In any case, he does have a good point – in nothing that I have put out is it clear how a spoke fund differs from a separately managed account. While I don’t think most investors care at all about the differences, apparently at least one pseudo-anonymous broker does, and I suppose there could be other folks with a similar point of view. So…

Spoke Funds versus Separately Managed Accounts

Here is a good overview of SMAs. You’ll note that many of the advantages of investing in an SMA are similar to the advantages of investing in a spoke fund – specifically, individual cost basis, direct ownership of shares, and portfolio customization. While I’d have to defer to an SMA expert to clarify this, I’d also be willing to assume that there are probably key similarities in technology, trading, and portfolio administration.

However, there are some key differences between the two as well:

- SMAs are sold by brokerages. Spoke funds are run by RIAs.

- SMA managers may or may not have a fiduciary responsibility. They may in fact be legally bound to put their employers’ interest above their investors’. Spoke fund managers are fiduciaries. They are legally bound to put their investors interests above their own.

- SMAs afford investors the ability to use multiple managers. Spoke funds do not.

- SMA investors may not have the ability to speak directly to their SMA manager. All spoke fund investors can speak 24/7 to their spoke fund manager.

- SMAs are often sold in conjunction with investment advice and/or other financial services. Spoke funds are not.

- SMAs and in particular wrap accounts have high fees, many of which are hidden. Spoke funds do not.

It’s also probably safe to say that SMA managers have little if any of their own net worth invested in the SMAs they manage. Spoke fund managers have the majority of their net worths invested in the funds they manage. This is the key factor that distinguishes the two in my mind – and to investors, too, I believe. I think the better question is not “Is a spoke fund an SMA?” as much as it is “Why aren’t all SMAs spoke funds?”

Some of the things on the list above are certainly subjective, and others might change over time. The larger point, however, is that I think there are big enough differences between SMAs and spoke funds that the latter is worthy of its own category. It didn’t have one, and after banging my head against the wall for a bit, eventually came up with the term “spoke fund.” But at this point, that term is much bigger than just me.

So, to sum up the ultimate difference between spokes and SMAs, I’d say it’s oranges and tangerines – same class, different species.

I suppose it’s possible that the better taxonomy for a spoke fund might be as a sub-category of SMA, but I’ll leave that to others. That seems to me to imply a certain deference to Wall Street, and I’ll set my hair on fire and run naked down US-1 before I kowtow to those guys.

What do you think?

I think the most relevant messages I tried to get across during this section were as follows:

1 – Being a good portfolio manager is not the same as running a company that is good at portfolio management.

2 – The economics of running a spoke fund can be very compelling.

3 – The internet gives you an advantage over potential competitors – mutual fund companies, hedge funds and even brokers chasing the same clients. More specifically, you can acquire customers at a cost very near zero.

4 – Certain technological tools can also bump your productivity up quite a bit. That’s important because it allows you to keep your focus where it should be – on the fund.

Also – nothing focuses the mind more on the importance of cash flow than running a small business. To paraphrase Warren Buffett, being a small-businessman makes you a better investor, and vice versa.

Other notes on the below:

That Sales Funnel slide is one of the most important of the day. Simple concept, and probably a bit too clinical, but to have a systematic way to attract the right kind of people and have them become investors is crucial. The “10 Things to Expect” slide was basically a rehash of this blog post. And while I emphasize the online channel in discussing marketing here, it cannot replace good old fashioned gripping-and-grinning. That should be a given. It just doesn’t scale. The right mix, the right spend, timelines and everything else that goes into marketing is still very much a work in progress for me, too, so as usual, take any and all of this with as many grains of salt as you see fit.

And yeah, I would much rather not worry about marketing, ads, sales, branding, yadda yadda…but the head of my company absolutely should keep marketing a priority. And, well, that guy is me.

The slides below cover prepping for launch and then the actual launch of a spoke fund. The prepping for launch slides were similar to this older post on Critical Path Items. The Launch series focuses just on specifics on the FOLIOfn platform, and assumes a handful of things that may not be obvious up front – namely, that you’re going to rely on window trades to make your initial purchases. You don’t have to, and may not want to, as per these comments on a previous post. I like using window trades for the reasons outlined in that same comment thread – i.e. they are free. This brings my inner cheapskate to tears.

The screenshots used to demo the steps in the FOLIOfn back-end also were taken from one of two advisory accounts I have at FOLIOfn (different billing plans), and were from a mock portfolio that just contained three stocks. Once you understand the core process, which is pretty straightforward, launching a fund with more stocks is simple.

Also, the topics on the “Things to Note” slide aren’t really done justice here. Each is probably worthy of a separate post of its own.

There are a handful of tools I’ve developed on my own, too, to fill in the gaps in FOLIOfn’s own system. The “Prepping to Invest Client $” slide (number 25 here) is a simplified version of one such tool – a basic spreadsheet – that I use to enable me to make sure I’m investing clients money in the right proportions. More specifically…

When initially syncing a new client account to the core model, you should manually adjust the weights of individual positions to be bought in order to meet your desired target weights. That’s because the default in FOLIOfn’s system when syncing client-by-client is to buy shares according to current market weights, not the most recent weights you’ve dialed in to the portfolio. If it’s been a few months, the differences can be big – and then your clients are buying more of those shares that have gone up the most.

The ability to tweak that initial buy-in is actually another advantage of spoke funds over mutual funds, as I get into more in this post on Q&A and the Ask the Geek section of this shareholder letter.

In any case, you only need to make those weighting tweaks when syncing a new client the first time. Once they’re locked in, any changes you make to the core model automatically brings everyone in line to the most recent weights you dial in. So the bottom line is that it’s not a big deal as long as you include that step in your own onboarding processes.

And finally, I’ve recently been looking at new ways to streamline my own client onboarding process, too. So while EchoSign has been great to me for the last few years (more about them later), I may soon tweak some things beyond what is shown here. And you all will be the first to know…

This section could be subtitled “Barely Scratching the Surface.” I tried to hit the three or four most critical issues to think about here, so there were only a handful of slides we reviewed. As it was, we spent a considerable amount of time walking through each slide and discussing the critical points in more detail. If the workshop were a week long course, a discussion about the economics of spoke funds could probably be a day by itself.

In the “Scalability” slide, “The Buffett Cap” refers to a cap on my own salary. I haven’t paid myself anything in salary to date, but I intend to before too long, obviously, and as I currently conceive of my own business, that will eventually max out at $100K a year…if for no other reason then that is what Warren Buffett takes home. I’d rather not tempt any lightning bolts by presuming I deserve more. Highly rigorous, I know.

Also, I am a cheapskate. I can be fat, dumb and happy on considerably less than $100K a year as long as I know the rest of my net worth continues to work hard for me in Tarpon. Too much more in salary would mean I’d be expected to buy a round for everyone, everywhere, every time in the Keys. So, you know, thank goodness nobody reads this blog. Plus, anything I earned beyond what I really needed would go right back into Tarpon, anyway.

In any case, cash in the business left over after hitting The Buffet Cap could go towards more virtual assistants, a full time employee and/or running the business in general. And that $20M figure in terms of assets under management is my bogey. Nothing to say it couldn’t be much higher, but that’s what I’ve been planning for since day one. As one of the guys pointed out at the workshop, my margins might be better at $30M in assets, mainly for for compliance/registration reasons, and I agreed, but I’ll get into that at another time here.

That whole not-taking-any-salary-yet thing is not nearly as ascetic as it might otherwise sound. That’s how 99% of all start-ups work, after all, a fact that often seems to be forgotten when it comes to managing money. And while I haven’t brought home a pay check to date, my business is otherwise funding itself now and my net worth is growing just fine in Tarpon – both of which mean I’m happy to eat palm fronds every day for lunch.

But to be clear, if you want to start paying yourself on day one, or bring home $500k a year in salary, go nuts. Just factor that in to the enclosed slides as you see fit.

The issue of whether or not to subsidize new accounts is a big one. And by subsidizing I mean either waiving my own fees and/or partially or fully reimbursing fees the custodian charges in order to keep my investors’ expense ratios as low as advertised. As you can see in the slides, it takes a little figuring to service small accounts in a way that keeps those investors’ fees under control – due to minimum annual fees the custodian charges each account. I chose to subsidize when I first launched Tarpon, and I recommend it for new spoke fund managers, too, unless you’re already coming to the game with a stable of active investor accounts. The reasons I subsidized were (1) I was launching a new firm and did not have an existing base of investors, (2) not all my friends and family could meet my official minimum and (3) there is a law in investment management that “assets attract assets.” Number three is probably one of the most important tips to remember in terms of growing the business that first year.

I also estimated that it cost me about $200 to acquire a new investor – a very rough early guesstimate but still a useful benchmark today. I decided that if the subsidy I paid out was less than that, and if I felt I could make the investor happy enough to refer new investors my way (without me having to beg), then subsidizing was a no-brainer. As it worked out, each account I subsidized more than made up for the cost of that subsidy through new client referrals by the end of that first year. Plus, I never had to ask. I’ll talk more about acquiring investors a bit later.

And as I pointed out in the workshop, the few slides below about a suggested budget don’t reflect the actual costs of my own business to date. Some lessons are learned the hard way, I suppose, particularly when it comes to spending money on marketing and advertising. I also spent a ton of money (at least, a ton to me) on legal fees related to compliance. Since the spoke fund concept was pretty new, I was paranoid about my own compliance efforts as well as what was I could and could not put in our ads, both in the papers and online. But assuming you can benefit from my own mistakes, and that you don’t have to pay the lawyers those extra fees, the suggested costs shown should be a pretty good benchmark – assuming you run things light, like a traditional start-up. If you feel you need the ocean-view office and mahogany conference table right out of the gate, you’ll want to adjust my numbers there, too.

Please ask any questions in the Comments section of this post. Next up: prepping for launch.

I’m always looking for things I can add to the ‘mental file cabinet’. Thought you might find this one interesting. This helps explain why Spoke Funds and aligning your interests with investors works.

“People don’t buy what you do, they buy why you do it.”

My favorite was this quote:

“The goal is not to do business with anybody who needs what you have. The goal is to do business with people who believe what you believe.”

Enjoy.

I think I speak for everyone in reporting that it was an enjoyable day. Steve, Kevin, Chris, Kai and Dustin came in from all over – DC, Phoenix, Indianapolis, Chicago and Gainesville – to basically sit all day in the old dynamite warehouse that is my office and learn more about spoke funds. Everyone there was a value investor, and I don’t think I was the only one that noticed we all seemed to share a certain ethic about the right way to treat our investors. I’ve found it’s pretty rare in this wacky industry o’ mine to find yourself in a room full of peers that you intrinsically trust, but this was one of those times. I began the day feeling flattered that they would show up, and ended feeling honored that they had.

I also found it a little bit surreal to hear other portfolio managers throwing around the “spoke fund” term like it was part of the vernacular. Kinda cool. Guess our little idea is growing up.

Unfortunately, the slides below don’t capture any of the many discussions, questions, comments or off-slide conversations we had. If you have any of your own as you view these, let ‘em fly in the comments section.

Since the workshop, I’ve also been doing some more digging on some of the topics I discussed that day – like finding out more about some new technology providers – and I’ll post those notes at some point, too.

So, here’s part one. If you’re already familiar with spoke funds and my firm, some of the early slides may look familiar, but hopefully there are more nuggets for you in the later ones.

And more slides will be posted soon.

Ah, mutual funds. If only you used your powers for good instead of evil…

And the first annual Spoke Fund workshop begins here in Islamorada in less than 12 hours. Notes to be posted soon!

At last count, there were 8 folks coming – though they clearly had the brainpower of 20. If you’d like to attend, too, please email me here prior to this Sunday night. More soon.

Arquitos is an independent fee-only value investing shop running a focused portfolio, based in Virginia outside of DC. Steve is an Iraq war veteran, a recovering lawyer, and an all-around great guy. And because the Freedom Fund is a spoke fund, he’s got almost all of his family’s entire net worth in it, too.

Find out more about Arquitos here. You can find Steve on Twitter here. Stop by and say hi. Or, come on down to the Spoke Fund workshop here in Islamorada on May 15 and meet him yourself.

And, for the record, the official scoreboard now reads like this:

Mutual Funds: 8,000
Spoke Funds: 4

You feelin’ us?

This would be an informal get together, meaning that while it’s not going to be the caliber of my recent investor meeting, there will be coffee, WiFi, and plenty of good info. Exact location will depend on the number of people who attend, but if nothing else, I’ve got a conference table for eight in my office. And there is nothing quite like talking regulatory statutes over a few beers in an old dynamite warehouse…

Plus, the tarpon will be thick under the bridges down here by that weekend, and we could definitely do some fishing.

I’ll put together a more formal curriculum of sorts closer to the day, but in general, think we want the weekend to basically be “How To Build A Spoke Fund” and cover everything from A to Z.

We’ll talk marketing strategy, review some things on the FOLIOfn back-end (and Interactive Brokers, too, if warranted), and I’ll walk you thru the operational and tech side of my business to see how things work.

Also thinking I may be able to convince one of the folks from RIA in a Box to come down to handle any compliance-related questions, and I’ll see if one of the support guys from FOLIOfn can come to get more in the weeds on their platform if needed. If there is interest, can tap someone to talk about social media and/or Google Adwords, too.

All ears on any suggestions for the weekend, obviously.

And to be clear…this is free. I would ask that you pick up the costs of whatever materials we end up printing and handing out, but I can’t imagine that will be more than $20.

Who is in? Email me at caleinthekeys@gmail.com to RSVP, eh?

In an effort to regain some momentum, I’m including some email exchanges below that I’ve had with other portfolio managers about spoke funds over the last few months. (Names have been removed to protect the revolutionary, but otherwise I made very little if any edits to the original emails.) I suspect others may have similar questions about setting up a spoke fund. So, here you go.

I also am very delayed in acknowledging Jason Blair, a hard-working value investor who runs Blair Advisers up in New York City. Jason also set up his own spoke fund a while back, officially making him the Second Spoke Fund Manager in The Entire World. Congrats, Jason! Keep us posted on things, eh?

In addition to the below, you can also find out more about spoke funds on my blog here. If you’d like to learn how to build your own spoke fund, you’re welcome to sign up for our email list here, or join the Spoke Fund Managers Group on LinkedIn. You can find that group here.

Now for that Q&A…

Q. Can you comment on what the advantages of starting a “spoke fund” are vs. a mutual or hedge fund? Potential drawbacks?

A. Advantages of a spoke fund compared to a mutual fund would be much lower start-up costs, more flexibility in investment style and strategy, easier administration, more transparency and lower opex. A drawback might be that it’s a direct sales model, so it can be harder to attract assets than, say, when paying an army of brokers to sell your mutual fund for you. I think that’s better for investors, mind you – lower costs, less conflict – but it is unequivocally a different kind of marketing. Think Geico versus State Farm.



Same advantages compared to hedge funds, with the exception of the investing style one…can’t short in a spoke fund, or at least not yet. Not an issue for me, but could be for some. The biggest advantage a spoke fund has over a hedge fund, though, is that you can advertise. I suppose a comparative drawback would be that it’s not nearly as lucrative…at least not in terms of income. But, hey, few things are…and depending on how much you invest in your own fund, it may be a non-issue for you, too. Probably a whole different philosophical discussion in there related to that.

Q. I’m an investment adviser on the other coast (California), and really like your idea of a spoke fund. Do you use Folioinvesting or Folioadvisor? How much do they charge you and your clients? Do you still think this is the best way to set up a spoke fund?

A. Thanks for reaching out. And yes, I use FOLIOfn’s Advisor platform for the spoke fund.

FOLIOfn’s fees start at 0.30% per account and ratchet down at certain breakpoints depending on size of account. And to date, I still think FOLIOfn is the best option. That said, always looking at others, and hope to post more should I find anything real useful. And if you and your clients get a better deal from FOLIOfn than I do, by all means let me know!

Q. How do I start up an investment advisory business like yours? I am essentially trying to set up a partnership fund similar to what Buffet did in his early days. Like yourself, I am planning to put a significant amount of my own savings in the fund (six figures also) but will focus on investing for friends and families only – at least initially. Fund size would likely be less than $1 million.

Also, if I want to plow back my investment management fees into the fund (like Buffett did), do I technically have to flow thru the $$ from the funds to the advisory LLC and back into my partnership? Doing that would require me to sell shares. Is there a more efficient way to increase my ownership stake in the fund from the fees that I earn? My style will be long-term oriented so I do not want to buy and sell securities unless warranted for valuation purposes — and even less so for compensation to myself!

A. On the legal structure thing…does not apply to a spoke fund – at least in the sense that you don’t need to go form another LP. The core of the spoke fund is simply a regular taxable brokerage account in your name, set up on the Folio platform once you’re a registered investment advisor (RIA).

So your investors are not purchasing shares in a mutual fund, nor interests in a partnership…they’re buying shares in the companies themselves that are in the portfolio.

Doing it this way is actually more tax efficient for you and your investors, as opposed to forming a hedge fund as an LP, having to issue K-1s every year, etc. In a spoke fund, you have very granular control over the tax lots in your and your investors accounts (more on this in a bit), and the custodian Folio tracks all taxes, issues 1099s to your investors, etc. You don’t have to lift a finger, and all the tax issues are taken care of for your guys. In that sense, you won’t get taxed until you sell or receive a dividend…just like a normal taxable brokerage account.

On reinvesting your fees…it’s simpler, too. You get paid as often as you want (I do quarterly billing) and fees are automatically deducted from your investors’ accounts by Folio, according to the fee schedule you work out with them and disclose to your clients. Those fees go to your business’ house account, and come in as revenue to the firm, at which point you can pull them out as salary and then just invest them back in the core portfolio through your own personal account that is set up just like another investor’s account would be. So, there is no need to sell more shares or another interest in the partnership…just add profits to your own spoke account and you’re there.

Q. Why did you choose to go with a separately managed account approach instead of launching a registered fund or hedge fund? Clearly the Tarpon Folio gives you a bit of the best of each. Still, you don’t get to share in any of the performance (except through incrementally higher fees).

A. Here’s the long version:

http://www.caleinthekeys.com/2009/05/why-i-built-a-spoke-fund/

Short version…wanted to build a business that I’d actually want to invest in. Mutual funds = broken – for both investors and PMs. Hedge funds = no moat and no marketing combined seemed like poor odds out of the gate, and being on an island certainly wasn’t gonna help me.

Thought about a Buffett style partnership for a long time, but in the end, thought it was unlikely to work out well for me given my circumstances (down here, no prior public track record as PM, not tied into enough HNW circles, etc). Kept chewing on an alternative until I landed here.

Performance fee thing was a nut I couldn’t crack. Law seemed pretty clear that you could only use ‘em with accredited investors. And practically speaking, billing for performance fees was going to be a big pain. Couldn’t scale that part – at least not with FOLIOfn and just me in the shop.

And I basically subsidize smaller accounts. Had a way to service them profitably, but in the end was getting to be too much of a pain. Even if it costs me $100 a year, cheaper than acquiring them some other way. Plus, assets attract assets, ya know?

Irony is that the only way to lower the minimum profitably is to raise your AUM fees, so to let a lot of small accounts come in, you’d have to charge them more. And that doesn’t smell right. But FOLIOfn does fractional shares, so even my waitress friend who wants to invest $1,000 tomorrow can still own a piece of a share of Google at $440, along with pieces of every other company in the portfolio, too. So, the accounts I subsidize end up being a fantastic deal for little guys. Just can’t build a business around them exclusively.

I’m thinking of it all like open source software at this point…put the code out there on the blog and see what happens. Should others find it and run off to create their own spoke funds, awesome. If all it ever does is get people thinking about what a rip most mutual funds are, that’s okay. But if it happens to completely change the face of Wall Street as we know it and spark a global movement of epic proportions that makes the managing of other people’s money a noble and dignified profession again…well, I’m down with that, too.

Q. I’m a value guy RIA – left a bigger boutique firm, moved and hung out my shingle. I went from planning to start a hedge fund w/ family/friends money just in time for the market to crash, everyone to start hating hedge funds, and having 2nd thoughts personally about the fairness of the hedge fund model and my management style’s suitability for that format. Since I am a value, long only, long-term guy why did I have the right to charge hedge fund fees? Not that that has stopped a lot of other folks….

So I was interested in your spoke fund idea. I too looked at the mutual fund structure and agree it is a joke and of course the industry as a whole is a joke. That has long been one of my main motivators in this business, having come into it from a science background 12 yrs ago. Nowhere else does an industry charge so much to destroy so much value. I read your posts on spoke funds, and would be interested in any additional info you have on the structure. It appears that it simply automates trading in all accounts based on trading in the central account? Anything more to it than that? Doesn’t seem so based on your funds’ website. What I really like is the potential to manage small accounts, which was one of my early goals since the small investor is so poorly served. Yet the typical RIA structure just makes small accounts uneconomical. The spoke structure looks to be the answer….

A. Yeah, it’s not much more complicated than you gathered. Don’t know if you know the guys at FolioFn or not, but their advisor platform basically lets you apply separately managed account principles in a scalable way. I just included all my own money in there, put some new process around it, and decided to go direct to the investor with it. Features are by far better. So, stay tuned on the old blog and will keep putting it out there. Been surprised by the reaction so far…and I’ve barely got anything up. Clearly lot of folks thinking about things the same way we are, ya know?

Follow-up Question: I did some poking around FolioFn, so yeah I got the basic rundown. Have not spoken to them though. The biggest question I have is, do you think you can scale it enough?? At 60bp net to you that is a lot of $20k accounts to get critical mass. Let’s just say you want $250k in revs, that’s 42M in AUM or 2100 $20k accts… I agree with your pricing, and I suspect Folio’s cut goes down as AUM grow. I guess Folio handles all the admin, so it is very little add’l work for you for each acct. And everything is electronic so, if you can find enough folks I guess it could work. Best of luck, still not sure it makes sense for me to give it a whirl, but we’ll see.

A. Yep, it’s scalable, but under a couple of different assumptions. First is that I’m good with revs much lower than that. Built it so I can run it all as a one-man shop with virtual assistants and contract help, and about to get a particularly nice deal on office space. Don’t need a big salary, either…most disposable income would go right back into my investment in the fund, anyways. And I’ve already got all the toys I’ll ever need.

Second is that our median account size is higher than $20k, so our overall margin is slightly higher cuz as you guessed Folio’s slice drops off. Would be an interesting study…how many folks I’ve waived our $12K minimum for, only to have them refer a HNW type. The Keys are funny like that. Assets attract assets and what not.

Third is that there will be some heavy spend on sales and marketing in the Keys, which we’re now starting to get into. Lot of local economies of scale I’m finding, which is translating into some solid ROI.

How well we do will be related to our marketing, which almost goes without saying…but I find it odd that the three professions – medicine, law and finance – are each so horrible at doing it. I’m no expert, but I’m getting better. So, game on.

Q. Let me first offer my sincere thanks for offering to share information about how to go about simply doing the portfolio management without getting bogged down with too much outside activities. I do love investing and am passionate about it. I am trying to research how to go about starting an asset management firm. I read lots of thing and came to conclusion that I can go with individual portfolio management style but that also requires doing lots of thing which adds cost for you and ultimately for your clients. I stumbled upon your site and found the articles written by you so far very interesting and although I don’t know how to go about this, if you can share further information it will be really helpful for me.

I saw the post which had “My next post in this series will identify the critical path activities that I think most deserve your initial attention.” I am waiting for the information and if you have it documented I can’t wait to read it even if it’s in raw format. I really appreciate folks like you who are ready to share information with others.

A. Here’s that post!
http://www.caleinthekeys.com/2009/06/building-a-spoke-fund-critical-path-items/

Q. I started following you on Twitter a while ago and really like your approach to your business. I think the Folio approach (hub and spoke fund) is a great way for the retail investor to get all of the positives of a managed portfolio and a manager, with very little of the negatives. I am a retail Financial Advisor and have been in the business for 18 years. Some day (maybe soon) I would really like to be doing what you are doing. I really appreciate the way you have posted all of the steps that you took to set up your business.

It has really been helpful, but I still have a couple of questions. Before you started to manage other people’s money, how did you establish a track record? Do you get your results audited and if so, how and by who? Thanks in advance and keep up the good work!!

A. Thanks for reaching out! Hope to put more out soon on the blog about spoke funds from the portfolio manager’s perspective. In the meantime, fire away with questions anytime.

I’d been an analyst for some time prior to starting my own firm, but I did not have a public track record I could point to being solely responsible for as a portfolio manager. The friends and family who originally invested with us knew of my success in the general sense that came from managing my own family’s money for some time, but I never tried to formalize that.

Professionally, I had buy/sell recommendations I could point to, and annual returns from a small hedge fund I did research for a few jobs back, but they weren’t reflective of just me by any means.

So, I haven’t used anything when it comes to citing a prior record. The question comes up, obviously, but our funds simply won’t have three year track records any earlier than three years. Irony is that I’m finding most people so far don’t care. You’d have to ask them, but I think the fact that my family’s net worth is in the funds I manage might speak to a level of conviction that a track record alone doesn’t address.

That said, had I had a decent public record prior to getting going, we’d probably be ramping assets sooner, but the pace to date is okay with me.

Q. We were not able to locate prospectus for below-mentioned fund on your Internet-homepage. Could you please provide us, by e-mail, with the prospectus and SAI (statement of additional information) of your funds?

We are especially interested in the legal aspects/forms of the funds – e.g. if it’s about Limited Partnerships or Limited Liability Companies. May we kindly ask you to indicate to us (or if available, of course to provide to us) whether there are any subscriptions documents are available when a client/customer wants to invest? Furthermore, we would like to know if the funds contain special liabilities like capital calls or clawback clauses.

A. Different animal. A spoke fund is not a hedge fund. We are basically taking a separately managed accounts approach to managing a single strategy. It’s better for our investors, and easier for me as the portfolio manager to administer. We call the model a “spoke fund.” It’s all invested in listed securities, and there are no capital calls, clawbacks or any other silliness. You own the underlying shares directly in a secure account held by our custodian. I simply manage it from there.

There are no subscription documents, but we do have an investment advisory contract that our investors execute. That agreement among other things grants us approval to set up an account for the investor at our custodian and gives us full discretionary authority over that new account.

The process to invest consists of three steps.

1 – Investor provides basic background info to us, via phone call or online sign-up form. That form can be found by going to the http://www.islainvest.com website and then clicking on the “How to Invest” link in the Quick Links menu at left.

2 – We’ll incorporate that client data into our standard investment advisory agreement, a document that is sent via email for execution by all parties using electronic signatures.

3 – We open a new account for the investor at our custodian, FOLIOfn. Then we’ll provide the investor with instructions on how best to transfer assets into the new account. Once the assets arrive, I’ll invest them in the Tarpon Folio.

We can handle any manner of traditional account (individual, joint, revocable trust, business) and tax-deferred accounts, too, including IRAs.

Q. Two questions. I contacted the FolioFN guys and they told me that each client has to pay $290 a year. It seemed very high to me especially for the clients having very little money. I saw that you had 0.30%, 0.20% and 0.10% deal with them based on total assets under your management. Did you get some promo deal or negotiate?

You are doing fantastic job to educate people and have been inspiration to me to start, which is in the best interest of clients as well. That’s the reason I am trying to dig information. I really appreciate your time and reply.

A. That Folio fee thing sounds odd – are you sure you’re talking to the institutional guys and not the retail folks?

And there is no such thing as a prohibition on publishing performance results that first year – assuming, of course, that your returns as shown from inception through the year-to-date. The regulators distinguish between recommendations and actual performance, and you’d probably want to clarify the rules around the former with counsel. As far as performance, though, while you’ve got to be sure to disclaim everything, that’s all the time, and not just the first year. Believe me, I’ve paid the lawyers enough by now that I’m confident our compliance is solid across the board.

Q. I have read all the info on your site about spoke funds and am still somewhat vague on the details. I see you can buy fractional shares. I am assuming that you have some way of trading these fractional shares, or are they just the percentage the investor owns in the hub set of funds?

Actually, that doesn’t make sense either, since as the hub grows with new investors my share percentage would decrease. Is there some tutorial on how the hub and spoke fund works for each individual investor? I am aware of hub and spoke structures as a way of off-shoring investments, but this seems quite different.

A. Our custodian FOLIOfn allows us to buy “fractional shares.” Everyone is subscribed to the same portfolio weightings (say, 9.0% in Paychex, 5.2% in Google, etc.) and with fractional shares all those percentages can stay exactly the same across everyone’s accounts. Eliminates the problem of, say, only being able to buy whole numbers’ worth of shares for companies like Google that trade at $525+.

There is no impact on your ownership of anything based on new investors coming into the fund – or leaving. When everyone comes in, they are independently subscribed to the most recent portfolio weightings I have established (as opposed to whatever their current market-based weights may be). So, you own shares in the same companies we all hold, in the optimal percentages…as opposed to owning shares in a third party entity, like you would at a mutual fund or hedge fund. Then your returns would be impacted by others’ actions. But, this way it is not.

You can also think of it like this…the spoke fund structure is a way to link all investors, including my family, to the same identical “model” portfolio – only the “model” was funded with real dollars within seconds of being created. So, a change to the core model changes everyone’s account the same way, and at the same time. Fractional shares allow us to own more of the companies we want to in a simple, pragmatic way.

Follow Up Question: Ok, I think I understand. When new money comes in, say $50k or $100k, the investor would get the same percentage weighting as the other investors, it is just that their number of shares would be proportionately greater. Right?

When you buy/sell into the core account, I would assume that would affect all the percentages of all the members individual stocks, including the stock you just sold and bought new, and their fractional shares would change. Do I have that correct?

A. Yes on the first question…percentages stay the same, but shares would be greater.

On the second question, not sure I follow ya, but as I read it, the answer is “Yes, except we minimize meaningless trades.” By that I mean that when I make changes to the core account model, I have thresholds I can set to eliminate small onesy-twosy trades in investors’ accounts whose real-time portfolio weightings already closely resemble the optimal portfolio weightings in the core model.

Say I have a Google weighting of 5.25% in the core model. A month later I want to adjust the core model position in Google from 5.25% to 5.00% and at the same time increase CarMax from 5.0% to 6.0%. So, I can tell the system to (1) only sell Google shares in an individual account if the real-time weighting in that account is more than, say, 0.25% different than the new weighting in the core account, and then (2) don’t do anything if an investors’ individual account is already within 0.15% of the new 6.0% core model weighting in CarMax – which could happen based on when the investor came on board and initially bought CarMax, as compared to the core account.

Ton of criteria I can use, but the point is that I set them up to try and minimize redundant and/or silly trades. Not perfect, but still pretty good…and much better than a mutual or hedge fund.

This part help explain that second question, too, at least as I read it originally. Otherwise, might just be FYI stuff:

All buys and sells are done either in the open market, or within FOLIOfn’s internal clearinghouse, after it looks for better pricing among all institutional clients. Here is an example:

Say I want to buy shares of GE in the portfolio. So, I make GE a 5% position in the core “model”, and tell the system to automatically execute the orders in everyone’s account to bring each individual’s account in line with that 5% position in GE as well.

If I decide to buy those shares during one of two “windows” during each day that FOLIOfn offers, then we can buy those shares without paying a commission. (I have always used “window trades” to date). During those windows, FOLIOfn matches up all my clients’ buy orders for GE, and sees how many other institutions on its platform are selling GE during the same window. Then it compares the pricing on those internal-to-FOLIOfn-shares to ones it can get on the open market. We get the shares that are the better deal for us…meaning the cheaper ones, obviously…and every account buys those shares at the exact same price. (That’s another reason for fractional shares…so everyone gets the same pricing and there is no post-trade allocation).

So, I make a change during a window, FOLIOfn finds us the best pricing either internally or on the open market, then everyone’s accounts automatically update to reflect that change – within pre-determined tolerances that are meant to minimize small, meaningless trades among individual accounts.

Second Follow Up Question. Thanks for the prompt replies. Here is how I think I understand: There is a large core account that is composed of your and your family’s money. This money is invested across a diversity of individual stocks. As a new investor sends in money, a spoke account is created where their money resides and is invested in the same stocks at the same percentages as the core account. When you want to make a change in the core account – e.g. reduce one position in order to increase another position or even to take a new position to add to the core – something automatic happens and all the spoke accounts get adjusted proportionately and the stock change happens everywhere. Since all spoke accounts are fully invested (probably as the core account is) to take a new position would pretty much always require reducing another position(s) to pay for the new one. Then everything happens automatically in the core and all spoke accounts. OK so far?

Now, the next question. Suppose I need money out of my account at some point. Do you sell off across all positions to keep the percentages the same so as not to unbalance everything between the core and the spoke? This seems like the complicated part.

A. Yep, think you got it there. And on the withdrawing money part…yes, I will sell off across all positions to keep the percentages the same. There is also a little wiggle room in the cash that is held outside the portfolio. So, withdrawals have not been an issue between both…can raise cash and/or take requested funds out pretty easily, and without disrupting anything between that account and the core account.

Q. Cale – Thanks for the info on this blog and congratulations on Gecko and Tarpon results. I am considering starting a spoke fund in Texas and have a few questions for you.

4) Are there other required/necessary documents to run a spoke fund beyond those provided by RIA in a Box?

A. Good questions. In quick order, then…

1. On the FOLIOfn platform, a spoke fund is a model portfolio that is synced to the manager’s account quite literally within seconds of creating the model. That way there is no difference between the model and the manager’s account in terms of cost basis, future tweaks, fees, performance measurement, etc. In my case, that account is in my name, and though you’d want to verify the tax effects, there is no reason it couldn’t be in your company’s name. So that “hub” concept probably won’t resonate with FOLIOfn reps yet (working on it!), but it doesn’t need to, either, for you to set things up the way you want.

That said, been kicking the tires on setting up a spoke fund using Interactive Brokers lately, and in that case, it appears the hub there would actually be an account. No real difference from either my or the investors side there than at the FOLIOfn back-end, but my interest was piqued due to lower costs….IB costs appear lower on more accounts. Couple of other things need to be checked out over there, and some IB features are not as user friendly for investors, but I hope to summarize and pass on info at some point.

2. Yes, all fees apply to the manager’s account(s) as well. I charge myself the same thing I charge all my investors. Right thing to do.

3. Registration requirements are very much state-to-state. A good rule of thumb is that once you have more than five investors from one specific state, you’ll need to register there as well. Doesn’t work for all states, though. Practically speaking, that may mean you only take on bigger accounts from out-of-state to more quickly recoup the costs of registration there. RIA in a Box can definitely help register wherever you need.

4. RIA in a Box can also help with all the regulatory and compliance documents you will need to get up and going. (They should be paying me for these plugs!). Highly recommend them.

I’ve also used lawyer Todd Schwartz (just started his own firm, Schwartz Law Group) for help on things that I needed definitive answers from a lawyer on, as well…the content of ads, disclaimers, reviewing online materials and a handful of other one-off things basically related to the marketing of spoke funds.

That said, there are plenty of other documents, spreadsheets, and/or process-related things you’ll need to actually run a fund. I consider all that to be “Operations Manual” material, and while some of that will be specific to your business, there is quite a bit that all spoke fund managers using FOLIOfn, for instance, will have in common. Not quite ready to post my manual online yet, but suppose I could be convinced to some day.

In any case, that’s exactly the sort of thing that makes me think I should have some kind of informal get-together with guys like yourself here in the Keys at some point this spring. Think folks could get a crash course in all of this without having to wait for me and/or my Operations Manual. Love talking about all this, but also gotta keep my primary job front and center. Blowing it all out in a weekend would probably be much more efficient for everyone.

Q. I was really excited to read your blog on “building a spoke fund” as I had been researching the ins and outs of starting my own hedge/mutual fund. I’ve read and reread your blog and have been on your site for your fund and was really impressed with what you put together. I know you must be very busy but was wondering if you could answer some questions or point me in the right direction to get the answers I need.

Thanks in advance for your response.

A. In short order…

1. Easiest way to answer that first question is here:

http://www.caleinthekeys.com/2009/05/why-i-built-a-spoke-fund/

2. Still looking for a good (read “competent and cheap”) auditor. Trying to find an auditor in South Florida – ground zero of what seems like Ponzi scheme central – has been challenging to say the least. The local firms I’ve talked to are saying they’d have to go get additional insurance, which puts the costs way too high. It’s not like I trade much, so verifying returns thru a bigger firm up north simply won’t take that long…but they want to charge like it does. In any case, my next call about this will be to a firm in Chicago that comes well-recommended.

In the end, though, I may just post all statements, tax forms, and trade confirms online on the blog or something, so anyone can verify things all by themselves. I suppose an audit would be quicker and have the patina of a third party endorsement…but if the purpose of an audit is transparency and verification, it sure seems like posting all statements online would do the same thing.

An audit isn’t as much of an issue in a spoke fund as a hedge fund in any case, because each investor can log-on anytime, day or night, to see their funds and returns. But I recognize I’ll need to do it at some point, anyways, though the cheapskate in me cringes.

If you’re aware of any good auditors, though, I’m all ears.

3. Boy, I’d like to write an ebook. A year ago I thought I’d have it done by now…but the reality is I’ve barely started. Hope to fix that before too long.

4. FOLIOfn will let you go long any listed domestic stock. So anything other than plain vanilla investing wouldn’t work on FOLIOfn. That said, I’ve been kicking the tires on Interactive Brokers a bit, and that may give us more options. Stay tuned.

5. There’s the business breakeven, and the account breakeven. Both can vary a bit based on the variables involved, and I need to get more in the weeds on this for everyone, but in general, given all my variables, I will be fat, dumb and happy at $20M in assets. We’re at about $7M right now, after a little over a year, so I’m confident my girth will be increasing.

Q. Thanks again for giving up some of your time to help a young aspiring spoke fund manager. Almost done studying for the Series 65, although I had to take a small break due to some training (I’m active duty military right now).

Once again, thanks for all the help. If I bug you too much with these questions (I’m sure I’ll have many more), let me know. Thanks man.

A. Here are some rough numbers as I think they might apply for you, based on reviewing my own firm’s financials at the end of the year:

Advertising = I spent almost exactly $10k in 2009. This will go up in year two…but I should also get a better return on that money, too. Lot of local advertising lessons learned last year.

Legal fees = I paid out a little over $8K – but will be about $500 total in 2010, I’d say. I spent what felt like a ton of money on lawyers and compliance guys on things specific to spoke fund model and compliance set-up (i.e. mock compliance audit, etc). So, one-time in nature…and if I can communicate things well enough, you won’t need to spend that money, either.

Office expenses = About $5k…but also includes a ton of one time things So, again, lot lower in 2010.

Stationary & printing = about $1500. Probably will go up 50% this year.

Research = Call it $5,000. (I spent twice that in year one but will halve that the next year). Then will be static…costs of a ton of different subscriptions.

Phone, IT & Internet = $2500 (includes webhosting, cell, office, and handful one-time set-up fees).

Figure about $2000 in licenses, travel, client meals, civic group dues, etc.

So, as a baseline, around $25,000 in opex is probably a reasonable bogey for a first year, truly from scratch spoke fund (i.e. no pre-existing clients) – and assuming you advertise as heavily as the above, and pay up to read everything you can get your hands on. You could run it very light at $10K a year if you come with client relationships already in place, work from home with the office gear and get selective on research.

Don’t really need an office that first year if you’ve got coffee shops/restaurants nearby…but after about a year people will start to look at you funny if you’re still working out of the home. I jumped a little early cuz I got a great deal on an office lease. And I would pay up for a good web site, logo, and presentation folders (in “stationary” above)…skimping there shows.

Also, cash starts kicking in the first quarter you get a client, so it’s not all necessarily coming out of pocket. Probably best to plan like it could be, though. You’ll also note the above assumes no salary in year one, and though that will change in year two over here, I leave that particular line item up to you.

Q. I’ve read your articles about spoke funds and really enjoyed the article about the 4 critical path items to building a spoke fund. Is a spoke fund only available through 1 broker (i.e. Foliofn)? And can you show me some additional funds that follow the spoke fund model?

A. FOLIOfn is my primary custodian, but I am also looking at Interactive Brokers, too, which appears to have similar technology. Neither calls their solutions “spoke funds”…I basically made that term up, but the functionality exists at both places.

There are a zillion separately managed accounts out there, but only mine and one other managed by Blair Advisers up in NYC that are “spoke funds” per se – at least that I know of so far. Hope to compile a list as more get launched.

Also – hoping to have a get-together for spoke fund managers here in the Florida Keys before too long. Will announce something on the blog soon!

Any other questions? Post ‘em in the comments section!

I’ve had a lot of fun and continue to enjoy myself. We expand our circle of competence – slowly. We hopefully get better and wiser and don’t make the same mistake twice. After about 30 years I’ve made my fair share of mistakes.

I have a trick I use: I put all of my family’s money into the fund.

I’m using every device I know of to make sure we maintain a level playing field and put ourselves in the shoes of our shareholders. The only way to do that is to become as large a shareholder as possible.

Amen. But it’s only a “trick” in mutual fund world. Otherwise, it’s a spoke fund, knowhatImean?

Here’s the whole interview. H/t @ManualofIdeas.

Q. Do the returns I see in your Tarpon Folio ads exactly mirror the performance of all your investors’ accounts?

A. Great question I’ve gotten lately from potential investors and other portfolio managers considering launching spoke funds of their own.

The answer is “no.” Here’s why, in several parts.

First, for investors: rarely will your own returns match the advertised historical returns of any fund you may see. Ours are no different. (Thus, the disclaimers.) Many variables explain the difference, some of which are specific to spoke funds. More on those below if you’re interested.

With regards to future performance, please understand that we will likely never see another period where the portfolio increases as much over a nine month period as it has since launching Tarpon. My goal when I launched Tarpon was for everyone to earn 15% a year. Then, in five years, we’d double our money. That remains my goal today. We have taken advantage of some truly exceptional circumstances lately, but it will likely be years before we ever see so many compelling values spread so widely across the market again.

So, to be clear, our returns over the next few years will not look like those of the previous few months. That won’t be for a lack of effort on my part, mind you. I still expect to outperform as much as is safely possible over the long term. But those are just the odds. Quality companies are simply no longer as dirt cheap as they had been, and the price we pay for them determines our ultimate returns.

The next part of this answer gets a little wonky. While it’s probably geared more for other spoke fund managers, I’ll include it here, too, for any investors who care to read more.

The question brings up a couple of other important points regarding differences between investors’ returns and those you see in our ads. The first, again, is that performance figures are historical snapshots, not future guarantees, as most investors realize thanks to the disclaimers in the ad and/or common sense. In the case of Tarpon, those advertised returns are also the actual, post-commissions-and-fees, pre-tax returns for a $12,000 portfolio of my own money outside of my family’s other investments in Tarpon, set up specifically to report performance. Our performance is presented using a simple holding period return for now, as I believe it’s the most objective during this first year. (I’ll talk more about geometric averages down the road). Currently, at the end of every month, I record the value of that tracking account, divide it by the $12,000 minimum required investment we started with in the tracking account, subtract 1 and, walla, that’s our return since inception as a percentage.

FOLIOfn computes performance differently, however, as you may have noticed when checking your account. FOLIOfn relies on the same method of calculating returns that mutual funds do – the “modified Dietz” formula. Tarpon’s returns calculated using modified Dietz have been at times considerably higher than the returns I publish, but that’s okay by me because (1) conservative numbers are a good thing and (2) I’d rather our returns reflect the logic of my calculator than the accounting logic of massive portfolios.

The other reason your returns may differ from what is advertised in the local papers and our website is because of what’s called “drift.” Because investors come onboard at different times, each of you are buying shares of Tarpon companies at different prices. The number of shares of each individual company that you own in your account will differ from the number of shares of each company owned in the tracking account, too. That’s because I buy stocks in your account according to a percentage-based portfolio weighting that I control for Tarpon through the FOLIOfn back end. So, any differences between your account’s performance and the Tarpon tracking account are most easily explained by (a) when you invest and (b) the number of shares you are initially buying of each individual company, according to a portfolio weighting formula that I determine.

To date, the “drift” or difference in performance between each account in the spoke fund and the Tarpon tracking account has not been large enough to be a concern to me. Some drift is to be expected given the huge swings in the market over the last year, which further amplify the impact of the variables above. More to the point, though – I’ve rebalanced Tarpon’s portfolio weightings twice since launching the fund nine months ago. Those rebalances have the effect of bringing that drift close to zero for all investors. I do not currently have nor do I plan to create a rigid rebalancing schedule, but I suspect once or twice a year will probably be a reasonable average looking ahead.

Another key point about those numbers: on the day you invest with us, you buy shares in all companies as determined by the most recent portfolio weightings I have loaded into FOLIOfn – not the current weightings of the fund itself as measured by the Tarpon tracking account. That initial “sync” will create some future drift between your results and the tracking account from that day forward, but it is intentional. I do it because (1) that drift will be negated during the next rebalance, and (2) even then that initial drift is still still in your best interest. Otherwise, on the day you invest, you’d effectively be buying shares in those companies that have already gone up the most in price. And that’s just, well, dumb. I want you buying more shares of the most undervalued companies, all things being equal.

That last point hints at yet another reason why I believe the spoke fund model is superior to the mutual fund model; because I as the portfolio manager can invest your money in accordance with the portfolio weightings that I want you to have. Mutual fund managers cannot make that first day tweak. The day you invest in a mutual fund, you are effectively buying more of the shares that have already gone up the most. Add that in with the other strikes against the mutual fund model, and it becomes even harder for your money to outperform – even at the hands of the most talented mutual fund managers in the world.

In summary, then – no, your returns will not exactly match those presented in our marketing material, particularly in volatile markets. But they should be close enough. When investing in spoke funds, also realize that a small degree of occasional “drift” is the trade-off for incrementally better long-term returns.

So take all fund performance ads with a grain of salt. They should be viewed only as a historical measure of portfolio management skill. In fact, a statistician will tell you that track records are effectively useless at predicting future performance until a fund manager has at least a 25 year history. I would say that I’ll be on the beach long before then except, well, I already am.

If you have any questions, by all means please let me know.

On taxes paid by investors in mutual funds:

I was struck as an investor as much as an academic by how unfair the process is, especially for middle-class people. We’ve set up a system that punishes people who can’t afford to invest in hedge funds.

The article continued:

Mr. Coates said the U.S. mutual-fund industry is hampered by tough restrictions imposed by the Investment Company Act [of 1940] that make the industry dependent on the Investment Management Division of the SEC for growth and innovation. The SEC division hasn’t kept pace with the growth of the fund industry, Mr. Coates said.

Long live spoke funds.

My apologies for the delay in posting these. I’ve been amazed at the feedback I’ve gotten on the first few posts. That said, our portfolios and our investors are my priority, for obvious reasons. Fortunately the new Keurig is here, so the sandman can wait.

The questions I’ve gotten have made me realize that I owe you all more – more answers, more details and more philosophy.

More Answers

I created this email list to more efficiently answer questions – the specific, detailed kind that 95% of the readers of this blog may find too wonkish, but that may make a difference when starting your spoke fund. Please sign up for the wonky stuff.

Along the same lines, if you’re on LinkedIn, I created a Spoke Fund Managers group. Join by clicking here. It may prove useful in helping you get things done without waiting for me to respond. If you’re not on LinkedIn, give it a whirl. It’s like Facebook without the stalkers.

More Details

Give me a few months and I’ll put together the definitive guide to starting a spoke fund. Seems like the perfect topic for an ebook. There will be some overlap between this blog and the ebook, but in general I’ll be able to get more into the details you’re asking for in the ebook…without making the investors who read this blog go narcoleptic.

More Philosophy

Posting more thoughts on my own philosophy behind building a spoke fund should help you identify the ways you’d like to build yours differently. In a nutshell – I already live in paradise, own the home I’m going to die in and have a couple of good fishing rods. At this point in my life I’m more concerned with helping to make the managing of other people’s money a noble profession again than I am with buying more toys.

You may be in a different place in your own life. If you need to charge fees higher than I do to get there, or set higher account minimums, so be it. I’m viewing this exercise as something like open source software: put the basic code out there and let a bunch of smart people run with it on their own. So, go nuts – and let’s each agree to try to make it easier for the next guy or gal who comes along.

Now, if you want to make a ton of money relatively quickly as a portfolio manager, there is no denying that you may be better off starting a hedge fund. Just realize that any business that has no barriers to entry and is prohibited from advertising could be a very hard one for all but a fortunate few.

Bottom line: look for a “spoke fund manifesto” sometime soon.

Now, on with it.

Critical Path

The first thing you’ll need to do before setting up your spoke fund is to set up your company. More specifically, you’ll need to decide what structure you want your firm to have.

That question may be one you want to bounce off some folks. Google searches seemed a bit lacking in real insight on this decision to me, so after talking to individuals in several different professional services firms and a few accountant friends, I decided to form Islamorada Investment Management as a limited liability partnership.

I chose the LLP structure because I wanted the firm to serve as a retirement plan of sorts. My thinking was that I’d grow the business, eventually bring on (or grow our own) partners, and then should I ever decide I wanted to go flats fishing every day, I could still receive distributions from the partnership long after I left.

There are plenty of good reasons to pick a different structure, however, and an LLC might make more sense for you. This brings me to…

Critical Path Item #1:

Find a good local accountant or CPA firm to help you set up your company.

You could take a do-it-yourself approach to setting up. It’s easy enough to get an EIN from the IRS. But if you don’t know what you don’t know, it’s easy to miss something important. The opportunity cost of doing many of these start-up tasks yourself is also pretty high. It’s time you’re not spending doing the research you need to on the companies that will be in your fund. In the case of finding an accountant, it also means missing an opportunity to make what could prove to be some pretty important local connections.

I’d look for these three criteria in an accountant:

1 – Expertise with QuickBooks.
2 – The ability to verify the returns of your spoke fund.
3 – The potential to refer clients your way.

Ask your accountant about which might be the best form of business given your own long-term plans. Make sure they explain to you the tax effects of being self-employed, as well as what will be required by your state. And ask about local businesses licenses or any permits you might need if you plan to work out of your house.

On a month-to-month basis, your need for an accountant’s services will likely be minimal. Businesses don’t get much simpler from an accounting standpoint than investment management firms. But when you really need an accountant, it will have paid to put some time into this relationship early on.

Critical Path Item #2:

Get the RIA ball rolling.

Becoming a Registered Investment Advisor is critical to the spoke fund business model. Among other things, it demonstrates to your clients that you are an independent fiduciary, or a protector of their wealth, not another Wall Street hustler. More practically speaking, you also need to be an RIA to get access to the FolioFN Advisor platform that will enable you to efficiently manage your spoke fund. Same for any of the other platforms that are anywhere near FolioFN’s.

As in Step 1, you technically could take a do-it-yourself approach here, but I would strongly advise against this. Why? In a word – compliance. If you’re starting out as a one-person shop, you will be the de facto Chief Compliance Officer, and that carries some heavy legal responsibilities. If you’re new to that role, like I was, you’ll need help in understanding what role will require of you every day.

My recommendation is to outsource the process of getting set up as an RIA. More specifically, contact Zachary Gronich at RIA in a Box. I used Zachary to start up and recommend him strongly. RIA in a Box is a one stop shop. They’re quick, accurate and relatively inexpensive. They’ve also set up over 650 RIAs nationwide, both at the state and SEC level. Here is their latest fee schedule, as well as the list of services they provide.

As Zachary will explain to you, if you’re not already a CFP or CFA charterholder, you’ll need to take the Series 65 test, too, prior to him filing your RIA application. I bought this book from Kaplan, studied hard for a week and passed the 65 with no problems. Don’t take it lightly – it contains a lot of pretty specific material. Compared to the CFA tests, though, the 65 is a breeze.

The process of becoming an RIA could take a few months, so I’d start immediately after you’ve set up your company. The next two steps are important, but won’t take nearly as long to do. If you’re done with both by the time your RIA application is approved, you’ll be ahead of the game.

Also, if you need any ideas about how to answer some of the questions Zachary asks for your application, you can reference my own firm’s Form ADV here, or post a question in the comments section. We’ll cover how to determine your fee schedule later here, too.

Critical Path Item #3:

Pick your technologies.

This could easily be a 3,000 word post all by itself, but in the spirit of Twitter, here are my recommendations in 140 characters or less.

Get a Mac. Use MS Office on it. Get VMWare Fusion if you need Windows. Use Mozy for backups. Use Gmail for emails. Get an iPhone. Firefox!

I run my firm using a MacBook Pro laptop and an iPhone. In order to scale as much as possible without having to hire employees, I use a handful of different tech tools. I confess I am a mild tech geek. I spent a few years in telecom, know a little HTML and like shiny things that beep. That said, I have plenty more to learn. I’ll talk more about software tools later, but for now, you need the basics to get set up.

If you’ve never used a Mac before, consider making the switch. But be warned. You’ll never want to return to PC-land. If there are programs you absolutely need to have, and they’re only available in Windows versions, get VMWare’s Fusion program and you’re covered. (Note: Apple’s Boot Camp program lets you switch between the two Operating Systems, too, but you’ve got to reboot to do it. Fusion lets you switch without rebooting.)

Back-ups are critical to meet your compliance requirements, and you need to start backing up emails (all of them, and I underscore all) from day one. The easiest/cheapest tool I found was Mozy. No-brainer.

Also, I use QuickBooks Online. Same functionality as regular QuickBooks, but it’s all hosted online so you don’t have to mess with updates, downloads, encryption keys, etc. Everything is done in your browser. I recommend getting that early in your set up process, too, if for no other reason than to start recording your expenses.

Plus, with the online version of QuickBooks, should I ever want to outsource our invoicing or data entry, it’s easy to enable remote access by a third party – so I don’t have to bring my machine to them, or vice versa. It’s also easy for the accountants to take a peak whenever I call in with a question. And thanks to the QuickBooks online app on the iPhone, I’ve got one-touch access to all of my firm’s financial reports, anytime.

How did people ever get anything done before the internet?

Critical Path Item #4:

Get chromed up.

You’ll need a logo, letterhead, business cards, and a website at a minimum. Eventually you may want envelopes, brochures, and folders, but you’ve got some time for those.

Please note that your logo, website and general corporate identity are much more important than the abbreviated list below might otherwise indicate. Marketers will tell you your brand is everything, and while that may be true, it’s also organic, meaning you probably can’t define it yourself by just picking a certain color. Take some time and think hard here about what you’re trying to convey. I’d give yourself a defined number of days to learn, doodle, and bang your head against the wall – and then get on with it. You’re after “good” right now. You can make it “perfect” later.

On the logo and business cards – we eventually had both done through a designer we found through Crowdspring.com and I couldn’t have been happier. Crowdspring takes a novel approach in that you post your thoughts on what you want, and then designers from all over submit actual logos based on your input. You keep giving feedback on each design until a winner emerges.

Crowdspring guarantees you’ll get at least 25 responses to your project, and we ended up getting quite a few more. The logo we eventually chose was actually designed by an artist in Serbia. Needless to say we probably would never have otherwise crossed paths. Best part is you pick the price, and for what we would have paid to have two designers give us four concepts and two revisions at Logoworks, we had about 35 sets of eyeballs on our idea, each giving us unlimited revisions. Brilliant.

Before we get to web design, I’d recommend you pick your own domain name first. And to make reserving your domain name as easy as possible, I’d recommend picking your own webhost first.

The webhost is the company that keeps your website files on their server for all the world to access. Most good webhosts will let you search for domain names and reserve them through their sites, which will save you the hassle of reserving a domain name at NSI or GoDaddy, but then trying to transfer those names over later when you discover you need more features (or better customer service) later on.

There is no shortcut to finding a domain name that works, however. If not through your webhost, you can always search for names that are available at the NSI site and buy them elsewhere. Brainstorm, check if available, then repeat until you’re happy.

Whole treatises can be written on choosing a domain name, but in general, I’d say keep it a dot com (as opposed to .net, .org, .us, etc.) and go for something as short and memorable as possible. Domain names are cheap, so grab a couple if you need to hedge your bets.

We host both our firm’s site and this blog on Hostway, which appears to be having a 50% off sale as I type. Another friend recommended Media Temple, and there are certainly plenty of other good hosts around. Assuming you’re not going to get too crazy with your site’s features, just about any basic starter package should do. (Note: If you choose to follow the tip below about using WordPress for your website, you will want to make sure your webhost meets these requirements.)

Picking a website designer is more challenging. On the do-it-yourself front, you can pick a cheap template (Google “HTML Templates), find a free web editor (like Kompozer for the Mac), and dive in. I went the ultra-cheap route for our website our first six months, creating a simple one page site with links to various files and an embedded movie I created right in the middle of that single page. Eventually, though, you’ll need to upscale your website, and I suspect you’ll accelerate how quickly you add assets by doing it sooner rather than later.

Crowdspring offers a website design service, too, and it’s probably worth considering. I wanted our firm’s site to be done locally in the Keys, though, and after a false start going to a friend-of-a-friend who couldn’t get it done, we went with the fine folks at FloridaKeys.com. This blog was done by another firm, Moxie Design. I can also personally vouch for the good work done by Outcome Labs.

Everybody (and I mean everybody) knows somebody “who does websites,” but it’s helpful to have a framework to think about what you want in your site before you go too far down any of those paths. Here are a few links from folks much smarter than I about all this:

The Do’s and Don’ts of Website Design
The First Question Every Website Designer Must Ask
How To Create A Good Enough Website
How To Create A Great Website
WebPagesThatSuck.com

One other tip: it’s worth considering using WordPress for your website. It’s a free open source publishing and content management system that originally started out as a blogging platform, but it’s advanced to the stage now where terrific sites are being built on it. Had I known back when I started up what I know now about WordPress (which is used on this blog), I might have used a WordPress template for our firm’s main site. To find a WordPress template, check out this section of the WordPress site or Google “wordpress themes” and start clicking.

At this stage, I’d focus on finding the right look and feel, and plan on writing the content (text) yourself. It’s a great exercise in articulating your business to others, too.

Once you’ve gotten each of the tasks above started, you’ll have plenty of time to come back and think deep thoughts about the strategic parts of your business as progress on those critical items continues in the background.

More on that, coming up.

Questions?

I’ll be posting the next installment in the How to Build a Spoke Fund series here on the blog tomorrow. The email list will be a more efficient way to answer all the questions I’ve been getting. Plus, I’m sensing that some of you could care less about the fish I catch. For shame…

But keep those questions coming! caleinthekeys@gmail.com

A Caveat

When it comes to building a spoke fund, I am assuming you already have the magic rocks necessary to be a good portfolio manager. It entails some hefty responsibilities, including a fiduciary duty. There is also a huge difference between being a good portfolio manager and running a business that is good at portfolio management. I’ll be focused on the latter here.

Learn From My Mistakes

I’m a value investor. Among other things, that means I can be pretty stingy. I’m so cheap that I once drilled a hole in a nickel so I wouldn’t have to pay six cents for a washer. My car is so old that I keep losing my wife on left turns. And when it came to starting my firm and my spoke funds, I instinctively took a do-it-myself approach, simply to save cash. At times, however, that approach ended up costing me more.

In an effort to spare you that trouble, I will be recommending you outsource certain tasks on day one. If another expert can do a project better and cheaper than you can, offload it. You’ll be extremely busy the first few months. The tasks you should outsource may not be the same as the ones I recommend, however. To be able to decide what to keep on your plate and what you should hand off, you’ll need to figure out your effective hourly rate.

The Outsourcing Number

I guesstimated my time during start-up mode was worth $27 an hour. How? Finger in the air, really. I knew Warren Buffett’s annual salary was $100,000 a year and decided that it was bad juju to assume I should be paid more than The Oracle. I also figured there wouldn’t be any vacations that first year and that I’d be working 70 hours a week. So:

$100,000 / 52 weeks / 70 hours a week = $27 an hour

There’s a little more to the actual formula, but I ignored self-employment tax. And to be clear – your fees as a spoke fund manager are based on assets, not hours, so consider that number a hurdle, not a measure of value added. In the end, the rate itself will be less important than having a rule of thumb for deciding what to outsource and a hyper-awareness of opportunity costs.

Using that rate, I could then tell the cost to the company if it took me ten hours to format our monthly newsletter – at least $270. If Gecko Graphics can do the same job in six hours for $25 per hour, I’d effectively save $120 by outsourcing it. Even more valuable, however, is that I’ve saved myself time I can then spend working on more important projects.

Simple concept, but a powerful one. I’m hopeful that if nothing else this blog can help reduce your hours per week as you launch your spoke fund. If we can get you down to 40 hours per week, your effective hourly rate will be $48 in the above and you’d save that much more time and money by selectively outsourcing.

Were I an investment banker, I do believe that would also mean I would then have created $21 of value per hour for you, right out of thin air. Paypal accepted.

Last Chance to Back Out

As I mentioned here, I choose to start a spoke fund versus a mutual fund and/or hedge fund after considering each option for some time. If you want more info on how to start a mutual fund, the best guide I found was Melinda Gerber’s first book. If you want to start a hedge fund, I’d highly recommend you see Joe Ponzio’s recent summary on FWallStreet.

Now, on to some initial thoughts.
 
How to Think About Building a Spoke Fund:

1 – Destroy the dream.  Many new portfolio managers dream that putting up great numbers is all it takes to bring investors to the doorstep in droves. Banish the thought. You need to love the business more than the dream if you’re going to make it work. 
 
2 - Think like a billionaire, work like an immigrant. Launching a spoke fund means building a firm, not just picking stocks. When it comes to the business, focus on process and systems. When selecting stocks for your fund, work like Rocky in that barn in Russia.
 
3 – Get comfy in the long tail. Starting a spoke fund means you’re a volunteer outlier. There simply aren’t many around yet. You’ll get no shortage of questions, and some folks may throw darts at your newfangled model. Ignore them. Your clients are all that matters.
 
4 – Find a brain trust. If you’re lucky enough to have a mentor, latch on like a tick in the tall grass. Otherwise, consider finding a business coach or putting together an informal advisory board. You’ll need those other voices in your ear as well as the occasional kick in your pants. Emphasize sales and marketing experience when choosing your advisers above all else.
 
5 - Plan like it was D-Day. Fund yourself. Have enough money in the bank to survive a nuclear winter before you start. Think about what you’ll sacrifice to make the business work. And though I think it probably goes without saying for this crowd – focus first on cash flow, then profitability.

6 – Obsess about the critical path. To launch your spoke fund as quickly and as smoothly as possible, you’ll have to juggle many tasks in parallel. I’ll give you my thoughts on the sequence of tasks that determines the shortest possible time to get you to launch.

7 - Become a registered investment adviser. No cute headlines here. Being a fiduciary is unlike any other role on Wall Street. It’s also essential to the spoke fund model. I’ll post more on how to accelerate this process soon (hint: we’re going to outsource it), along with some thoughts on NAPFA.
 
8 – Master the Folio platform. Three things are essential to the mechanics of spoke funds from the manager’s perspective: basket trading, one click syncing and cost control. FolioFN is light years ahead of everyone else. We’ll spend a lot of time going over the Folio back-end.

9 – Stay lean. Technology will be another huge help in keeping your costs low and productivity high. I’ll tell you more about every tool I can think of when we get to this point – from desktop software to electronic signatures to CRM tools.

10 – Think local. As an analyst, I used to think the power of local economies of scale were among the most underrated advantages in business. As the owner of a small business, I’m now convinced they’re even more valuable.

11 – Your weakness is better than their weakness. Sales and marketing will be by far your biggest challenge when it comes to growing any fund. That represents an opportunity for the spoke fund manager, though, for three reasons. First, unlike a hedge fund, you can advertise your spoke fund. Second, your business will have a ridiculously low breakeven point compared to the average mutual fund company – which means you can successfully market directly to investors in places where mutual funds won’t go. Finally, while brokers and mutual fund companies are good at filling investor demand, you, my friend, can create it – assuming you’ve got those magic rocks.

12 – Yours is a superior product. I believe the features of spoke funds are unequivocally superior for investors when compared to both mutual funds and hedge funds. All things being equal, it’s far easier to market a remarkable product like a spoke fund then to put whipped cream on the cow chip that is yet another mutual fund. And now more than ever, people are exhausted from having being fed so many cow chips by Wall Street. So your timing and product couldn’t be better.

My next post in this series will identify the critical path activities that I think most deserve your initial attention.

And if you decide to start a spoke fund, please let me know in the comments section, this form or via email. I’ll plug you and your firm here on CaleInTheKeys, help you as best I can on Twitter, and eventually highlight all new spoke fund managers on SpokeFunds.com. There is probably a lot we could do with that site in particular, but I’ll need your help in figuring out exactly what that should be.

For now, let’s get ready to go to work.

Portfolio managers: join our email list here for more about how to build a spoke fund.

I wanted to build a firm that was independent of Wall Street, so I could manage my new portfolio as I knew it should be done. I also wanted to invest my own family’s wealth in the fund to grow it as much as possible over the years. That meant saving money on fees, taxes and commissions.

I wasn’t interested in trying to be all things to everyone. My strengths were in value investing, or selecting a handful of good undervalued companies and owning them long-term. I wanted my friends and clients to be able to invest the same way, too, right alongside me.

I decided I needed a way to consolidate all of my family’s brokerage and retirement accounts under one roof, and then manage them all as if they were a single portfolio. Each account owned the same stocks, after all. If I could group all those accounts together and invest them the same way, I’d save money on fees and reduce the time spent managing each individual account.

Then I could easily bring friends and other investors onboard, too, since they would also benefit from lower fees and the additional time I could put into research when easily managing all accounts as a single portfolio.

Unfortunately, there was no obvious way to build the kind of fund I needed. I talked to brokerages, fund managers, financial planners, analysts and lawyers. Most would say the same thing – that I should start a mutual fund or hedge fund. But I considered those lousy options.

The mutual fund model as we know it today originated in the 1920′s. That model is broken.

The vast majority of mutual funds chronically underperform, charge fees that are too high, own too many stocks and trade too much. Mutual funds force taxes onto their investors, make their fund managers inaccessible and spend investors’ money as if it were their own. The majority of mutual fund managers do not own a single share in the funds that they manage.

Not that those managers are entirely to blame. Mutual funds are a very highly regulated product. Those rules directly impact the performance of the majority of mutual funds, dictating everything from how many shares of a company can be owned to the number of companies the fund can invest in. While investors need to be protected, the mutual fund industry has abandoned its fiduciary duty.

I’m also way too cheap to spend $400K a year in operating expenses just to get a mutual fund off the ground.

Hedge funds have a better model, although it still has flaws.

Most investors in hedge funds pay exorbitant fees. They also have zero daily transparency into where their money is invested, and why. As recent headlines have illustrated, these funds also have effectively no oversight.

While there are few barriers to starting a hedge fund, running one of these funds still has its difficulties. Hedge funds cannot advertise, for instance, yet they can only service a certain group of investors. As a result, managers spend considerable energy trying to find new investors.

I just wanted to buy amazing businesses. Plus, I live on a small island down the road from this guy, and you can’t out hedge-fund the king of the hedge funds.

Investing money in a retirement account like an IRA in a hedge fund can also be a hassle, often tying a portfolio manager to a Wall Street brokerage.

While the hedge fund model is not quite broken, it was a far cry from what I needed.

So, I decided to piece together what I eventually came to call a spoke fund.

Three months after launching our flagship portfolio, the Tarpon Fund had attracted almost 40 new investors – without any marketing and during the worst economy in decades.

It was a model that worked. And I think it could work for other money managers, too. So please consider this an invite to stick around as I tell whoever might be interested how to build a spoke fund.

Portfolio managers: join our email list here for more about how to build a spoke fund.

“Spoke fund” is short for “hub and spoke” model. The portfolio manager’s money is the hub and the spokes lead to each investor’s account. Any changes in the hub are simultaneously made in the spoke accounts. Thanks to technology, this can all be done pretty easily.

I like to think the result is a much more investor-friendly alternative to a mutual fund. I’m biased, though, since I run two spoke funds. I also came up with the name “spoke fund” because Wall Street didn’t have one for this particular way to invest. It’s not a hedge fund, nor a mutual fund, nor a separately managed account. I think it’s better than them all, for reasons I will soon explain, but, well, there’s that bias thing.

I wouldn’t call it revolutionary. That word comes pretty cheaply these days. I just introduced some new processes to some existing tools to build a fund I’d feel good about putting my family and friends in.

As of today, there are exactly two spoke funds I’m aware of – the Tarpon Fund and Gecko Fund, both run by yours truly at my firm. But I think it’s safe to say our investors love them. I also think spoke funds are an idea that will spread.

In this blog, I’ll be talking more about the benefits of spoke funds for investors. I’m also going to tell any portfolio managers who want to listen exactly how I built them.

So, welcome to Mutual Fund 2.0.

Portfolio managers: join our email list here for more about how to build a spoke fund.