How to Create and Manage a Mutual Fund or Exchange-Traded Fund: A Professional's Guide

By Melinda Gerber

With this book, author Melinda Gerber walks you through the twenty-nine steps needed to start a mutual fund and the thirty-six steps needed to start an ETF. She provides costs and detailed explanations of how to accomplish each task from fledgling idea to the actuality of selling shares, and also takes the time to explain the importance of creating a clear vision for your fund as well as how to successfully profile customers and identify your competition.

• Language: English
• Publisher: Wiley
• Release date: Jul 7, 2011
• ISBN: 9781118160718

Book preview

PART One

Create and Manage a Mutual Fund

CHAPTER 1

Why the World Needs Another Mutual Fund

From its birth in the United States in 1924 to today, the mutual fund industry has witnessed its share of scandals, changing regulations, new products, and emerging players. Each change that the fund world has experienced over the years has created opportunities and bred innovation. Seize the opportunity and bring creativity to the marketplace. Start your own successful mutual fund.

WHAT IS A MUTUAL FUND?

This professionally managed, pooled investment vehicle allows individuals and institutions to combine smaller amounts of money into a larger sum for investment. This pooling of assets allows for these individuals and groups to attain economies of scale (that is, smaller brokerage commissions than an individual investing alone) and a reduction of risk through diversification.

The term mutual fund reflects the mutual relationship between the shareholder and the fund. The fund sells shares to investors or redeems shares from those wanting their money back, at a price that depends on the net asset value (NAV) of the fund. NAV is the price of one fund share at the end of the trading day.

SCANDALS

When Edward Leffler, a former securities salesman, created the first U.S. open-end mutual fund in 1924, it was shadowed by a more popular investment vehicle, the closed-end investment trust. These trusts issue fixed amounts of nonredeemable securities that are traded inside secondary markets. By 1929, open-end mutual funds numbered 19, with $140 million in assets. In contrast, 89 closed-end investment trusts held $3 billion in assets. The dominance of the closed-end investment trusts, however, was about to change.

THOSE INVOLVED IN THE DAY-TO-DAY FUNCTIONS

A mutual fund generally does not have employees, although a recent SEC rule requires funds to have a chief compliance officer that reports directly to the fund’s independent members of the board of directors. The fund has contracts with firms that provide services it needs. These contracts are with the investment adviser, fund administrator, principal underwriter or distributor, fund accountant, custodian, transfer agent, shareholder servicing agent, attorney, and independent auditor. The fund’s board of directors or trustees oversees the contracts of these and other firms that provide services to the mutual fund.

Investment Adviser—the firm that manages the fund. The portfolio manager, the person who decides which securities to buy and sell to attain the fund’s investment objectives, is typically an employee of the investment adviser.

Fund Administrator—interacts with each service provider. It ensures that all the fund’s checks and balances are in place and that the fund complies with certain federal requirements.

Principal Underwriter or Distributor—is responsible for reporting commissions paid and received, state registration of shares sold, advertising and sales-literature compliance, and selling agreements between the brokerage firms and the mutual fund.

Fund Accountant—calculates the Net Asset Value (NAV).

Custodian—pays cash for securities (securities settlement) and makes sure all trades match (trade confirmation).

Transfer Agent—keeps shareholder account records, calculates and disburses dividends, and prepares and mails confirmation statements and federal income tax information, as well as a host of other services. The transfer agent is responsible for anything to do with account-owner shares.

Shareholder Servicing Agent—responds to inquiries from potential and existing investors, gathers information from them, and provides another means to deliver the fund’s message. This agent is typically an extension of the transfer agent.

Attorney—specializes in the Investment Company Act of 1940 (40 Act), the primary law governing mutual funds, and is commonly referred to as a 40 Act lawyer. The attorney assists the fund in understanding how to integrate the various federal and state regulations with the fund’s business parameters.

Independent Auditor—certifies the fund’s financial statements. The independent auditor is required under the 33 Act.

Board of Directors—in addition to overseeing the fund’s contracts, the directors serve to protect the interests of the shareholders.

Shareholders—the fund’s only owners and its only customers. They are critical to a mutual fund’s success. Without them, the fund’s assets stagnate or dwindle. They enjoy certain rights affecting the fund. Under the 40 Act, all shares issued by a mutual fund must be voting stock and have equal voting rights. The shareholders use these voting rights to elect the board of directors to vacant positions, approve or reject any changes deemed fundamental, and in some cases approve or reject any changes in the fund’s investment advisory contract.

The impetus for change was the stock market Crash of 1929, which shed light on the investment trusts’ inherent problems. Many closed-end funds did not disclose their underlying portfolio holdings. This allowed those funds to value their own shares at whatever price their fund managers wanted. It was also common for fund managers to borrow money to inflate the size of their fund. The leverage enhanced the investor’s return, but exposed them to the potential loss of their stake to senior debt-holders. Also, many closed-end funds purchased securities as favors to help insiders unload undesirable stocks.

Speculation before the Crash drove prices of closed-end funds higher than the prices of the securities they owned. When the Crash hit, closed-end trust holders were hurt more than common-stock investors.

Open-end funds also lost value during the Crash, but their policy of redemption upon demand at NAV safeguarded them against many of the problems that devastated closed-end funds. Because open-end funds might have to sell portfolio securities at any time to meet investors’ redemptions, they could not borrow heavily or hold any large proportion of their portfolios in unmarketable securities. Also, pricing fund shares at NAV avoided speculation, since a fund could not be priced beyond the prices of its underlying securities.

Although growth in the investment market was slow after the Crash, by 1943 open-end funds’ share of the market exceeded that of closed-end funds for the first time. At the end of 2006, open-end funds continued to be a more popular investment choice; there were 8,726 open-end funds with $10.4 trillion in assets under management versus 646 closed-end funds with cumulative assets at $298 billion.¹

It took 74 years for another major scandal to strike. Regulators are currently investigating such abuses as excessive trading, late trading, and time-zone trading. Excessive trading is the rapid buying and selling of fund shares. While not illegal, excessive trading may increase expenses for long-term fund shareholders. Most fund companies prohibit it.

Late trading, which is illegal, takes advantage of price movements in securities held by a fund after the stock exchange is officially closed. Customers who place a trade after the 4 p.m. ET cutoff get the pre-4 p.m. price.

Time-zone trading takes advantage of price movements in foreign securities held by mutual funds after the foreign markets have closed, but before the NYSE has. If mutual fund companies do not use a fair-value price for the foreign securities, an investor may take advantage of a disparity in price by buying or selling fund shares.

REGULATIONS

With scandal comes regulation. Following the Crash of 1929, Congress passed four significant laws: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisers Act of 1940, and the Investment Company Act of 1940.

The Securities Act of 1933 (33 Act) established rules for any public offering of securities. Anyone who wants to offer securities to the public must register those securities. In addition, prospective investors must receive a prospectus that adequately discloses a description of the offering.

The Securities Exchange Act of 1934 (34 Act) created the Securities and Exchange Commission (SEC), whose role is to enforce federal securities laws. The 34 Act also established rules and registration requirements for the securities exchanges, broker-dealers, transfer agents, and distributors.

While the 33 and 34 Acts affected all public companies, the Investment Advisers Act of 1940 and the Investment Company Act of 1940 specifically addressed the mutual fund industry. The Investment Advisers Act targets the investment adviser, the firm that manages the fund. The rules require, among other things, registration with the SEC, keeping certain records, and prohibit acting in a manner that would deceive or mislead somebody to whom the investment adviser owes a fiduciary duty.

The Investment Company Act of 1940 aimed its regulations at investment companies (for example, closed-end and open-end funds and unit investment trusts). It formed the foundation upon which all regulation specific to the mutual fund industry is based. Unlike the 33 Act, which is predominantly disclosure-oriented, the 40 Act prohibits a broad range of conduct and mandates various types of fund behavior.

Some of the provisions aim to:

Counter inadequate disclosure to shareholders by requiring investment companies to register with the SEC, maintain specified accounts and records, and file annual reports with the SEC. Independent auditors must audit the financial statements in the annual reports.

Circumvent management from pursuing their interests above the shareholder’s by requiring the investment company’s board of directors be composed of at least 40 percent independent members who are not affiliated with the management company. (Recent rules increased this number to 75 percent.) In addition, the shareholders must initially approve a written contract between the fund and its investment adviser and principal underwriter. Thereafter, the board must approve this contract annually.

Further protect shareholders by requiring that investment companies’ shares have equal voting rights and that shareholders vote on changes to fundamental policies.

Avoid mismanagement by requiring that investment companies’ officers and employees, who have access to cash or securities, be bonded with what is called a fidelity bond. A qualified custodian must hold the securities.

Ensure an investment company has adequate assets or reserves by requiring that it begin with at least a net worth of $100,000, which is known as seed money.

As you can see, the 40 Act addresses many of the abuses by closed-end investment trusts that came to light with the Crash of 1929.

The SEC has also proposed a series of new regulations to address the instances of market timing, late trading, and other recent developments in the mutual fund industry. The scope and impact of this new body of regulations may be significant.

Not all regulation occurs to circumvent future scandal. Some create benefits. For example, Congress passed the Revenue Act of 1936, which established the tax pass-through treatment. It states that investment companies, such as open-end mutual funds, can avoid paying federal income tax on their income if they meet a number of requirements, including distributing all taxable income to their shareholders and redeeming their shares upon demand. This benefits shareholders. Instead of being taxed twice on their investments like a regular corporation, they are only taxed once.

PRODUCTS

Regulation can also create new products. For example, in 1974, the Employee Retirement Income Security Act (ERISA) passed and created the Individual Retirement Account (IRA). This pension reform act mandated that employees be vested in their pensions within 10 years and retain their pension rights as they move from one employer to another. Four years later, the Revenue Act of 1978 passed. This act permitted the creation of 401(k) retirement plans. Many other retirement vehicles were spawned over the years and with them we have seen a shift from employer-sponsored defined benefit plans to employer-sponsored defined contribution plans. As of the end of 2006, 32 years after the passage of ERISA, IRAs and defined contribution plans accounted for $4.1 trillion (or 39 percent) of mutual fund assets.²

The adoption of Rule 12b-1 in 1980 also created new products. Rule 12b-1 allows for funds to pay for distributions out of fund assets. This gave sponsors of load funds new ways to design commission arrangements. In addition to the traditional front load, the contingent-deferred sales charge (CDSC) and level-load arrangements were created.

The industry also benefits when regulations are dropped. In 1974, the SEC ended fixed stock commissions. This paved the way for the emergence of discount brokerages. Discount brokerages allow investors who do not need advice to execute their own trades. Customers pay a transaction fee to buy or sell a particular mutual fund.

Discount brokerages spawned fund supermarket platforms. In 1992, Charles Schwab created OneSource, the first mutual fund supermarket. With OneSource, the customer trades mutual funds on a no-transaction fee (NTF) platform. The mutual fund pays an ongoing fee, which is tied to the size of investor assets brought in through the platform. Both discount brokerages and fund supermarkets created new distribution opportunities for mutual funds.

PLAYERS

Charles Schwab was not the only player to shape today’s mutual fund industry. Jack Dreyfus, Ned Johnson, Gerald Tsai, Peter Lynch, and John Bogle were also important innovators.

In 1957, Jack Dreyfus did something no one had done before: He introduced advertising to the mutual fund industry. The launch of this new era began with a TV ad featuring a lion that strolled out of a subway, past a newsstand on Wall Street, and into the Dreyfus office where it transformed into the Dreyfus company logo. Dreyfus again made mutual fund history in 1958 by publishing the Dreyfus Fund’s entire prospectus as a supplement in the New York Times. Brand advertising came later and Ned Johnson was the one to do it.

In 1972, Ned Johnson took over the reigns of Fidelity Management and Research from his father, Ed Johnson. During his tenure, the younger Johnson helped transform the mutual fund from a service into a product. One way he did this was through brand advertising. Much as consumer-products companies sell detergent or cola, Johnson initiated an advertising campaign that emphasized the Fidelity name. Also supporting the transition from service to product, he and his management team initiated or popularized new features and services such as check writing against money market funds and expanded their product offering to include an exhaustive list of funds such as sector, international, and tax-exempt. By the late 1990s, every fourth or fifth dollar flowing into U.S. stock funds was invested in a Fidelity fund.

Gerald Tsai, another giant in the industry, came from Fidelity. After leaving Fidelity, Tsai started the Manhattan Fund (1965). Over its first year, the Manhattan Fund grew faster than any mutual fund up until that time. It attracted $100 million in one year, largely due to Tsai’s portfolio management style that emphasized performance. This style rocked the world of mutual funds in two ways. People previously invested in mutual funds for diversification, professional management, and economies of scale. In this go-go era, people invested for performance.

Also, portfolio managers, previously considered fiduciaries of their client’s assets, were now becoming stars. People in the investment industry knew where Tsai ate and what he was buying and selling. Tsai, along with other gunslingers of the time, created the mutual fund world we live in today. People chase performance and adulate the most successful portfolio managers like they do rock stars.

Peter Lynch, another Fidelity player, took star status up a notch to celebrity. In 1990, Peter Lynch ended his thirteen-year reign of the Fidelity Magellan Fund. His Invest in what you know strategy helped the Magellan Fund skyrocket from $26 million to $14 billion. Someone investing $1,000 in Magellan at the beginning of his reign and leaving it in there for the remainder of his tenure would have had $28,000, a 29.2 percent return each year for 13 years! His amazing track record combined with his personality elevated him to celebrity. He even starred in a series of Fidelity ads.

Portfolio managers are not the only shapers of the industry. John Bogle, founder of the Vanguard Funds, is a great example of this. In 1975, John Bogle started the Vanguard Group. What’s unusual about the Vanguard Group is its structure. The funds themselves own the investment adviser. Bogle believes this not-for-profit structure is the way to minimize the cost to the funds, which in turn minimizes the cost to investors. Throughout his career, Bogle has been and continues to be an advocate of index funds because he believes that actively managed funds create more cost than returns for a shareholder over the long term. In the past thirty years we have seen the emergence of discount brokerages, fund supermarkets, defined contribution plans, IRAs, new fee structures, and the status elevation of the portfolio manager. Change continues today. Exchange-traded funds, the mutual fund’s next evolution, are fully explored in Part II.

GOING FOR THE BRASS RING

Whether you want to be a star, take your current business to the next level, look to prove a theory, change your career, or make a social statement on a broader level, this is a great business. There are no accounts receivable, write-offs, bad debt, inventory, or heavy lifting. Your fee is built into your fund’s NAV so you do not have to bill anyone to get paid. Also, through asset appreciation, revenues may increase even without any new sales.

In addition, compared with other financial products, people are comfortable with it. Even with the scandals that periodically arise, people are familiar with and trust mutual funds. If you ask someone to invest in a commodity fund, hedge fund, or to place her cash overseas, her natural inclination would be to run away. Even these scary products, however, wrapped within a nice veneer of a mutual fund would be more palatable to the average investor.

It is also a very profitable business. Studying the 1998 financial reports of eighteen publicly held management companies, Strategic Insight, an industry research firm, found an average 36 percent operating margin. The companies in the study were large firms totaling over $1 trillion in assets under management. I want to point out that bigger in this case is not always better. Some of the small funds I spoke with averaged even higher net margins!

WHAT’S YOUR MOTIVATION?

While managing a mutual fund is exciting and profitable, I wanted to know the personal reasons why individuals decided to take the plunge and start a mutual fund. To answer this, I picked up the phone and called an assortment of money managers who chose to throw their hat in to the ring. The funds they manage or managed were very different from one another. These money managers represented a variety of investment objectives, strategies, distribution methods, and fees. Where they also differed was on why they started their fund(s). Some of them:

Wanted to add value for clients. While managing separate accounts, one registered investment adviser (RIA) got frustrated when he found a great value stock and was not able to allocate it effectively across his clients’ accounts. By starting a mutual fund, he was able to take positions in the stocks within the mutual fund and have his clients own a portion of the fund.

Hoped to grow the business. One RIA felt limited growth by managing separate accounts. He had increased the minimum investment for clients but did not like turning away smaller investors. By starting a fund, he was able to maintain the separate-account business and grow his total business by adding new clients to his mutual fund.

Desired daily public exposure and greater visibility. One money manager had a great track record, but wanted the world to know. He started a mutual fund so people could see his investing skills daily in the newspaper.

Wanted to create a profit center. One business was already managing money internally as a cost center. By starting a mutual fund and offering it to outside investors, they turned the cost center into a profit center.

Aimed to enter the subadvisory business. Another RIA wanted to become a subadviser, but she could not find an entry point. By starting a mutual fund, she was able to get visibility and attract offers to subadvise for other mutual funds.

Sought to prove a theory. Another RIA wanted real money invested so that no one could say her investment approach was just a theory in a computer and that it could not be done in real life.

Meet a client challenge. One RIA heard this challenge from clients thousand of times: If your model is so good, then why not run your own fund?

Wanted to make an impact. One money manager who had a social agenda wanted to make an impact on a broader scale.

Others launched funds to make a change in their lives. Some simply enjoyed investing and wanted to get paid for it. Some wanted to prove something about themselves or switch careers. One individual got tired of being fired and another wanted to keep busy when he retired.

Not all these money managers’ funds survived. Some closed within a few months of becoming effective, some years, and a few never happened. Regardless of their survival rates, it’s important to learn from these managers. Their stories, words of wisdom, and warnings are sprinkled throughout this book. So too are the insights of more than 40 industry professionals who work with mutual funds.

In addition to being a great business, managing a mutual fund is an amazing career. A portfolio manager is like a detective. You examine individual companies, dig into the details, put together pieces of information, and create an informed decision to either buy or sell. Something new and exciting is always happening.

On top of this excitement is the awesome responsibility of managing people’s money. People trust you with their money and that feels great. You are making a positive impact on the lives of your shareholders.

Managing an open-end mutual fund has awesome responsibilities and rewards associated with it. You get paid for doing something you love and have a positive impact on those who invest with you. As things change, new opportunities evolve. Change brings about new ideas, new products, and new players. You can lead the change. If you can do it a little different or a little better, then do it. Those who have come before you have been passionate and committed. Join them. To your success!

1 2007 Fund Fact Book, an Investment Company Institute Research Publication.

2 The 2007 Investment Company Fact Book, an Investment Company Institute Research Publication.

CHAPTER 2

Money, Product Differentiation, and Distribution

Success Factors

What do successful funds have in common? I posed this question to current and former fund sponsors, as well as more than 40 other industry professionals. Two consistent themes emerged: working capital and marketing. I call these the success factors. These two success factors need to be in place and integrated to support your fund.

Generally, small funds do not have enough assets on Day 1 (or 2 or 3) to cover their fund’s expenses. That is why working capital is needed. Working capital pays for start-up and ongoing expenses until your fund reaches a point where income equals expenses.

While you may feel that assets under management will grow quickly and therefore cover your fund’s expenses, realize there are factors working against a new fund. Many investors shun funds that are new, small, and have no track record. Remember you are dealing with other people’s money. Money is a very personal subject. The cash may be earmarked for a house, college education, wedding, retirement, or another financial goal. Investors may not want to take what they perceive as a risk on your fund. To ensure that your fund survives past its new fund status, you need plenty of working capital. What’s enough working capital? The general consensus is enough cash to cover your start-up expenses, as well as expenses for your fund’s first three years.

During your first few years, put your fund’s marketing plan in motion. The hardest part of starting a mutual fund is reaching $10 million in assets, then $50 million and $100 million. As you attain each milestone, it becomes easier to reach the next one, but getting started is like pulling teeth. While there are limited barriers to entry into this industry, there are definite barriers to recognition. This is where marketing helps.

Let’s clear up a potential point of confusion from the very start: Marketing is not advertising. With advertising, the firm pays to endorse itself. As one fund manager phrased it, Advertising is about as effective as spitting in the wind. And let’s face it, the big guys spend more on advertising by 9 a.m. than you will all year. This is an area where it’s tough to compete.

Where you can successfully compete is with marketing. Marketing is about getting the name of your fund out to its target market repeatedly without paying an exorbitant fee for it. It is free most of the time. Here is one example of a low-cost marketing method. When offering your fund to your existing clients, put information about your fund into a pre-existing mailing such as a newsletter. This may attract customers to your fund. There are endless smart and low or no-cost strategies that get your fund’s name and message known.

Be consistent with marketing. People walk down a predictable path before investing. At the beginning of the path, they are completely unaware that your fund exists. Make them aware. They may not understand what your fund is trying to achieve and how it fits into their goal. Make them understand. Once they understand, they need to believe it is the right step for them. Make them believe. When they believe, make it easy for them to act on their decision to invest. Once they have invested, they will leave your fund if their conviction falters. Remind them why they invested. One news release or one story or one TV appearance will not attract a crush of customers. It is a blip on the radar screen. You must continuously market to attract and retain investors.

You must integrate working capital and marketing to be successful. You will have to spend some money to support your marketing efforts to grow your business. Increasing assets under management means your fund no longer relies on outside working capital to pay for everything. At the point of profitability, your fund sustains itself.

Superior performance will also boost your chances of success. Unfortunately, performance is, to a large extent, uncontrollable. There is no guarantee that under all market conditions your fund will be number one in its Lipper category or in the top 10 percent of its Morningstar category. Figure 2.1 shows the performance of ten major asset classes from 1996 through 2006. How has your asset class done? How often has your style of investing been in favor? As you can see from the table, no category or style of investing can enjoy top returns every year. You can’t depend solely on your fund’s future performance to attract assets. The smart money manager also implements a marketing strategy. Successful firms do.

FIGURE 2.1 Annual total returns of key asset classes, 1996–2006

Source: Stifel, Nicolaus & Company, Incorporated, using data from Zephyr StyleADVISOR.

DETERMINE WORKING CAPITAL

Let’s focus on working capital. To determine how much you require, you need to know how much it costs to start and run a mutual fund.

For my start-up example, I’m imagining a Florida-based Registered Investment Adviser firm that wishes to grow its total business. Managing separate accounts has limited its growth, and although it has increased the minimum investment for clients, they do not like turning away smaller investors. Starting a mutual fund enables them to maintain the separate account business and grow its total business through the addition of new mutual fund clients.

The proposed mutual fund is a no-load, plain vanilla, domestic equity product with a 1 percent expense ratio. Owing to their established clientele, assets under management on Day 1 will be $10 million. Other details:

Offered through direct sales and on four no-transaction fee (NTF) platforms

Registered for unlimited sales in all states and provinces of the United States

Uses outside service providers, but investment management is done in house

Has Directors & Officers and fidelity bond insurance

$3,000 for prepromotion

$10,000 buffer

Given these parameters, it costs approximately $150,000 to start a mutual fund. The details, however, don’t necessarily match the situation. For example, if the focus is existing clientele in Florida, why have the fund available in all states? Also, why the need for the NTF platforms? Good questions.

When fund sponsors research other mutual funds, they see those products sell in all states and trade on all platforms. This makes them feel they should too. By making this choice, however, it costs an additional $80,000 in start-up fees. Ouch! If unnecessary on Day 1, then start-up costs drop to $70,000. Additional states and platforms (also broker-dealers, defined contribution plans and so forth) can be added at any time. Do it when it makes sense for your business.

If you start two or more funds, your start-up costs will not double. Many expenses are one-time costs, such as establishing the fund family’s legal structure. Each additional fund should increase costs by approximately 50 percent.

What if you don’t have $10 million to invest on Day 1? No problem. At an absolute minimum, you need $100,000. This $100,000, known as seed money, must be in the fund for an indefinite time. The Investment Company Act of 1940 (40 Act) requires this minimum amount. There is an exception to this rule. To understand this, let’s take a step back and look at a mutual fund’s business structure.

Because a mutual fund needs to be able to legally issue shares, it is generally set up as a business trust or corporation. This legal structure forms an umbrella for the fund. Under an umbrella, a series may be started.

A series is the ability to offer different portfolios, or series, within the same legal organization. A small cap growth fund and large cap growth fund would be two series under your umbrella. If you wanted a small cap growth fund with classes A, B, C, and R, then that represents one series with four classes within the series.

Establishing a series can be done in two ways: The fund sponsor creates the umbrella and series or the sponsor uses another’s legal umbrella. For the latter, this separate entity creates another series, or class, for your fund under their umbrella. From an investor’s standpoint, it looks and functions like any other fund. The only hint of the arrangement is a small note on the cover of the prospectus (the Widget Fund, a series of Share Umbrella, Inc., for example). Two possible structures of a series within the same legal organization are presented in Figures 2.2 and 2.3. By joining a pre-existing series, you remove the need for the $100,000 seed money. The 40 Act requires these monies only for the first fund in a fund family. (Note: this would be true for additional funds you start under your own umbrella as well.) While this seems like a deal, have some money to invest on Day 1. One fund sponsor discovered this the hard way.

FIGURE 2.2 Two Series

FIGURE 2.3 One Series, Four Classes

The fund firm focused so intently on the start-up process that they neglected to raise capital to invest once the fund became operational. This lack of multitasking resulted in an NAV of $0 on their inception date.

Returning to the imaginary Floridian fund example’s details, I mention a $10,000 buffer. This buffer is what I call the four flat tires phenomenon. Four flat tires is emergency money for the unforeseen. The name comes from an experience I had with my first car. The car, a ten-year-old Datsun 510 was a continuous money pit. Every month, there was something that needed to be done, but luckily, they were small repairs. Then one day, when my Datsun was getting a new timing belt, the mechanic discovered that each of my tires had holes in them. They could not patch the tires because they were so worn down. Despite working two jobs, I did not have the money for the tires and had to go to my parents for it—so much for proving my independence.

You should always maintain a cash reserve for the unexpected for both the start-up and running of your fund. If you are not completely financing this yourself, imagine having to ask your backers for additional funds for something you did not foresee. Now, the $70,000–$150,000 start-up costs previously mentioned were for a plain vanilla, domestic equity fund. If you have something unique, bump up the numbers to account for additional costs. A unique concept I encountered was the Loyalty Fund.

The Loyalty Fund was intended as a consumer loyalty solution. Paul Hakim and Pat Palcic developed this idea when they studied the cost of acquiring a new customer for various businesses. What they discovered was that many businesses had low customer-retention rates. For example, if you participated in a frequent-flier program, there was no incentive to remain loyal to the airline if a competitor offered a better frequent-flier program.

Upon further research, they found a high correlation between stock ownership and consumer-loyalty behavior. So if a customer owned shares of Home Depot and they were confronted with a choice to turn left to shop at Home Depot or right to shop at Lowe’s, they would turn left.

Using their findings, Hakim and Palcic created a loyalty solution. Their premise was to offer consumers shares of stock for their patronage of merchants as well as reward them with points that could be redeemed for shares of the mutual fund. The fund would be weighted 60 percent based upon consumer participation and 40 percent chosen by the investment adviser.

Three major things needed to be in place to make this happen: secure agreements with participating companies, a relationship with a company with experience facilitating direct stock-purchase programs at the point of sale, and subaccounting to track and report the points to consumers. All this was accomplished. These additional costs were above and beyond those of a regular fund.

On top of this were even more costs. Because they were a unique product with four patents, their registration process was a bit more involved. After writing their prospectus, they had numerous rounds of negotiations with the SEC and corresponding rewrites.

Being unique is a good thing in the mutual fund industry. You want to be unique. If additional time and resources are needed to achieve it, factor them into