Monday, December 3, 2018

If You Like Investing, Don’t Start a Fund

In my research and investing I stress three things: people, structure, and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below fair value if not outright cheap.

My personal investing was going well so I decided to start a fund to help others – and myself - grow their wealth. After about 15 months since making our first investment, my key take-away is that if you like research and investing, don't start a fund.

The reason for stating this is that since starting, I’ve spent a disproportionate amount of time, energy and money on paperwork. While I knew there would be lots of administrative tasks in managing other people’s money, I never knew that it would be so time consuming, expensive and banal.

Most of this shuffling is due to the increase in the ‘compliance’ function. 

In finance and other industries compliance means the function and effort that goes into keeping within all the laws, rules and regulations for a particular financial asset. Most of these concern securities that are listed on public exchanges such as stock, bond or commodity markets. There were already many disclosure rules before the 2008/09 "global financial crisis".  However these increased substantially afterwards, not only in developed markets, but around the world. In fact I get the impression that many emerging market regulators imposed even more draconian rules in an effort to be seen to be more upright and upstanding then many developed markets.

Most compliance is meant to cut down on money-laundering and centers on banks knowing their client (KYC), and making sure their clients’ funds were lawfully gained so the bank is not laundering money. There are a substantial number of rules and laws that make it illegal to help make dirty money clean. These are known as anti-money laundering laws (AML). KYC and AML are noble endeavours and something I support. However I do wonder if they’re working and if the document shuffle that accompanies these has gone too far. 

Compliance is so onerous that several contacts who’ve been operating independent funds for much longer than I are thinking of closing their funds and just managing their own money. This could be a smart move on the manager’s part. But not for their clients who will lose access to talented managers who are more interested in higher returns rather than gathering more funds to manage. Just as smaller companies tend to outperform larger ones, newer smaller fund managers tend to do better than older larger ones (see here and here).

Expensive and Time Consuming. Much of the time and expense revolves around proving that the person investing in a fund or opening a bank or brokerage account is who they say they are. Not only is this is done through numerous identification, address proofs and other documents on each of a fund’s investors, it is also necessary for all parties connected with the fund (brokers, custodians, lawyers, regulatory agencies, etc.) to provide similar documentation. 

Not only are these collected, but copies or the original must be ‘certified true copies’ meaning that a notary, accountant, lawyer or other designated person has seen the original and the copy is an actual copy of the original.

This can be expensive and time consuming as notaries in Hong Kong charge about USD100 per document which means that the 20+ documents needed to open a brokerage account cost almost as much as I spend on research trips. Ultimately, it’s the end investor that pays for this.

Regulation favors the incumbents.  The cost and time spent on compliance are mostly the same regardless of fund size. For a large fund, USD2,000 in notary fess is chump-change. But for our fund these costs add up. This is a barrier to entry for new, smaller managers.

Leads to a decrease in the number of listed companies? The number of companies listed on stock exchanges in the United States has fallen by about 50% in the 20 years leading up to 2016. I think some of this could be attributed to fewer managers kicking the tires of small companies. With little investor appetite why spend the time and energy to list at all? (see here)

Many smaller companies are off the radar for big funds as even an out-of-the-park return on  a USD50m company will barely move the needle for a USD20b fund. 

Discourages shared interests. All this compliance seems to be turning people away from investing. On a recent 10-day trip to Istanbul only 2 out of the 61 people I met directly owned stocks. And these are all people who are involved in the investment process. This is a big switch from earlier when brokers and corporate professionals would have skin-in-the-game by investing in the companies they were recommending.

When asked, most people said that there was too much paper work and/or too many restrictions as to when they can buy and sell.

In travels to other places it’s been about the same. It’s hard to find analysts and brokers who invest in the companies and products they recommend. Much of the industry essentially does not have any skin-in-the-game, a concept so important to one of the better-known market philosophers that he wrote a book about it (see here). 

Here to stay.  In fact, 'compliance' is now a profession. So much so that the other day I received an unsolicited email from the "International Compliance Training Academy", to sign up for their "ICA International Diploma" which is awarded in conjunction with the "Alliance Manchester Business School, The University of Manchester".   

It's also likely the fastest growing subset in finance with demand exceeding supply (see here).

With all these people spending time and money to learn about compliance, I’m pretty certain of two things.  Firstly, that compliance will remain and secondly that the rules, regulations and procedures will increase. With so many going into the field, they will find new ways and methods to make it more effective (i.e. cumbersome).

Is it helping? I’m not sure that all this paper shuffling is helping or if it ever will. People are smart, and as soon as one roadblock is put up someone will find a way around it. Instead of using banks and other financial firms much of the action seems to have moved to the digital world.

What appears to be a legitimate website for most of us becomes a money laundering platform for the more ambitious. ISIS was reported to have used eBay to move money, and other seemingly innocuous sites such as AirBnb, WhatsApp, PayPal, Uber, Amazon and other tech companies’ platforms have also been abused (see here and here).

Even this may pale alongside what’s taking place with bitcoin and other cryptocurrencies (see here).

The most damning statistic comes from those who should know. Europol estimates that 98.9% of estimated criminal profits were not confiscated between 2010 and 2014 (see here).

Even Harvard Business Review notes that most compliance programs fail (see here).

Over the Hump? Hopefully the worst is past. Our fund is on several broker platforms and operationally things seem to be running smoothly. We know how to fill out ‘onboarding’ forms and can collect information from our directors and clients without taking too much of their time. We’ve found some inexpensive and efficient solutions that should save us some time, money and energy when opening new accounts.

However, I wonder when this could all flare up again. What will it take for more rules and regulations to be piled on top of the ones we already have? Will the cost, time and focus of filing forms eat into our research effort and hinder performance? The big banks and funds can pay for it, but what about the small, innovative and dynamic firms?

This is a good situation for lawyers, notaries and accountants who are the new middlemen. Before deregulation and technology it was the brokers who got in the way and made money from being in the middle. 

Technology moves us two steps forward. Governments and regulations move us one to three steps back.


  1. Interesting post Mike. The massive scandal that Danske is engulfed in suggests to me that compliance is still very much in the headlights.

  2. Welcome back Mike! Please post more , love your blog

  3. The following comment came through email from an institutional buy-side investor based in Australia. I thought it adds value to the article however they did not want their name to appear.

    "Mike, I wholeheartedly agree. In fact the whole financial industry is no longer any fun to be in given the explosion of regulatory restriction & reporting requirements. Half my work hours are now tied down with mind numbing regulatory work.

    "Fortunately none of my kids have shown any inclination in that direction. Yet. Long may it stay so until things improve."

  4. Hello Mike,

    good to hear from you and you described very well the pains of (over-) regulation. There is only one point that I would like to add: Compliance not only affects KYC and AML, but it also regulates in every conceivable detail what you can, are allowed to and must not present to clients - and not only prospective ones, but even to existing ones. And do not forget those disclaimers, that inform clients that they can spend several 100k on a new car or yacht within the blink of an eye, but investing one 10th of that in a properly managed fund can be potentially hazardous.

    And of course you are right: Each and every regulation pretends to protect the consumer, but more often than not in reality it protects the vested interests of the incumbents at the expense of the challengers.

  5. A fund manager in Europe kindly forwarded the following quote form Ronald Reagan after reading the blog, "Government exists to protect us from each other. Where government has gone beyond its limits is in deciding to protect us from ourselves".

  6. Excellent post Michael! I can confirm from my wealth management days in Hong Kong that my first client onboardings were all nightmares.

    50 plus pages of compliance doc and certified copies of clients personal doc would be necessary, and as soon as one signature or any minor detail would be missing, a new meeting would have to be rescheduled for the client to just sign above the line of such and such paragraph, instead of signing below the line... Needless to say that it's a complete waste of time for people with tight schedules and that a couple of clients are lost like that...

    All in all, compliance is good, but the price of it can taste really bad...