Thoughts About Starting a Mutual Fund

One of the things I told you all I was considering when I turned 30 was launching a mutual fund or hedge fund because people are always asking me to manage money and I’m always saying no.  I love investing.  I get as excited cracking the cover of an annual report as most people get opening the first pages of a Playboy.  Discovering how a company works, what is driving the return on equity, how the capitalization structure is put together … it is like intellectual candy for me.  It never gets old.  It makes me want to jump out of bed in the morning.  The thing is, I like my life because I’m already doing very well, I’ve never had to work for anybody else, and I can pretty much buy what I want.  Money flows in from the family businesses and I invest it.  It’s simple.

If I decide to start a mutual fund (as opposed to a hedge fund), it will likely be something like the Kennon Global Value Fund, focusing on acquiring shares of stocks around the world, hedged back to the United States dollar, that have characteristics of so-called “value” stocks that have done well historically, such as high returns on equity, high returns on assets, low leverage ratios, high cash conversion ratios, low price-to-sales multiples, high dividend yields, large share repurchase programs, etc.

I Actually Had Discussions with Several Investment Banks

Based upon no 12b-1 fee and a 1.25% management fee, it would require a mere $15 million in net assets to break even.  Above that level, I would begin to earn compensation for overseeing the fund itself.  Since I have no interest in setting up the fund infrastructure, I’d gladly pay the investment bank for handling all of the detail work, including compliance, shareholder services, custody, etc.  Perhaps at the point the fund became large enough, I would consider bringing some of those functions in-house but, frankly, I want to show up to my office, pour over annual reports, buy stocks, collect dividends, and drink coffee by the fireplace as I wear a Kiton suit.  That really is it.  I love business.  I love investing.  I love finding great ideas.  I don’t enjoy shuffling papers.  I also don’t want to deal with clients – I have no desire to enter the asset management business for individuals – but this way I’m not just sitting in an office making myself rich.  Benjamin Graham criticized Bernard Baruch for that kind of behavior and I want to avoid the same fate.

Pros of Starting a Mutual Fund

There are several pros and several cons of going with a mutual fund instead of a hedge fund.  (Technically, they aren’t mutually exclusive.  I could do both.) Right now, since I’m still several years away, I’m thinking out loud.  I may not even do it at all, sell my businesses in Kansas City, and go to some island.  Who knows?  But I doubt that given my personality loves the game too much and watching things grow over time.

This article is nothing but me thinking out loud to myself.  I’m engaging in what Charlie Munger calls the Orangutan Theory, which states that simply organizing thoughts into structured form, even if you were giving a speech to a primate in a circus tent, will result in you understanding your own thought process better.  It forces you to clarify things mentally.

The pros of a mutual fund structure are:

• Virtually anyone who has followed me or read my books, articles, and publications could read the prospectus, consult with their own financial adviser, and if they decided the fund was appropriate for their needs, buy shares through any stock broker on the planet or directly with the fund itself, unlike a hedge fund, which would only allow accredited investors with high incomes and / or net worth requirements.
• Strong, well-developed regulatory environment.  Almost everyone is familiar with mutual funds.  The investment banks that handle fund administration services have extensive experience with SEC requirements.  This is not some new structure with a lot of questions surrounding it.
• A mutual fund would allow me to greatly simplify the administration of my immediate family member’s accounts.  They would be able to just use their paychecks to buy more shares of the fund without worrying about which account had shares of Philip Morris International and which had shares of Berkshire Hathaway.
• The fund would provide a mechanism through which I could hold my “blue chip reserve” stocks – the good, high quality companies that I think offer good long-term compounding results that will be satisfactory but not outstanding.  The fund will be the sort of thing that I am comfortable having my grandmother own.  I’m not going to be chasing obscenely high returns like I do in the private companies, where I can rely on the underlying cash flow of the businesses to get really aggressive buying some little-known property and casualty insurer trading at a few times earnings.

In short, if I were to start a fund, I think my fundamental goal would be to create an investment product that my grandparents, parents, siblings, children, and friends could regularly acquire throughout their lives, reinvest their dividends, and retire well.  My concern wouldn’t be volatility – I don’t care if the fund is up or down 50% in a single year – but rather overpaying for a business, which I consider the worst and most dangerous risk.

Cons of Starting a Mutual Fund

The cons of starting a mutual fund are:

• I have a great life now.  No one knows what I buy or sell, I have total autonomy, I can sleep till noon, play video games until 5 in the morning, spend my days meeting with friends or going out to dinner, or reading biographies in my study.  I choose to work a lot but I don’t have to do so.
• It won’t be nearly as flexible as an investment partnership or hedge fund would be, where I could raise money from a few, close partners and work on a compensation system that resulted in much higher performance fees.  There is no doubt I’d get richer with a hedge fund but, again, launching a mutual fund first doesn’t stop me from getting into that business later.  Just look at the investment partnerships run by Tweedy, Browne & Company.

If I end up going with a mutual fund first, I think that, as a matter of principle, I will keep every penny of my management fee, net of taxes and charitable contributions, in the mutual fund itself so that each year, my personal stake in the fund grows and it comes to represent a significant portion of my liquid net worth.  I think it is only fair that I am invested in exactly the same thing as the shareholders of the fund.  Besides, I’ve never taken a salary from my businesses so I would just continue to live off writing income.

Honesty and Self-Reflection

If I were honest with myself, the biggest disadvantage with a mutual fund is two-fold:

1. It will pay me less in fees

2. The structural limitations mean that I will unquestionably earn lower returns for my investors than I could with a partnership because I can’t buy, sell or start businesses, I can’t put myself on a company’s board, I can’t borrow money and use it for expansion, and so forth.

My idea of a good time is showing up to the office with Councill chairs (hey - Buffett has his seven-figure private plane habit, I can have a few $2,646 chairs - I decided that if I launch a fund, a set of these will be my "gift-to-self" to celebrate), a fireplace, gourmet coffee, music softly playing in the background, and a stack of annual reports and 10K filings. That is all I have ever wanted to do with my life. I don't like Wall Street's culture - I just want to own businesses and put the money to work.

In fact, somewhere, some foolish person is going to believe the mutual fund will be as successful as my private businesses.  That is impossible given the structural disadvantages.  With the private business, I can get money at cheap long-term fixed rates to optimize the capitalization structure.  I can meet with a handful of other people and make a decision to go big in a new industry, investing at book value and making huge returns.  If we make a mistake, I can bury it without anyone second guessing me.

With a mutual fund, there are specific rules that must be followed, you can’t have more than 5% of the fund’s asset at cost in an individual stock, etc.  I mean, during the melt down, the reason we could buy stocks when they were cheap is because we had this flow of money churning out from the sporting goods business.  With a mutual fund, I would have had to just sit there and tell everyone to be patient.  Unless money was flowing into the fund (unlikely – it tends to flow out when people panic), I’d have to sit on my hands and do nothing as businesses were super cheap.  I mean, even Buffett’s partnership purposely bought enough of stocks like Beatrice that they were valued on fair market terms, making comparison to the S&P 500 intellectually dishonest.

I told myself I wouldn’t do anything until I was 30.  I have two more years of growing my own net worth and focusing on these businesses.  But as I approach that age, I’m struggling more and more with the decision.  This is going to take a lot more effort.  There is no doubt that, God willing I live long enough, I’m going to retire very, very rich.  The question is simple which path will I take and how rich will I end up being?

The truth is, I’m probably going to have to get on a plane and go have some discussions with the people I personally look up to and who have given me sage advice in the past.

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1. A Hedge Fund vs. a Mutual Fund
2. The Mutual Fund Expense Ratio Matters A Lot to Investors Over the Long-Term
3. Mail Bag: Did You Decide Against Launching a Mutual Fund?
4. New Stocks and Cash Added to The Kennon Retirement Insurance Fund (or “Stupid Fund”)
5. Cherry Mashes and Mutual Funds
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9. Aaron Convinced Me to Shut Down the Coupon Index Fund and Instead Open a Joint Global Investment Account Following the Same Value Investing System We Use at the Company
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