Oh Money Where Art Thou

So my concerns about starting a business, like anyone starting a business, are many. And, like anyone starting a business, the primary concern is money.

I should start by saying that my mission, other than injecting some much needed long term responsibility into investing, is to be the anti-hedge fund. Even look at my name, "Smug Investments LLC" - it's like I'm kicking old white men in the teeth a bit (sorry old white men, no offense!). I want to be as open source as humanly possible. Without sacrificing the ability to make a meager salary, of course. I grew up using open source, hacked, and warez software in the information age. I've used the interweb for 17 years or so, I like that I don't have to pay someone to learn how to fix my bike or file legal documents, since the information is readily available if you are patient in searching and willing to work at it. I think my fund should be similar. No more secretive shenanigans. No more hedge fund implosions and subprime riduculosity (I coined that phrase, of course). Instead, let's talk about what the fund does, why it does it, and how I set it up.

Since open source is as much about freedom of information as it is about community, I want to lay out the fees, mine and the standard, to go through. Anyone into hedge funds knows about 2 and 20, which basically means a 2% annual "management" fee and 20% of new profits taken quarterly. Now, that's a lot of fees. People balk at mutual funds that charge 1.5% in management fees. In fact, a good argument can be made for Vanguard as your sole source of mutual funds, since they are either low cost or free of fees entirely. In fact, DIYers should be using Vanguard and a series of ETFs, and screw professional management all together for the most part. You'll understand why when you see the fee chart below. The fees listed are actual fees from a fund I've sold before. They do not include interest or dividend income (which is really just a way to make fees look lower):

Fee Type	Fee Payee	Annual %
Brokerage Fees	Prime Broker	0.66%
Management Fees	Trading Advisor	1.00%
Management Fees	General Partner	1.10%
Agent Fees	Selling Agents	3.00%
Incentive Fees	Trading Advisor	0.50%
General Partner Fees	General Partner	0.08%
Adminstrative Fees	Service Providers	0.75%
	Total Annual:	7.09%
Incentive fees are 25% of net new profits paid quarterly
"General Partner fees" consist of 1% of profits/losses
per year taken by the General Partner

So let's go over this bit by bit. Firstly, it's obvious that hedge fund companies basically pass along virtually every operational cost they can think of to their investors. These are in the form of "Management" fees (in this case, there are two payees: the General Partner and a Trading Advisor), "Administrative" fees, and "Broker" fees. Administrative fees are often capped by larger funds, anywhere from 0.75% to 0.25% per year. It still amounts to the same thing: they charge you for legal and accounting. The same is true of Broker fees, since the clearing broker needs to make their cut - trades don't come free after all. The problem with the Administrative and Broker fees is that the investor has no say. You cannot negotiate, you cannot pass go. And what you don't see, you don't know. For instance, many larger funds get kickbacks from brokers and legal/accounting firms for keeping the business with them. The accounting is often not that difficult, the legal is "ongoing", but minimal in reality, and the broker basically does what it does all day anyway. So, even though the offering memorandum names law, accounting, and broker companies, it doesn't say a peep about any conflict of interests with the fund. In fact, I have been told by a lawyer that I shouldn't try to do anything myself and should hire big name firms to look "credible." He said, "once you have investors, you just pass the cost to them anyway."

The "Management" fees are some of the more egregious. In this case, the management fee is split between a Trading Adviser (often a third party to the fund) and the General Partner (the fund "manager"). They charge 2.1% per year no matter what. I suppose your consolation should be that if you lose all your money, they make nothing. Not that this is anything new, if you want "professional management" at a separate accounts like the institutions, it'll cost you almost the same amount. So, there is a conflict of interest that becomes apparent in this fee - what is the incentive to be profitable if you're making money anyway? Doesn't that incentivise funds to gather assets rather than make new profits? Short answer, yes. Long answer, yes.

My favorite ridiculously stupid fee is the "Agent" fee. I was an agent, let me tell you what we did. We had Joe Investor on the phone and said, "Hey Joe, check out this fund. They're low correlation with good historical returns. We recommend it. We'll send you the paperwork." Now, Joe trusts us, so he says, "Sure. What will it cost?" We'd laugh and say, "There's enough fees to choke a horse! But returns are net of fees, just the cost of doing business." And inevitably, because they trust us, they say, "Sure! Sign me up!" That is what we do for our 2% per annum of your hard earned dollars. Of course, if Joe has a problem, we have to deal with it, but is that really worth 2%? To put 2% per year in perspective, that's $2K for every $100K. So if you invest $100K on Jan 1, and it's worth $110K on Dec 31, a 10% return, we've been getting about $2K just for signing you up. That doesn't include compounding, since agent fees are paid monthly in most cases. It just goes to show that not only are the funds ripping you off, but so is your broker. ALWAYS ask what's in it for the broker, and you'll find they're getting paid handsomely.

Now we're on to the "Incentive" fees. Now, here's a fee I can agree with in principal. Basically, the fund is paid 20% of new net profits only on a quarterly basis. Hypothetically, this aligns the fund and the investor perfectly. It basically says, "if you don't profit, we don't profit." You'll not that there are virtually zero funds that are purely incentive fee based, since they all realize one thing: we can and will lose money. And if they lose money, they make nothing. So they cover all their bases and charge for everything just in case they implode.

So what's a fund to do? How do I make money, be open source, and align my interests with the investor? I'm proposing a lower fee structure for one thing (see below for my proposal).

Fees	$s (Ann)	% (Ann)
Management Fee	$7.50	0.75%
Brokerage Fee	$7.50	0.75%
Custodian Fee	$2.50	0.25%
Administrative Fee	$3.30	0.33%
Performance Fee*	$2.79	25.00%

And I'm going to use local services only for the administrative if I can. But ultimately, I have to charge for what I'm doing until I'm sustainable. But I will say this: I'm making my first investors free of charge for life. I haven't decided how much, maybe $1M, maybe $2M... but it will be free of all this nonsense. And I will extend the same courtesy to any community based non profit that works in any local community if they demonstrate they are committed to local sustainability or green causes. It's only fair, right?