The current fund industry is riddled with challenges; the complicated web of financial intermediaries required for compliance, auditing, administration, custody and overseeing transactions means that setting up and operating a fund is extremely costly, inefficient and lacking in transparency. Melon provides a better way to serve investment managers, investors and actually solves many of the concerns of regulators. To explain the challenges in a little more detail we provide a primer on the fund industry - how funds are set up and operate - in order to shed light on some of the major challenges facing the industry.
A primer on the fund industry
Funds, also known as ‘pooled investment vehicles’ or ‘collective investment vehicles’, are portfolios of assets chosen by a portfolio manager but made available for outsiders to invest in (hence the ‘pooled’ or ‘collective’ nature of the investment vehicle, since the capital available to the portfolio manager to invest with is provided by numerous investors). The investors will range from pension funds, endowments, insurance companies, to ordinary individual savers like you and me. The investors have no say on the choice of investments which go into the portfolio. That is the exclusive role of the portfolio manager and the investors pay the portfolio manager fees to make those decisions. Those fees consist of management fees (typically paid quarterly, bi-annually or annually regardless of how well the portfolio performs) and performance fees (typically payable only if the portfolio reaches a certain threshold of performance).
The above diagram illustrates what the typical asset management value chain looks like for a fund. A fund with AUM (Assets Under Management) of approx $10m might incur a one-off fee of 40bps of AUM (0.4%) in Year 1, followed by a 35bps recurring fee after that.
The pooled or collective investment vehicle is created as a separate legal entity (usually called a ‘fund’) which investors invest in by buying shares in the fund (so the fund, the fund manager and the fund investors are distinct entities). The fund is set up according to specific rules (the mandate) which ensures the investors have exposure to a particular asset (e.g. US tech shares, African resource shares, Latin American USD government bonds, high yield corporate bonds etc.). The mandate defines what kinds of assets can be invested in (the ‘investable universe’) so that the investor knows roughly what type of investments the portfolio manager will make. This ensures that, for example, an investor looking for exposure to European blue-chip equities can invest in a European equities fund knowing that the portfolio manager will be in legal breach if he or she invests the fund’s capital in, say, Nigerian mineral rights, or defaulted Cuban debt. The mandate will also specify other limits and restrictions (parameters), such as, for example, no more than 10% of the fund being allowed in one single security, sector, issuer, commodity etc. The fund’s legal documents will also specify who is and who is not allowed to invest. For example, some hedge funds are only open to ‘designated’ investors, namely those who can demonstrate a level of financial sophistication deemed necessary to understand the strategy employed by the hedge fund’s manager.
How long does it take and how much does it cost to create a fund? The fund set-up usually takes between four and eight weeks, depending on the legal jurisdiction chosen (Luxembourg, Ireland and Cayman are some of the more popular destinations). The cost of setting up a fund is usually between $25,000- $50,000
How do funds operate?
Once the fund is set up, the investors provide investable capital to the fund by buying shares in it. The portfolio manager decides how to invest that capital, subject to the permissions and restrictions set out in the investment mandate.
It is important to note that once the investor invests in the fund, they are no longer in control of their assets. To protect the investor from fraudulent or error prone fund managers, there are rules in place which require the capital to be held by a trusted third party, a custodian bank. While the fund’s capital is held by one of these custodian banks, only the portfolio manager has control over where that capital is invested. How can the investor be sure that his or her assets are safe, and being invested according to the mandate? The answer is that the fund is administered by a third party administrator which is responsible for ensuring that the fund’s capital is going where it is supposed to, that the investments made by the fund are correctly valued, that dividends, coupons, rights or other transfers etc. are properly received. The records kept by the administrator are in turn audited each quarter by an external auditor.
Then there’s the fund’s back office - entire departments of people which are essential to any kind of investment fund. Typically an investment fund in traditional finance will have 5 back office staff per investment professional. Additionally, they will also be required (by law) to have a relationship with one or more known regulated financial intermediaries, essentially organisations which support, check and oversee the work of an investment fund’s back office. These financial intermediaries include the auditors, custodians and administrators mentioned above, but they also include transfer agents, clearing and settlement services and more.
If this is making you feel a bit dizzy - you are not alone! Hopefully you are now seeing how complicated the apparently straightforward activity of setting up and maintaining an investment fund is. You might have thought that we were going to talk about investment management, different types of investment strategies or different types of assets. But we haven’t. Instead, we have talked about back offices, legal documents and fees, custody banks, fund administrators and auditors. Each of these third parties charges fees, and so represents a financial (and often time) cost to the investor. Together these components consume huge portions of the cost-base of traditional financial organisations but until now they have been necessary to reduce financial fraud. The costs are typically passed on to savers (end investors) through hidden fees. These high operating costs also present a high barrier to entry, preventing new talent from entering and competing.
Each of these third parties will be a separate entity employing its own people, and during the day to day of the fund’s activity, these people will be gathering their own records of what the fund is doing, verifying them with other third parties and reconciling each other’s records to ensure the fund is doing exactly what it is supposed to be doing.
For example, if the portfolio manager (remember them?) decides that the fund is going to sell holding X in favour of holding Y, someone has to ensure that the fund does actually hold X in the first place. In selling holding X, the fund will receive cash for the sale. Someone needs to check that the cash was received by the fund. Then someone needs to check that the cash received is sufficient to buy holding Y, and finally, after holding Y has been purchased, someone needs to check that the fund is in fact in possession of holding Y.
None of this is particularly sexy (or interesting, frankly). But it is how the roughly $50tr mutual fund management industry works today. And if relying on all these third parties and intermediaries seems inefficient and opaque … well, that’s because it is. It’s also costly. We already mentioned the fund set-up costs of $25-50k. In fact, that is dwarfed by the ongoing expenses incurred in running funds. Even the most vanilla mutual funds run up annual expenses of anywhere between 0.5-1% of total assets under management. Some index trackers run much cheaper than this but only because they lend out the securities (e.g. equities, bonds, and other debt instruments) in their custody. At every stage a third party is involved, effectively to provide accountability and oversight in order to protect the investor. But every time a new actor is involved in this complicated web of fund administration, there is a risk that this actor may act maliciously or make an error. Failings in this convoluted set-up have historically been exploited by the unscrupulous (most infamously Madoff) at significantly more emotional cost to the end investor. Post Lehman Brothers, the legal and reporting requirements increased drastically in an effort to protect investors. Reporting requirements also went up in an effort to improve transparency to investors - however, all it has really done is added huge layers of cost base to the industry without really providing much more additional transparency. This adds another layer of work which investment funds or their investors ultimately end up paying for. In short, the barriers to entry in the financial industry are higher than ever because transparency is low. Hopefully you get the idea by now - the current system is inefficient, complicated, expensive, labour intensive and not secure.