If you’ve devised a market-beating strategy and have a track record of outperforming the market, you might be considering launching a hedge fund. Hedge fund managers are well compensated for their efforts, and the tax benefits are substantial for high earners.
A short track record of outperforming the market in your personal trading account, on the other hand, is insufficient to start a hedge fund. You’ll also need to put together a team to ensure that you establish and operate legally, as well as register with all necessary parties. You’ll need to publicize your fund and raise funds to invest in it. In addition to managing the hedge fund’s investments, you’ll need to run a business.
Here’s how to start a hedge fund if you think you’re up for the challenge.
What Is a Hedge Fund?
Any type of private investment company that operates under certain exemptions from registration requirements under the Securities Act of 1933 and the Investment Company Act of 1940 is referred to as a hedge fund. (Ironically, hedge funds may employ investment strategies unrelated to hedging.) Given these exemptions, it is far easier to start a hedge fund firm than it is to establish a firm that manages more strictly regulated investment options such as mutual funds. The relaxation of hedge fund restrictions has contributed to the industry’s growth.
How to Start a Hedge Fund Legally
#1. Develop your strategy
The first step is to define your investment strategy as precisely as possible. Ascertain that the strategy is replicable and scalable. It cannot succeed by relying on specific policies or economic environments. Hedge fund investors want to see consistent gains. The strategy you used to grow your personal account over the last decade may not work with an account worth tens of millions of dollars in the next decade.
If you have a strategy that is repeatable in any market, that you can scale by investing more time in research, and that investors can easily understand, you have something to work with. Long/short equity positions on undervalued/overvalued stocks, merger arbitrage where markets misprice securities slated for mergers, buying distressed companies, and algorithm-driven quantitative approaches are all common hedge fund strategies.
You’re ready to start a business once you’ve developed a viable strategy for your hedge fund.
#2. Implement
Hedge funds are typically structured as limited partnerships, with the hedge fund manager serving as the general partner and all investors serving as limited partners. You could also form an LLC or another structure. It is best to seek professional advice on the best structure for your hedge fund.
Once you’ve determined the best business structure for you, you’ll need to register with the secretary of state in the state where you want to incorporate and file your articles of incorporation. In addition, you should apply for an employer identification number (EIN) with the IRS, which you will need for future registrations and taxes.
As a hedge fund manager, you should probably form an LLC to protect yourself. If the hedge fund declares bankruptcy or is sued, an LLC will protect your personal assets (though you will still be personally liable if you commit wrongdoing on behalf of the company).
#3. Complete all necessary registrations
Once formed, you must register the new company with the Securities and Exchange Commission (SEC) and the regulatory bodies of the state in which you formed it. You must also register the firm as an investment advisor.
You must also register as an investment advisor, as must any other representatives of the hedge fund manager. This necessitates passing the Financial Industry Regulatory Authority’s Series 65 exam (FINRA).
Finally, you must file Form D with the SEC to register the hedge fund offering. You must do this for each state where the fund will be offered. Form D is only for exempt securities like hedge funds.
When it comes to filing all of the registrations required to set up your hedge fund, a good lawyer will ensure that you cross your t’s and dot your i’s.
#4. Create your investment contract.
You’ll need a clear investment agreement to show prospective investors before you go out and market your new hedge fund. The investment agreement will contain information such as:
- Your fee schedule: What is the expense-to-income ratio? Do you charge a fee for performance? The industry standard is a 2% management fee and a 20% performance fee, but fees have been under pressure to be reduced over the last decade.
- Minimum time commitment: Is there a set amount of time or money that an investor must invest? Many hedge funds require a one-year commitment and at least $1 million.
- Distributions: Will there be set periods during which investors can request distributions, or will they be able to request distributions by providing notice 30, 60, or 90 days in advance?
Again, a good lawyer will be invaluable in ensuring that your investment agreement covers all of your requirements.
#5. Assemble your team
In addition to the aforementioned lawyer, you should put together a team of key service providers.
- A broker who provides prime brokerage services: The ability to make trades or borrow cash and securities is critical for running a hedge fund. A broker can aid in the core activity of a hedge fund. Hedge funds require prime brokerage services in order to lend securities to other institutional investors and facilitate commercial bank margin loans.
- Auditor: Hedge funds must have their results audited if their track record is to be taken seriously when marketing to potential investors.
- Administrator: You want to concentrate on trading as a hedge fund manager. An administrator can handle the day-to-day tasks that keep the rest of the business running smoothly.
#6. Promote yourself
Before you can manage people’s money, you must convince them that your fund is a better fit than managing their money themselves or hiring someone else to do it. As a hedge fund, you can only accept investments from accredited investors. An accredited investor has $1 million in liquid assets or a yearly income of $200,000 (or $300,000 with a spouse). Start with your network of friends and family who fit that description. If not, you should be an excellent networker and salesperson.
When marketing, make certain that you follow all applicable laws and regulations. Consult with an attorney.
Display your (audited) track record from using the same strategy you’ll use for the hedge fund to prospective investors. Explain why the strategy will remain effective in the future. Then request their money.
#7. Launch
You can start your fund once you have enough investors. Connect the brokerage account and start trading.
Even after the launch, the hard work is likely not finished. In fact, it might be even more difficult. To expand the business, you must now manage the fund, continue to market it, and attract new investors.
Why Would Anyone Start a Hedge Fund?
The management of a hedge fund has the potential to be extremely profitable. The standard fee structure of 2 and 20 includes a 2% management fee for all assets managed and a performance fee of 20% of annual profits. Even if there are no profits, the company retains the 2% management fee. When it comes to hundreds of millions of dollars, the money adds up quickly.
Of course, in order to control $100 million or more in assets, you’ll need a network of high-net-worth individuals. You’ll need to show them that you’re a better steward of their money than they are. You’ll also need to market the new fund in order to grow the business, and don’t forget to invest all of your investors’ money.
If that sounds like a job you could handle, perhaps you should start your own hedge fund.
How Much Money Is Required to Start a Hedge Fund?
In the United States, average hedge fund startup costs range from $50,000 to $100,000, with first-year operational costs typically ranging from $75,000 to $150,000.
Is It Possible for Me to Start My Own Hedge Fund?
Yes, you could start with much less capital, go through a hedge fund incubator, or target only high-net-worth individuals. However, if you start with, say, $5 million, you will not be able to pay yourself, hire others, or even cover administrative costs.
Is It Difficult to Start a Hedge Fund?
It is relatively simple to start a hedge fund with a small amount of capital. However, it is extremely difficult to implement risk controls, grow assets, hire staff, and run the organization as a profitable business while producing positive results.
What Is the Profitability of a Hedge Fund?
Over the last five years through 2021, the average hedge fund generated net annualized returns of 7.2% with a Sharpe ratio of 0.86 and a market correlation of 0.9, according to BarclayHedge.
Where Is the Best Place to Start a Hedge Fund?
Although each country can provide an appealing investment environment, certain jurisdictions offer the best conditions for establishing a hedge fund or another type of investment vehicle.
- Luxembourg.
- The Dutch.
- Ireland.
- Cyprus.
- Panama.
- Seychelles.
- Hong Kong, China.
- Singapore
Conclusion
The difficulty of establishing a hedge fund firm is determined by the number of investors who have invested in the fund, the number of assets under management, and the complexity of the hedge fund’s investment strategy. There are a few hurdles and hoops to jump through when establishing a hedge fund firm in the United States, but they are simple to understand. The greater challenge will be raising the necessary investment capital to operate the hedge fund firm as a going concern, as well as generating consistent hedge fund investment returns that outperform their representative benchmark proxy on a net-of-fee basis over time.
Related Articles
- HEDGE FUNDS VS MUTUAL FUNDS: 7 key Differences You must know
- Hedge Funds: Simple Guide To Investing For Beginners (+Top 10 Hedge Funds list)
- FINANCE JOBS: Best Of Finance Job 2022 {Updated}
- Alternative Investments: Beginners Guide to the Investment Options
- Mutual Funds vs. Index Funds: All You Should Know
References
