[as a post-script to yesterday’s post on Leveraged Investing, please read Canadian Capitalist’s thoughts on the same issue]

I once remember an investment counsel friend of mine who met a potential client with a high net worth who wasn’t happy with her current investment advisor. When he asked her what she expected him to provide by way of return on investment on her stock portfolio she said 15%-20% with no risk. My friend has common sense and his common sense told him that this was not going to be a happy relationship. Rather than lose the rest of his hair, he walked away.

I am reminded of this story lately as we tackle potential returns on investment in the financing company (for those new to the post, please see here for a back-ground). For those lawyers out there, we are not guaranteeing any returns on investment to our investors but, on a structural level, we have to consider what type of investment we are: conservative, moderate or aggressive since this goes hand in hand to who are ideal investors are. However, what I am beginning to find is that the market-place is full of unrealistic expectations. Perhaps this is due to the fact that the stock market has generated historically high returns for the last several years. Perhaps the Internet has trained us to have 4 second attention spans and to conveniently forget last year much less the dot com bust (or even Enron). Perhaps we all collectively think that this time it really will be different and the good times are here forever.

Regardless of the reason, by observation only, I have found that many people now consider 15% plus to be an “acceptable” rate of return. While achievable, a company that attempts to return 15% ROI to investors year over year exposes its investors to a variable of risk that, if you thought about it for a second, is too risky for most average investors. Companies that are supposed to return 15% plus are supposed to have venture capitalists as investors who could lose their money and not worry about it too much. We worked on some financial models and to consistently achieve 15% plus year over year the financial company would have to invest almost 100 cents on the dollar in riskier plays and hope that the market conditions stayed the same. Oh, we also wouldn’t get paid either. We would be constructing a potential deck of cards hoping that the economic winds didn’t blow us over. Being a big supporter of how banks manage their risk, we have set aside a reserve of money which we will not invest and taken a prudent approach on how the money will be invested. We hope that this will produce a steady rate of return over time rather than promise big, peak early and have the house of cards come down on us.

Cheap money since 9/11 has conditioned us to turn a blind or partially obscured eye towards risk. As I mentioned yesterday, there are some who support leveraged investing without educating people on downside risk; I suspect if this was 1982 the voices for leveraging people’s homes to invest in the stock market would not be so great. I watch mutual fund managers stock-pile cash and I begin to get nervous. I’ll update you on how our prudent approach works.

(this post is in the continuing series about building a financing company that I am the President of)

One of the issues that any investment company faces is how much money do we invest? For every dollar invested, some of it has to be factored in for overhead, salaries and other fixed expenses. Once those deductions are made, the fundamental question is how much money do we hold back in cash? This is no different of a question than any other investor faces- do you put all your free cash into stock, real estate, exchange traded funds etc. or do we hold some of it back?

If you look at the holdings of a lot of successful mutual fund managers, you will notice that some of the more successful managers are holding a lot of money in cash recently (I am not running a mutual fund). For example, The Chou Associates Fund, managed by noted value investor Francis Chou (annualized return of 15.1% over the last 10 years), has 40.5% of the fund in cash as of December 31, 2006. Peter Cundill, another well-publicized fund manager, also has large cash reserves in his international equity funds. The argument against any investment vehicle holding excess cash is that they are still charging fees to hold your cash; thus, in many ways, you are paying a manager de facto interest to hold your cash- you may as well keep your money in a high interest account if only 60% of your money is invested at any time.

However, the opposing argument is that all investment vehicles require sufficient cash on hand to: (i) take advantage of buying opportunities (the argument of the Chou’s and Cundill’s are using who believe the market is over-valued); and (ii) to hedge against downside risk, mainly being: (a) investors redeeming their investments and having money on hand to pay for such redemptions; or (b) having emergency funds in case the investments do very poorly. This is no different than banks having sufficient cash to fund operating losses (see my post last week on this topic). As a benchmark, and as a gross simplification, a well-operated bank hold 10% of its assets in cash.

I have no intention of keeping 40.5% of cash on hand; it is a new vehicle after all and it must establish a track record quickly to build a reputation. However, how much less than 40.5% in cash is becoming the big question. I will keep you updated.

I wanted to share some insight into how any investment product determines fees based upon my experience in building a finance company (quick recap- I am the president of a financing vehicle that investors can purchase shares in; its being formed as we speak so I am trying pass along things I am learning to you. FYI, its not a mutual fund; its much more investor friendly than that!). As a general comment, I am NOT in favour of high fees so this is not an implicit or explicit endorsement of high fees. This post should be read into the thought process behind fees- whether a mutual fund or hedge fund charges high or low fees is partially based on the structure of the industry and partially by choice (see my previous post on WRAP Accounts).

If anyone reads an prospectus or offering memorandum, you will understand that most securities (whether a conventional stock, mutual fund or structured product like a hedge fund) outsources most of its back-office functions (custodian duties, trusteeship etc.) - we’ll call all of these providers “Management Companies.” Some structured products like hedge funds will even outsource who makes the investment decision (some hedge funds are started as private investments based on a mathematical model derived by a math Ph.D).

All of this outsourcing costs money (there is a school of thought in the business community that outsourcing in the long run costs more than keeping everything in-house but I digress) and all the costs are passed down to the investor. Most Management Companies charge fees as a % of assets under management and not a varying dollar amount every month based on services rendered.

This practice of charging as a % actually costs you, the investor, more in the long run- let me give you an example that everyone can relate to. Some accounting firms in Toronto have taken on the practice of charging disbursements (photocopy, faxing, courier etc.) as a % of the final bill rather than passing on the cost on a dollar for dollar basis to the client. But here is the kicker- the % is in the low double-digits. So if your accounting bill is $1,000 (to keep the math easy) and the disburement fee is 12%, you are paying $120 on top of your accounting fee. That sounds like an awful lot of money for photocopies and faxing doesn’t it? I suspect that firms who are doing this are pocketing a lot of profit on these “disbursements.”

In the investment world, fees are typically referred to as 1/20 or 2/20. The first number is the management fee expressed as a % and the second is the preformance fee (if applicable). Thus, a 2/20 scheme means that a Management Company charges 2% admin. annually and a 20% performance fee (its very rare to see a 1/20 now). 2% does not sound like a lot but in a large mutual fund that is literally millions of dollars a year. In some months, the Management Company may do little or a lot- but it takes 2% regardless.

But here is the fundamental issue with outsourcing to Management Companies (especially in Canada). This may address Canadian Capitalist’s post yesterday about fees in mutual funds.

1. Many of the Management Companies are owned by the same group of people so money is being cycled between related parties (read a prospectus from any bank issued product for example).
2. Canada is such a small market place that there is not a lot of supply of Management Companies which means these companies have pricing power (for example, there are only two large institutions who provide custodian services to companies); they can charge more than their American counterparts and get away with it. After all, where are you going to go? Since these costs are being passed down onto the investor, the management fees (or MER’s in mutual funds) are relatively high. This has always been my pet theory about why MER’s are high in Canadian mutual funds.

These are real structural issues facing the Canadian investment community.We are in the process of shopping around for Management Companies and these are the structural issues we face. Stay tuned.

I have alluded to this before but through a series of strange accidents, this blog is about primarily two things:

1. Thickening your wallet; financial musings from an advisor to businesses; and
2. Building a financing company from scratch with the general public as investors

Some of the financial blogs that I read have been musing about outing themselves. As much as I would love to, a team of lawyers will not allow me to do this since any details about the company and the product pre-launch would be considered a solicitation which would get me into a lot of trouble with various securities commissions.

In a nutshell, this is what happened:

1. Advise businesses
2. Advise a business that does really well and become a key clog in their management team
3. Said business has connections to financial community with connections asking me to head up a finance company

This is what I have learned thus far:

1. There seems to be a great demand on main street for easy to understand investment product. Our company finances something exceptional simple (that’s all I am going to say! My lawyer is watching me as I type); we have some potential investors who say to us that they don’t want to buy tech anymore or commodities because its too much of a roller coaster ride. Maybe its time for the stock market to get back to basics?
2. The financial capital of Canada is Toronto but Ontario (the province which Toronto is located in) is also the toughest regulatory market to raise money. Ontario does not have an offering memorandum exemption (what this means is that you cannot sell certain types of investment products without showing an offering memorandum, which is a disclosure of opportunities and risks in the investment) which makes it hard for the middle class to take part in many investment vehicles.  Western Canada has a much more liberal attitude and it is easier to raise money there. I can’t decide whether this is a good or bad thing yet.
3. Every business needs three things (in no particular order): (1) someone who knows the product/service inside/outside; (2) someone who can sell it; and (3) someone who can build it from a business perspective. Next time you look at the management team of any business you want to invest in look for those three things. Most of the time, one person cannot be all three. I am putting together a team now to address all three.

I’ll write more as this develops. Now back to the originally scheduled program…