How To Start A Hedge Fund

On average, hedge funds are believed to perform better than stock markets, but is it true? Consider that the Dow Jones Industrial Average returned 9.7% with dividends in 2020 while the aggregate return for hedge funds was 11.02%. When you’re talking about millions of dollars in investments, 1.3% makes a huge difference. If you want to know how to start a hedge fund of your own, here’s your guide.

Develop a Hedge Fund Strategy That Gets Results

Starting a hedge fund takes a lot of time and effort. Before you get serious about learning how to start a hedge fund, take a few minutes to get familiar with the legal requirements. Then, you can take a deeper dive into creating a hedge fund that generates solid returns for you and investors.

The most important part of learning how to start a hedge fund involves creating a strategy that generates above attractive risk-adjusted returns for your investors. It’s also the hardest part of starting a hedge fund.

Keep in mind that your hedge fund can include much more than stocks. You can add almost any type of asset to the fund. Ideally, you should find a balance between high-risk and low-risk investments. That way, you create ample opportunity for a high ROI while protecting your fund from significant loss.

It’s practically impossible for a single person to know enough about stocks, currencies, derivatives, and other investment options to create a successful hedge fund. Look to combine your experience with the expertise of others. Creating a team of advisors will set up your hedge fund for long-term success. You might also find that having a few high-profile names attached to your hedge fund makes it easier to attract investors.

Find a Lawyer to Help You Navigate Legal Requirements

Hedge funds aren’t as heavily regulated as mutual funds. You still need to meet numerous legal requirements before you can start marketing your product and taking money from investors.

Hiring a lawyer that practices investment law will help you avoid regulatory pitfalls that could stall your progress.

When exploring lawyers, look for someone experienced with the type of hedge fund you want to start. Do you plan to accept investments from people outside of the United States or only from Americans? The SEC has different requirements for each.

Will you manage more or less than $150 million in investments? That will influence the documents you file with the SEC.

Do you want to create a limited liability corporation (LLC) or limited partnership? You can choose either one, but they have independent pros and cons that your lawyer should help you understand.

Remember that you will soon start investing millions of dollars owned by other people. It’s understandable that the federal government wants to oversee some aspects of your organization. Otherwise, Ponzi schemes and other types of fraud would happen more often. Find a highly qualified lawyer that can take care of as much of the setup as possible.

Communicate With Your Secretary of State

Overall, the United States has loose regulations that make it relatively easy to create and manage a hedge fund. Each state, however, has the right to enforce additional regulations on top of those from the SEC.

It’s very important to keep in mind that you do not need to incorporate your hedge fund where you live. Many hedge funds incorporate in Delaware because the state has business-friendly laws.

The state that suits your needs best might depend on the specifics of your hedge fund, though. Again, talk to a hedge fund lawyer for advice. It’s the best way to make the right choice for maximizing returns without breaking any regulations.

Apply for a Federal Employer Identification Number

Since your hedge fund will operate as a business, you will need a Federal Employer Identification Number (FEIN). You can apply for your FEIN on the IRS website.

Once you have your FEIN, you will use it to file your taxes and tax-related documents. At some point, you will want to hire some employees to help manage your hedge fund.

Make sure you have a FEIN before you reach that point. You will need it to withhold income and payroll taxes.

Choose a Fee Structure for Your Hedge Fund

Hedge fund managers usually get paid according to the amount of assets they oversee and how much money they make during a fiscal year. You can expect hedge fund managers to ask for 1% to 2% of their managed assets. Performance bonuses are usually about 20%. These numbers are just examples, though. An extremely talented hedge fund manager, like Jim Simons, could ask for higher percentages to ensure they earn more money.

You might think that 2% doesn’t sound like much money. Consider how much that becomes, though, when someone manages $150 million in assets. That’s $3 million per year. Even at 1%, a manager overseeing $150 million in assets will earn a guaranteed $1.5 million per year.

The performance bonuses can also add a lot of money to a hedge fund manager’s base pay. Top managers can earn more than $1 billion in one year. Not many people reach that much money, but it happens.

Choose a fee structure that helps you attract a terrific hedge fund manager without significantly lowering the returns your investors expect. Most investors will already understand that the average hedge fund manager takes a 20% cut, so you shouldn’t have any trouble as long as you stay close to that percentage. Then again, you might find that you can attract more investors by giving your manager a lower rate. It’s a balancing act that deserves careful consideration.

Put Together a Team to Run Your Hedge Fund

Hedge funds don’t run themselves. Someone needs to keep a close eye on every asset to maximize performance. If your hedge fund includes some short-term or day-trading strategies (it probably will), you have to monitor market fluctuations 24 hours a day. Luckily, software can make this work easier. Don’t think that you can rely on software to do everything, though. You still need a professional to analyze data and make decisions.

Over time, you might need to add members to your team. For now, let’s assume that you can manage the hedge fund with a skeleton crew. That means you will need a(n):

  • Lawyer with years of experience in the financial sector.
  • Auditor who can provide objective financial analysis of your hedge fund’s performance (an essential for any investor to take you seriously).
  • Administrator who makes day-to-day decisions about how to invest money for maximum short-term and long-term growth.

You don’t necessarily need a full-time lawyer and auditor when you start your hedge fund. At the beginning, you can get the services you need and save some money by outsourcing to contractors or firms.

Start Attracting Investors for Your Hedge Fund

If you thought meeting SEC obligations was a challenge, just wait until you start trying to attract investors to your new hedge fund. Several obstacles potentially stand in your way.

The biggest challenge is that you don’t have much proof that you know how to generate large ROIs with your hedge fund. You’re new to the game, so a lot of people will want to sit back and watch your performance for a few years before they risk any of their money.

The second challenge is that you have a limited number of people that your hedge fund can serve. If you run a mutual fund, you can let just about anyone invest. The SEC has more requirements for hedge funds, though, because they’re a bit riskier and don’t need to meet as many regulations.

The only people allowed to invest in hedge funds are institutional investors and qualified investors, typically these are accredited investors.

Institutional Investors

Institutional investors are usually pension funds and other organizations that want to make money from your hedge fund. For example, a person working for the state might have the option to invest a percentage of their income in a pension fund. That gives the individual an indirect way of investing in your hedge fund.

Qualified Investors

Qualified investors must have net values over a certain amount. Currently, the net worth is set at $1 million. That $1 million does not, however, include the qualified investor’s primary residence or the first $200,000 of their annual income ($300,000 if they’re married).

How much does this influence how to start a hedge fund? A lot! Only about 4% of American households earn more than $300,000 per year. Of course, not all of those people will have $1 million in assets and cash.

Assuming that everyone earning $300,000 meets the other qualifications, you have the opportunity to pursue investments from fewer than 5 million American households.

Oddly enough, the SEC hasn’t updated its requirements for qualified investors since the 1980s. If the SEC decides to update the requirements according to inflation, you would need to focus on investors worth $2.5 million and earning $500,000 to $750,000 per year.

What would happen if the SEC adjusted its expectations for qualified investors? You would only be able to serve about 1% of households. That’s about 1.23 million. 

Marketing to Institutional and Qualified Investors

You have a fairly small pool of potential investors. How can you convince them to dedicate money to your hedge fund? It will require an excellent team and persuasive marketing.

Unless you have a superstar manager behind your hedge fund, don’t expect many people to take an interest until you can show them five years of returns. Once you can make a five-year report that proves you and your team know how to invest intelligently, more investors will come to you.

In the meantime, prepare to spend a lot of money marketing to people and organizations qualified to invest in your hedge fund.

Should You Start a Hedge Fund?

Starting a hedge fund clearly requires a lot of time and work. You will also need to dedicate a substantial amount of money to the fund.

If you think you have a group of people that can make a hedge fund successful, you can use their skills to attract investors and generate superior returns.

If you’re not 100% certain, you should probably focus on your personal investments before you dedicate your resources to starting a hedge fund.

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