The first stage of a successful money manager

Okay, time to be serious.  This is serious business after all.  Making the right decision early on in your solo money management career can mean the difference between destitution and, well, something the opposite of living under a bridge.

I'll start this post with quote from Monish Pabrai when a student wanted to know how to "break into the biz."

"If you are interested in creating an investment business, you should start by creating a track record that is audited so you can show it to your investors. If you beat the indices consistently, people will swim to you."

Source: http://www.gurufocus.com/news/229743/2013-pabrai-investment-funds-annual-meeting-notes--chicago

This is total baloney.  Let me explain why.  Hypothetically, let's say you are a college student who compounded $100,000 from student loans (I'm assuming my audience is the dirt broke college student. Good for you if you happen to have that kind of money outside of student loans, you already have a massive leg up over most 20 year olds).  Let's say you end up with an after-tax return of 10% after ten years.  You now have $259,374.  I'll tell you what: you'll be lucky to compound 10% after-tax as a student.  But even if you pull that off, here are several big, big problems.

• How the heck are you supposed to survive on $160k over ten years?  You're going to be starving in your studio apartment in the bad part of Baltimore.  Just to prove out your track record?  I don't want my money manager living off a soup kitchen on the bad side of town.  There's no reason for it.

• Most investors are simply not good enough to avoid massive losses within the first several years of their career.  Those massive losses are even (dare I say it) helpful.  While helpful for developing an investment process, it kills your attempt at a track record.  This is cliche, but you learn more about an investor when they have large losses versus when they have large winners.  You'll learn even more about them when the loss is crippling.  I'll save more on this for a later post.  

• The first several years of your track record are also highly dependent on market conditions.  God forbid you start in 2007 without the skills to properly manage risk.  

• 10% after-tax isn't a strong enough track record to raise hundreds of millions.  Once you take in new money, the track record starts all over again.  If you put up a bad year or two early on, you'll lose that capital you spent a decade to attract.

• It assumes you can sell yourself once you have the track record.  If you can't sell yourself early on, why would you be able to sell yourself in ten years?  Are you that insecure about your investment process that you'd rather let historical returns drive a potential client's investment decision?  Odds are, if you can't sell yourself now you probably can't in ten years either.  There are exceptions to this rule, but not many.

So what is the right investment decision with that $100k if a track record isn't necessarily going to be the foundation for 99% of aspiring managers?

When I started my career, I worked under a colorful bond guy on the sell-side.  I'll go into some fun stories on this later.  But we ended up parting ways when I came to the following conclusions:

• I wanted to run a hedge fund.
• I was the worst salesman you could ever imagine.
• I should make as many mistakes with my own capital before investing other's capital.
• I should get in front of as many investors as possible to explain my investment process, particularly because my sales skills were very lacking.  I needed more "eyeballs" to make up for poor conversions into real clients.
• If my process was any good, I'd raise more and more capital while compounding client capital.
• Eventually this could lead into a hedge fund.

Back to that $100k.  Here's what can create the first stage of a successful fund.

Hypothetically, it's going to cost you $20 to get in front of someone who has some reasonable probability of being an investor you might like in your fund.  With $100k, you can get in front of 5,000 investors.  Of those investors, maybe 20% are "qualified."  And of those, maybe only 10% like you and understand your investment process.  So you only get a pool of 100 clients that, if you're any good at closing, can give you some money to start.

Perhaps you're a crappy salesman like me and you only end up with 20 clients with that $100k spend.  But on average they might give you $500k.  It's going to cost you around $20/prospect or more to acquire people who can write you a check like that.  But if done properly, boom, there's $10 million of assets.

Now let's say you compound 15% for five years and keep 20% of the profits as an incentive fee.  It will take time to raise money and get it invested, so perhaps you only get compensated for three years worth of work instead of the five.  You might have created $5 million or so of pre-tax profit  for your investors but you get to keep 20% so your $100k investment has now turned into $1 million.  You can now put more capital into marketing and put the rest into your fund.

Is that not 100x more effective than trying the "track record" approach?  And here's why you shouldn't feel guilty about it.

• It's going to take time to raise assets.  While you're raising assets, do all the crazy stuff with your capital that you're using as examples to close clients.  Make the mistakes with it you won't repeat with their money.
• You're not a good investor if you can't see that you'll get much better returns using most of your capital to market versus trying to "eat your own cooking" as a minuscule investor in your strategy.  In the beginning, "being 50-100% invested" in your fund isn't doing anyone any favors.  When you make more money you'll have plenty of time to put more of your own capital in your fund.  For the time being you need to approach this like a business.
• You're taking more risk by focusing your capital on the marketing.  As soon as you spend it, it's gone.  You don't have some security that trades on the NYSE.  You have the uncertainty of what your spend might bring.  And it only brings positive returns if you're any good at managing money anyway.  If that's not good enough for you, go structure your fund in a way where you don't make any money if you suck.  So you're actually eating your cooking more than someone who has a more tangible asset like stocks or bonds when starting your career.

There are different ways of marketing effectively, but again I'm not a good salesman.  Instead I did lots of pitches at lots of dinners to get in front of lots of investors who might share a liking for my process.  You should never pitch your track record (you'll get performance chasers anyway), only your process.  And if you keep pitching good ideas, eventually the smart investors catch on and send money your way.  It's simple but it works.

I also only mentioned the first few years of "net present value" on your marketing spend.  The real value is further out where you compound their capital, get more of their capital, and get introduced to their friends with more capital.  This is not rocket science.  If you're in the first few years of launching, you need to spend just enough time and money on marketing without hurting time devoted to investment research.  It will mean the difference between success and failure for 99% of young managers out there.

So why don't more people do it?

Most fund managers are lazy about picking up the phone and getting in front of investors.  It's more fun pulling up SEC filings and looking at stock quotes.  Marketing is also painful and the least fun part of raising a fund.

Now go get off social media, pick up the phone, and tell potential investors some cool ideas of yours.  After all, if they aren't cool ideas that will make others lots of money, why are you even running a fund?

-yolo