are for you (although please remember as always we’re advocating a portfolio approach with your bonds and other asset classes, not all or nothing).

Intermediate-term gilts

This is the regular coke choice of government bond funds. It holds conventional gilts: short, long and everything in between to end up in the risk/reward sweet spot for fixed income.

Intermediates are a good choice because:

• They should be better rewarded than short-term funds. That’s because they earn a risk premium for accepting increased exposure to interest rates and inflation.

• You’ll suffer less volatility than if you were in a long-maturity fund but you’ll still grab much of the return.

• The standard advantage of guarding against stock market trauma at the cost of accepting lower returns still applies. And again, no currency risk.

How to recognise: An intermediate fund won’t call itself intermediate. It will have a very plain name: UK Gilts fund or UK Government Bond fund with no mention of any kind of timescale. Look out for an average duration of nine to 10 years in the fund factsheet.

Long-term gilts

You’re into long-maturity gilt funds because you fear deflation. Long bond funds are chock full of conventional gilts with maturities of 20 years and well beyond.

Key features are:

• They can be ravaged by spiking interest rates and inflation. If new bonds are issued that pay out at a higher rate than older existing bonds, then a 30-year bond becomes outmoded faster than last year’s smartphone. Yet it hangs about like mercury in the water supply.

• When a financial earthquake lets rip, long bonds are likely to be a safe haven. As equities, interest rates, and inflation collapse, it’s gangway for high quality, long-dated, liquid assets.

• Volatility and expected return are much higher than for their shorter bond brethren. However as bond maturities lengthen, so volatility rises faster than returns in comparison to intermediate bonds.

Who for: Young investors with 80% plus equity allocations and reasonably stable jobs have the most reason to fear deflation. The increased volatility of long bonds is barely relevant in such an aggressive portfolio.

However, long bonds are currently considered to be extremely risky given the widespread expectation that interest rates will eventually bob back to their historic norms. Under the circumstances, intermediate bonds can fulfill much the same role but will take less of a beating if rates do rise.

Perpetual bonds

Economic Cassandras sometimes snicker that Western governments have no intention of ever paying off their mountainous debts. The existence of perpetual bonds is this cynicism incarnate.

‘Consols’ are a special kind of gilt issued in the distant past by the UK government that look set to pay a fixed amount of income forever. Other similar bonds include “War Loan”, which was issued in 1917 to encourage patriotic citizens to help pay for World War 1.

In theory these bonds are redeemable by a determined administration, but in practice nobody expects this to happen any time soon – where “soon” means in our lifetimes, or your grand children’s lifetime for that matter.

The origins of consols dates back to the 1700s. Their value – and hence what the government owes on them in real terms – has been utterly destroyed by the higher inflation of the 20th Century, and they now amount to a tiny proportion of the nation’s loan stock.

So while buying something that pays you an income for the rest of your life might seem akin to a perpetual motion machine, there are snags  – principally caused by inflation and the time value of money.

• Perpetual bonds are essentially long-dated bonds turned up to 11. Whereas even a 40-year bond has the anchor of distant redemption date, there’s no such capital return guaranteed for a consol. This means they are entirely at the mercy of inflation and interest rate risk.

• When I say “at the mercy” I really mean it. In the late 1970s, the running yield on “2.5% consols” (and which were issued with a 2.5% coupon) flirted with 18%! This means that loyal holders who held from the 1920s saw the spending power of their consols utterly destroyed.

• On the other hand, anyone who picked up those same consols from despairing octogenarians throwing them overboard in the ’70s did very well. Since then the yield steadily fell to less than 4% by the middle of 2013, resulting in a huge capital gain over the period, as well as enormous annual income payments on their buying price.

• You can buy consols and other perpetual bonds via a stock broker, but beware their big spreads.

Who for: Doomster deflationists. Arguably they could in some other reality have a role for ordinary investors in providing steady income, but we think not at anything like today’s prices – we’d have to turn Japanese and see decades of deflation for them to be attractive. A long-dated gilt fund does a better and cheaper job at protecting against that risk for passive investors.

Index-linked gilts

Want inflation-proofed government bonds? Then you want index-linked gilts (other wise known as linkers).

Here both the principal and the interest component of the bond rises and falls in line with the retail price index (RPI) measure of inflation. Plus you get a smidge more yield on top.

Inflation is the great nemesis of bonds, which makes linkers extremely useful. Indeed they are so popular in the current environment that some are priced to deliver a negative yield. In other words, you’ll pay through the nose for the safety features.

Why else should you not commit your entire bond allocation to linkers? There are a few reasons:

• Conventional (or nominal) gilts will beat linkers when inflation falls short of market expectations. Part of a nominal bond’s yield is an inflation premium. That’s why linker yields seem lower than conventional bonds. If a 10-year nominal bond yields 3% and a 10-year linker yields 0.5%, it means the market expects inflation to be 2.5%. If inflation is higher than that the linker wins. If inflation is lower then the conventional bond wins.

• If RPI inflation falls over the lifetime of the linker then you are not guaranteed a positive return from the bond.

• Hence, investors are likely to swim towards nominal gilts during crisis scenarios, not linkers.

• Linkers benefit from the same low risk traits as conventional gilts. The shorter the maturity of the bond, the smoother the ride. However, linker funds tend to be quite volatile as they have long durations – around the 18-19 year mark.

Who for? Everybody! But it’s not a good idea to place all your fixed income bets on linkers. Rampant inflation is not the only fruit.

Corporate bond funds

Corporate bonds are debt issued by companies instead of governments. They yield more than gilts because companies have an unfortunate propensity to go bust and not pay back their debt. Hence corporates offer a risk premium to compensate for the possibility of this happening, compared to the low odds of the UK government not paying up.

They’ve become popular of late as investors – who mistakenly think of bonds as blanket “safe” – scratch around for anything that seems similar to a gilt yet mysteriously offers a higher return. (The London Stock Exchange has even launched a special market to cater for retail bond investors like us).

Things to know:

• Corporate bonds are typically split into investment grade and high-yield (or junk) varieties.

• Investment grade bonds are rated AA+ to BBB- . BB+ to C is junk. Anything below that is in default.

• The fortunes of high-grade corporate bonds largely rise and fall with interest rates and inflation. Default is still a risk though.

• What’s more, many corporate bonds embed features that enable firms to repay the debt when it suits them rather than the investor.

• The higher rates of default on low-grade bonds means that they are likely to pay out less than their high yields imply.

• The volatility of corporate bonds can be deceptive. At times they appear to be as benign as government bonds. But when the markets cut up rough, corporate bonds behave more like equities, especially at the lower grades, as investors become more fearful of company defaults.

• At the very moment your bonds should be cushioning the impact of plunging equities, your corporate bonds are likely to be tanking in tandem.

• Like all bonds, interest paid by corporate bonds is taxed at higher income tax rates, not dividend income rates.

Debating point: There’s an argument that an international corporate bond fund further diversifies your portfolio, enabling you to increase expected returns without increasing risk. Many American passive investors are in ‘total bond market’ funds that include a 20-25% corporate bond slice.

But personally, I prefer asset classes to play a clearer role in my portfolio: Equities to deliver growth, and domestic government bonds to reduce risk. Corporate bonds do not strictly fulfill the defensive criteria outlined for bonds at the start of this post.

International government bonds

Adding a touch more diversification is also the reason to consider international government bonds.

However, there seems little point in devoting a portion of your bond allocation to AAA–AA rated countries that are in the same low yield boat as the UK. You’d be taking on a fair chunk of currency risk in the part of your portfolio that’s meant to offer stability.

Instead, you might consider emerging market government bond trackers that take you into the realm of sub-AA countries. If you go down this route, make sure you diversify as much as possible across countries, maturities, and currencies.

As with corporate bonds, you can expect a choppier ride from emerging market bonds. It’s probably best to carve their allocation from the equity wedge of your portfolio, rather than the low risk, fixed interest side.

Heavy bonding session

So there we have it. If you can handle equities see-sawing like Chucky after a rejection letter then bonds may be optional for you.

If not, then they have a place in your diversified portfolio regardless of the widespread conviction that interest rates must rise and that bonds will take a shoeing for a time.

Fancy grabbing some? Here’s Monevator’s take of the cheapest trackers around, including some cost-effective ways to get exposure to bonds.

Take it steady,

The Accumulator

*Editor’s note: I think this is called “irony”, but check with Alanis Morissette.

1. Please note: It’s not all or nothing! Many comments miss this point, and say bonds are “sure” to go down so why hold them. But we diversify because nothing is so sure. If government bonds do decline a little in price, it’s very likely that your equities will be more than making up the difference. And if equities crash, you’ll be glad you own some bond ballast, and of the income they pay out, too. [↩]
2. Getting your money back assumes you bought when the bonds were first issued. If you (or your bond fund) buys them in the after-market, then you may get more or less back depending on the price you paid for them. [↩]
3. That is, they are not linked to an inflation index. [↩]
4. This is true of all domestic bond funds. [↩]

Good reads from around the Web.

Never let it be said that the Scandinavians lack a sense of humour, or at least a strong sense of irony.

This week saw the Nobel Prize go to three famous economists who’ve done a lot of work on asset pricing.

But as Bloomberg reports:

Eugene F. Fama, Robert J. Shiller and Lars Peter Hansen shared the 2013 Nobel Prize in Economic Sciences for at times conflicting research on how financial markets work and assets such as stocks are priced.

No kidding! Whereas Fama’s work laid much of the framework for the efficient market hypothesis, Shiller has concentrated on the behavioural tendencies that I think undermine some of its key assumptions.

Writing in the FT, Tim Hartford wasn’t perturbed about this “all shall have prizes” approach from the Nobel committee, noting:

In the light of the financial crisis, the contribution of Prof Shiller to economic thought is obvious. Prof Fama’s is more subtle: if more investors had taken efficient market theory seriously, they would have been highly suspicious of subprime assets that were somehow rated as very safe yet yielded high returns.

Any follower of Eugene Fama would have smelled a rat.

We have our own modest version of the Fama/Shiller dichotomy here on Monevator. I actively invest quite a bit, despite believing it’s a bad idea for most investors, whereas The Accumulator (rightly) follows a pure passive approach.

Neither of us expect to win the Nobel Prize, of course.

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