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Considerations for Launching a Mutual Fund

Aug 17, 2021

Considering adding a mutual fund to your investment company complex? Why would an RIA want to launch a mutual fund?  What are the benefits?

Investment advisers (RIAs) registered with SEC are able to deliver their investment strategies via different products to their investors such as private funds, collective investment trusts, retail separately managed accounts, institutional separately managed accounts, sub-advised funds and/or mutual funds.

According to the Investment Company Institute 2021’s Investment Company Fact Book, at the end of 2020, there was $63 trillion of investments in “regulated open-end funds.”   In the United States, regulated open-end funds include mutual funds. 

Adding a mutual fund to your investment company complex can significantly increase your assets under management (AUM) since the investment minimums are usually lower than investing in a private fund.  Investors in private funds are required to meet the income and net worth requirements of ‘accredited investors’ or ‘qualified purchasers.’ There are no such requirements when an investor makes an investment in a mutual fund.  The AUM of a mutual fund can grow at a rapid pace since there are no limitations as to the number of investors a mutual fund can have.  Also, the investment process from the investor’s point of view is less complex than investing in a private fund. 

In addition, launching a mutual fund might provide the opportunity to consolidate small accounts into one portfolio -- making it easier to manage -- and might lead to operating efficiencies.  Also, some investors might prefer the mutual fund model to other offerings of the RIA.

RIAs have two options when launching a mutual fund, a series trust or a standalone trust.  A series trust is a simpler process to launch as the new fund joins an already established structure.  The RIA can spend its time on managing money since the new fund becomes part of a trust with other established funds.  Each fund within the series trust maintains its own investment strategy. 

A standalone trust is used when the RIA wants to establish a family of funds or wants control of those on the board of directors.  When launching a standalone trust, service providers are determined by the RIA. Such service providers include the initial board of directors, fund officers, counsel, custodian, auditor, administrator and transfer agent.   For either structure, fees incurred to organize the fund are typically incurred by the RIA and not the mutual fund itself.

One of the key features of mutual funds is their ability to pass through income to investors without incurring tax at the fund level.   To obtain this tax advantaged treatment, a mutual fund has to qualify as regulated investment company under the rules established by the Investment Company Act of 1940 and the Internal Revenue Code (IRC).  These rules include diversification requirements for investments, types of income earned, distributions, liquidity, and leverage. At a high level, under the IRC rules, a mutual fund must satisfy the 50% test and 25% test on a quarterly basis to meet the diversification requirements.  Under the 50% test, at least 50% of the mutual fund’s total assets must be represented by cash (including receivables), U.S. government securities, securities of other registered investment companies and other securities that meet both of the following tests: (a) the mutual fund has not invested more than 5% of the value of its total assets in securities of the issuer and (b) the mutual fund does not hold more than 10% of the outstanding voting securities of the issuer. Under the 25% test, no more than 25% of the value of the mutual fund’s total assets may be invested in the securities of (1) any one issuer (other than U.S. government securities and securities of other regulated investment companies), (2) two or more issuers that the mutual fund controls and which are engaged in the same or similar trades or businesses, or (3) one or more qualified publicly traded partnerships (including master limited partnerships).  Further, a mutual fund has to ensure that at least 90% of annual gross income is derived from dividends; interest; payments with respect to securities loans; gains from sale or other disposition of stock, securities, or foreign currencies; other income derived with respect to its business of investing in stock, securities or foreign currencies; or net income derived from qualified publicly traded partnerships.  In addition, investments made by a mutual fund must meet liquidity thresholds and the mutual fund itself is limited in its use of leverage.  The rules were established to protect the shareholder.

Mutual funds take more time to launch than a private fund since SEC registration is required.  Typically, a series trust is able to launch quicker than a standalone trust.

So it is worth it?  A typical mutual fund only charges its investors an advisory fee and not a performance fee (which would normally be earned from private funds).  If the RIA has a unique, non-concentrated and more liquid strategy, a mutual fund is another fund product which, if assets under management grow substantially, could be beneficial to both the investors and the RIA.

Mutual funds versus private funds:

  Mutual funds Private funds
Amount invested Lower minimum investment requirements. Higher minimum investment requirements.

Do not need to be an accredited investor or qualified purchaser.

Accredited investor or qualified purchaser status required.
Liquidity Investors are permitted to redeem daily. Permit their investors to redeem monthly, quarterly, semi-annually or annually with notice requirements, provided there are no lock-up provisions.
Investment strategy More liquid investment strategy  (illiquid investments are limited to 15% of the portfolio). More liquid investment strategy  (illiquid investments are limited to 15% of the portfolio).
Taxes Pass through income to investors annually via dividends and capital gains.  Investors can reinvest the income or receive cash. Pass through income to investors annually but cash may not be distributed to investors depending on the terms of the fund agreement.
Fees paid by investors

Management fees.

Management fees and performance fees.
Leverage Limited to 1/3 of the portfolio value. Limited to the amount stated in the private fund’s governing document.

Annual Gross Income test

Limited to 10% of gross income from certain sources such as real estate and commodity investments. No regulatory limit.

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Sheila Handler

Sheila Handler is a Financial Services Group Audit Director experienced with hedge funds, broker dealers, and mutual funds.

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