Start an Investment Club: How To, Rules and Reality Checks

by Darwin on May 20, 2009

A few years back some coworkers and I started an investment club.  We were an ambitious bunch (still are), but perhaps too much so for the realities we’d face in trying to run an investment club.  There was a group of five of us and our stated goal was to return 15% per year on a sustained basis.  Nevermind that the best minds in finance the world wide can’t achieve such returns and the ones that do are named “Madoff”, but we thought we had it all figured out.  We were going to use a hybrid approach to investing with each partner becoming a subject matter expert in various investment methods.  We had sector expert, the quant, the options expert, the value investor, etc.  While I learned a lot about investing, technical analysis, building financial models, utilizing complex options strategies and more, I also learned that successfully running an investment club was much more work and had many more surprises than I had anticipated.

Stock Investment Club Benefits

We started out with some strong drivers to form a private stock investment club.  Conceptually, the benefits seemed to outweigh the risks/downsides tremendously.  We viewed the following benefits as justification for formation of our private club:

  • Unregulated – we didn’t have to abide by the same rules a mutual fund manager or passive ETF would (obviously).  We could go short, we could use options, we could use any portion of cash we chose, we could use margin (bad idea!), we could even invest in real estate directly or other alternative assets now that we had formed a Limited Partnership and had some decent seed money to start with.
  • Economies of Scale – One of the gripes of individual investor/traders is the commission drain.  Trying to do a few trades a month with a typical online broker at the time was running about $12/trade, which adds up to several hundred dollars per year.  We figured that by splitting the trades across five members, we were now looking at a much diminished cost structure.
  • Tapping the wisdom of other members – Each of us had some trading experience, were getting into MBA programs, etc. and were doing independant research.  We figured we’d learn a lot from each other about various strategies, and we did.

Investment Club Rules

We came up with a set of by-laws, or rules, which governed every conceivable outcome, grievance, oddball situation we could think of.  While it may seem plain and simple to just pool some money together and start investing, there are several scenarios you need to factor in to your by-laws and consider before starting up.  Here are several considerations and provisions you should build in:

  • Expectations around research, input for members
  • Meeting frequency
  • Positions for members (Treasurer, Trade Executor, Secretary, etc)
  • Investment club mission statement or philosophy
  • Which types of investments are allowed/disallowed (i.e. long options, naked shorts, stocks only, etc.)
  • How to handle tax issues (split evenly or based on % ownership)
  • Starting contributions, ongoing monthly contributions
  • How to handle departures from the club and new members
  • Risk Tolerance (ever use margin, ever do anything besides straight buy and hold?)

More Complex than Initially Thought

Aside from the common considerations above, there were a few scnarios that don’t initially come to mind that have to be considered in your investment club rules as well.  One of our members had been in a club about a decade prior and had shared some perspective in complexities we hadn’t considered initially.

Tax Consequences

The club ran for a long time, and was one of those investment groups you hear about that actually bought Microsoft for under $1 split-adjusted.  Well, that was good and bad.  For one, that portion of their club’s investment obviously had an outsized investment return.  The downside was that when the club dissolved, there was an outsized tax consequence as well.  The problem is that various members had joined and left along the way.  Say you had one guy who joined in 1991 and left in 2001.  You have another guy who joined in 2001 and left in 2003 when the club dissolved.  Well, say the MSFT shares weren’t executed until 2003.  The guy that left in 2001 got the benefit of his share of all the upside in Microsoft and didn’t pay a dime in tax liabilities.  The guy that joined in 2001 actually saw a loss in the MSFT portion and to add insult to injury, he was slammed with a humongous tax liability for his share of the club’s tax bill while all the guys who jetted earlier paid no taxes.  This holds true for other investment moves of course too, but this illustrates what can happen when you don’t have a plan for how to handle this.

Aside from how to handle tax issues amongst the team, there were the formal tax reporting requirements.  In the US, we had to employ an accountant at a cost of a few hundred dollars per year to manage some atypical tax forms.  Primarily, there was a K-1 form, which each of us had to reference on our individual returns each year.  We had to form a limited partnership to tie to the tax form.  Some of the benefits of running a club with the intent of saving money on commissions and scale were offset by fees and headaches like this.

Termination/Departure from Club

In addition to the tax consequences above, there are other factors at play.  What if one of your members just wants out?  What if someone’s moving and can no longer participate in a meaningful manner?  What if someone Dies?  How do you handle their portion of the club.  When should they reasonably be expected to recieve their disbursement?  If the club’s fully invested and you had to liquidate shares immediately, you might be selling at a bottom or acting against a strategy that required a set amount of liquidity/capital (i.e. if you had sold shares short or had naked credit spreads and you paid out, you might get a margin call).  We built in provisions for each, requiring a 6 month lead time between notice to the club and expectation of payout.

Investment Club Software

When we had started up, the only investing club software out there to track investments, ownership, etc. was provided by the National Association of Investors Corp (NAIC website here) which is a non-profit (but they charged for the software of course) and we found it to be completely inadequate for our purposes.  Perhaps they’ve improved it a bit in the past few years to account for some of the complexities I mentioned above, but at the time, it was pretty much useless.  I actually ended up developing an elaborate spreadsheet to calculate % ownership each month since we had different members auto-depositing different amounts of cash into the club each month.

Why Did our Investment Club Fail?

The reasons were numerous.  One thing was timing.  We started up in an up market and become overly optimistic.  Since our long positions were in stocks with a Beta of 2-3, it seemed great when we were returning 50% when the market was up 25% during the year ago period.  However, when the market turned, we were crushed accordingly.  We had tapped into margin, we were net long, we were using options, and we were creamed in particularly horrid fashion on a credit spread that went south.  As our returns started to diminish, so did our enthusiasm.

There are some online investment clubs out there, but given the complexities you’re dealing with with people you know and trust already, delving into an online relationship and trying to make it work is probably not going to be easy.

One of the most famous investment clubs was the Beardstown Ladies club, who claimed long-term returns of over 23% over a ten year period, which was unparalleled even by 99% of the professional hedge fund and mutual fund managers of the time.  This type of lore drew many investors into the fray and the urban legend still survives today.  The reality is that these ladies apparently were not very sophisticated in their tracking of real returns and actually included their cash investments IN as part of their claimed investment returns.  An audited assessment showed that they actually returned 5% less per annum than the S&P500 over that period! (source:wikipedia)

My advice is to be realistic about your expectations around net returns, time commitment, address the complexities up front and what you think you’ll get out of this experience before starting an investment club.  In retrospect, I look back fondly on the experience and I think I learned enough new investment strategies and analysis from my colleagues that it justified the time and financial losses.  However, based on the endless emails over tax returns, the less than stellar market returns and my complete lack of free time, I wouldn’t do it again!

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{ 4 comments… read them below or add one }

1 Ryan P Smith May 22, 2009 at 4:52 pm

Darwin,

What advice would you have about having everyone disclose their credit scores, especially if you didn’t have a close relationship with them?

Ryan P Smith’s last blog post.."Twitter Porn Names": Fun Social Networking Game? Or Something Darker?

[Reply]

2 Darwin May 22, 2009 at 5:08 pm

Hmm. We had never considered credit scores. Is the concern being in the same Limited Partnership or just that they may have to withdraw or cease monthly funding? As a general thought, I’m not a big fan of sharing personal income or savings with friends, but I guess if my credit score was decent, I wouldn’t mind. I’m not sure what the driver is though; would be interested to know the rationale.

[Reply]

3 Ryan P Smith May 22, 2009 at 5:13 pm

If you are close enough with everyone in the group then I don’t think it is needed. If there are “friends of friends” I would want to know the people I am investing with are stable financially. I would worry about them stopping funding or wanting to cash out early (possibly at an inopportune time) if they were dealing with credit and debt issues. I know there are rules in place, but why get in a messy situation if you can prevent it?

[Reply]

4 Jim Lear January 10, 2011 at 7:27 pm

Thanks for sharing your experiences. It was a very interesting and informative post.

[Reply]

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