This article was co-authored byMichael R. Lewis. Michael R. Lewis is a retired corporate executive, entrepreneur, and investment advisor in Texas. He has over 40 years of experience in Business & Finance.
There are16 referencescited in this article, which can be found at the bottom of the page.
Becoming the manager of your own hedge fund will give you the opportunity to invest other peoples money for them, which can be profitable for you and your investors. If youre an experienced financial advisor, it may be advantageous for you to step out from under the umbrella of the investment banking industry and strike your own path. To start a hedge fund, youll need to create and register a fund and start an investment company to be the funds general partner. In this endeavor, the investors will act as limited partners in a private partnership.
Hedge funds are pools of investor money that use a large range of different strategies to both generate returns for investors and manage risk. Hedge funds are typically only available to sophisticated investors with large amounts of assets to invest (often over $1 million).
The term hedge fund comes from the practice of hedging, which is the practice of reducing risk in an asset by taking a position in a related security to offset any downward price movements. These related securities often take the form of derivatives like futures, options, and forward contracts. Essentially, this strategy is intended to protect capital in the event of a negative event that causes an asset to lose value.
Hedge funds often use a wide range of complex strategies to maximize returns like using leverage (or borrowed money), using derivatives to profit from global economic trends, trading currencies, and investing in stock and bonds in markets all around the globe.
Distinguish between hedge funds and mutual funds.
Mutual funds and hedge funds are similar in that they are both pools of money managed by a fund manager. Other than this, however, there are several key differences. These differences are important to consider when starting one.
Firstly, hedge funds are not as regulated as mutual funds, and so they can invest in a more diverse and risky range of securities, as well as use strategies that mutual funds cannot use. Hedge funds can use large amounts of leverage (or borrowed money), short sell, and perform riskier trades on behalf of their investors, whereas mutual funds cannot.
Note that the strategies available to the hedge fund manager must be identified in the private placement memorandum that must be available to the investor before purchase.
Secondly, hedge funds and mutual funds have different levels of availability. Mutual funds are publicly-registered securities with SEC-approved prospectuses and are available to all investors. Hedge funds are funded through private placements to accredited investors, who must have a net worth of over $1 million (not including the value of your home) or an annual income of over $200,000 (now and going forward).
Thirdly, hedge fund investors are typically locked-in for a period. Whereas a mutual fund investor can sell their shares whenever they want, a hedge fund shareholder may be restricted for a certain period of time.
Finally, hedge fund managers are compensated differently from mutual fund managers. Mutual fund managers receive a set percentage of total assets managed each year, whereas hedge fund managers typically receive a set percentage of total assets (usually about 2%), plus a percentage of profits that are earned. This percentage is usually about 20%.
Manager compensation is defined in the hedge funds prospectus and is agreed to by the investor.
Hedge funds managers usually get their start by achieving a successful investing track record throughout years of industry experience. This is how they attract their first clients and build out their funds. But even with the requisite experience, youll also need an overall vision for your fund, including an idea of how it will generate returns for investors. Hedge funds can follow a number of different strategies, including:
Market Neutral Strategy: This is a popular strategy that involves purchasing a group of investments that are expected to go up, and then offsetting these investments dollar-for-dollar by short-selling the overall market (one of the S&P 500 Index ETFs, for example). If the portion that is expected to go up does better than the short-sold portion, the fund would make money. This can be a useful strategy to market to investors who are concerned about market crashes.
Hedged equity strategy: This strategy is similar to the market neutral strategy, except instead of shorting the entire portion of the portfolio that you expect to rise on a dollar-for-dollar basis, only a portion would be shorted. For example, if you had a $1 million portfolio, $300,000 may be shorted. This means if the market were to collapse there would be some protection, but generally speaking your fund would be structured to make money from markets rising.
Global Macro strategy: This type of strategy seeks to make money from large economic trends. If you have extensive knowledge of economics, global economic trends, global economies, and how these pieces fit together, this may be a good strategy to pursue. Global Macro strategies make money by forming an idea of what will happen to a particular countrys (or multiple countries), stock index, interest rate, currency, or inflation/deflation levels.
Hedge fund managers typically pursue a strategy to reduce the volatility of a portfolio while maximizing the upside profit potential. In times of expected market declines, this may mean buying low velocity stocks while shorting high velocity security. In this way, the decline in the former would be offset by greater gains in the latter.
One benefit of a hedge fund over a mutual fund is…
Nope! Mutual funds, since theyre publically registered, are available for anyone to invest in. But in order to invest in a hedge fund, a potential investor must have a net worth of at least a million dollars, not counting the value of their house.Click on another answer to find the right one…
Not quite! Mutual fund investors can choose to sell their shares whenever they want. Hedge fund investors, on the other hand, are typically locked in and must keep their shares for a specific length of time before theyre allowed to sell them.Try another answer…
Absolutely! In general, hedge funds are less strictly-regulated than similar mutual funds. This greater freedom allows hedge fund managers to make riskier trades and therefore have a chance of making a much higher profit.Read on for another quiz question.
Not necessarily! In order for a security to be offered as part of a mutual fund, it needs to have an SEC-approved prospectus. Hedge funds, on the other hand, are privately funded and can invest in a security without an SEC-approved prospectus.Pick another answer!
When starting a hedge fund, it is absolutely certain that you will need a lawyer throughout the process at some point. It is always advisable to establish contact with a group of lawyers experienced in financial law who will be be able to help you not only with the initial incorporation, but also with other aspects of establishing the fund. This is not the time for a silly paperwork slip-up that could cost you. Consult the experts.
Look around for lawyers that are experienced in financial law, and even better, lawyers that have experience specifically working with and starting hedge funds.
Decide what kind of entity you want to create.
The fund entity type that you are able or required to create will depend on your states regulatory laws. Limited partnerships, limited liability companies, and trusts are the typical entities used to create a hedge fund, but youll need to research local laws regarding the formation of business entities to learn more. Contact the commerce department in your state.
A limited partnership has two parts. It will have a general partner, who will serve as the manager and is personally liable for all the businesss debts and obligations. Corporations can serve as general partners. It will then have limited partners, who are not liable for the debts of the company.
For the most part, hedge funds are typically formed as limited partnerships, in which an incorporated group of investors acts as the limited partners, and an investment advisor acts as the general partner
Assemble an investment team of trusted advisors.
If youre spinning off from an investment bank, its typical to try bringing some coworkers with you to your new venture. A good team is essential to success.
Its hard to sell yourself to investors without first establishing a successful track record. Choosing workers with great employment histories and successful track records buying and selling securities will help in the long run, seeding your company with human capital and enabling you to hit the ground running.
When establishing a team, your goal should be to first finding people who you have a strong personal chemistry with, and who share your vision. Your next criteria should be experience. For example, if you are starting a market neutral fund, choose analysts who have experience doing the kind of high-level analytical work that is associated with creating a fund like that.
Your fund needs to have a name attached to it before you can fill out the proper paperwork. It should be something that sounds memorable, stable and reputable. Use the name to promote your image.
Try to connect the name of your fund to its overall strategy in some way. For example, if you are operating a market neutral fund that attempts to eliminate exposure to the overall market and generate steady, reasonable returns, your name should reflect this vision.
In the U.S. your fund entity will need to get a Federal Employer Identification Number (FEIN) from the Internal Revenue Service (IRS). This can be done by calling the IRS or going to its website and filling out the necessary forms.
Its free to get your ID number. The process takes only a few minutes and can be completed online.
You will need to register with the Securities Exchange Commission (SEC) as an investment advisor if you have 15 or more investors associated with your fund. If you have less than 15, you generally do not have register with the SEC, but it is advisable to do so anyways since it adds to your overall credibility.
In addition, most states require an prospective investment adviser to pass the Uniform Investment Adviser Law Examination (Series 65). Some states will waive exams for holders in good standing of professional designations such as the CFP, CFA, or CIC.
To register youll also need to take the Series 65 regulatory exam. This three-hour test covers your basic knowledge of securities laws and practices as well as your understanding of ethics. When you pass the exam you will be a licensed investment advisor in your state.
Fill out a form U-10 with your state to register for the examination, then pay the small exam fee and schedule your test. It typically costs around $30.
If your hedge fund has 10 investors, why should you register with the SEC?
Try again! Youre required to register as an investment advisor with the SEC if the hedge fund you manage has 15 or more investors. Even if you have fewer investors than that, though, its a good idea to register even though youre not legally required to.Try another answer…
Not exactly! Whether or not you register as an investment advisor with the SEC, it doesnt affect your ability to incorporate as a limited partnership. And thats good, because limited partnerships are the most common structure for a hedge fund.Choose another answer!
Right! Youre not legally required to register with the SEC if your hedge fund only has 10 investors, but you should do it to convince potential investors that youre trustworthy and professional. Registering when you dont have to projects confidence in your hedge fund.Read on for another quiz question.
An investment advisor has two basic choices in structuring a fund: you can either run your hedge fund as a sole proprietor, or you can create a corporation to partner with you and limit your own liability. Its a common practice to seek protection from liability by creating a corporation to act as the general partner of your fund entity. This partner will be your investment advisory company.
Remember that with a limited partnership, the general partner is completely responsible for all the firms debts and obligations. So, if you incorporate your general partner, your personal assets are protected in the case of a lawsuit or in the case of debts. This is because a corporation is a separate legal entity.
Fill out the articles of incorporationin your state.
Always consult your lawyer before incorporating, they can guide you effectively through the process.
Your firm will need to compile an in-house rulebook to move forward with incorporation and register with the SEC and the regulatory bodies in your state. The bylaws are yours to choose but might commonly include:
Register your company as the Registered Investment Advisor (RIA).
Do this on the website of the Investment Advisor Registration Depository to make the partnership legal. The process is free but will take several hours to complete. You may want to speak to your legal team before moving forward with the process of registry.
This process is necessary to make your company able to manage assets and provide financial advice.
Register yourself as the Investment Advisor Representative (IAR).
After your fund is legally a Registered Investment Advisor, you must register yourself as the investment advisor for your fund.
You can register yourself as the investment advisor for the fund by going to the same website you went to when you registered your company as the Registered Investment Advisor. To complete the process, youll need to submit a Form U-4 and pay the fee to the IARD.
This establishes you a representative of your company.
Register the fund offering with the Securities and Exchange Commission (SEC).
Hedge funds dont technically register with the SEC but do register the offering of the limited partnership to investors. Just as corporations offer stock and LLCs offer memberships, limited partnerships offer interests, and the offering of this interest must be registered with the SEC.
Offerings exempt under Regulation D from registration must comply with specific limitation on the solicitation and sale of private securities. This includes restrictions on the type and number of investors solicited as well as the interests sold and requirements for adequate disclosure of the investments details.
To register, fill out Form D with the SEC. Youll also need to fill out Form D in each state in which you intend to offer your fund.
Why is it a good idea to create a corporate partner for your hedge fund?
Not necessarily! Having a corporation as the general partner of your hedge fund doesnt automatically make you look more or less legitimate than a sole proprietorship would. There are other important benefits, though.Choose another answer!
Nice! If you incorporate as a sole proprietorship, youre personally liable for all business debts. Forming a corporation to be the general partner of your hedge fund offers some protection to your personal assets.Read on for another quiz question.
Nope! You need to register as an investment advisor with the SEC regardless of whether your hedge fund is a sole proprietorship or a limited partnership. The only exception is if your hedge fund has fewer than 15 investors.Pick another answer!
In order to attract investors to your hedge fund, you will need to create a set of documents that explain your funds goals and terms of investment. This generally takes the form of a prospectus or private placement memorandum (also called an offering memorandum). This document both protects the hedge fund, by assigning liability for losses to the investors, and the investors, by providing specific strategies that will be employed by the hedge fund.
These documents are not optional. They are required by securities regulators and must disclose specific information. Consult with professional legal counsel to ensure that you meet all of the necessary disclosure requirements.
Despite regulations that prevent hedge funds from publicly advertising their funds, they are allowed to set up informational websites. These websites can display the experience and backgrounds of the funds partners and provide information on the partners investment strategies.
Having a clean, professional, and informative website can help foster trust in potential investors.
Getting the cash to get your fund off the ground can be the most difficult part of starting a hedge fund. You need assets under management, which youll have to get from investors unless youre independently wealthy and want to seed the fund yourself. The best way to make your case to investors is to have an air-tight operation as well as an established track record of success during previous employment.
You will need to approach banks, venture capital firms, and wealthy investors with whom you or your team have prior relations with. It may be useful to establish strategic partnerships with these institutions where possible.
In addition, many hedge fund managers gather seed money from friends and business acquaintances.
Ultimately, seeking capital requires salesmanship, and you will need to convince investors that you can create value. To do this, when speaking to potential sources of capital, focus relentlessly on your strategy, how your strategy works, why your strategy works, and how it has an edge over the competition. Secondly, focus on your team, and your experience, strengths, and successes.
Investors are more likely to fund somebody with a proven track record of success, so be sure to play up your prior successes, as well as those of your partners or employees if you have them.
Consider offering reductions in your management fee or partial fund ownership to early investors.
Be aware of the regulations affecting the marketing, solicitation, and sale of private interests on a Federal and state level.
Initially, many hedge fund managers start with a small fund that is made up of a large amount of their own funds. Even with a prior record of success outside of hedge funds, investors are still skeptical of new funds until they have proven themselves. After an initial period of success, if you earn large returns on your investments, you will find it much easier to attract investors.
A prime broker is a bank that essentially provides you with all the financial services you need to run your fund. This includes lending you money, executing trades on your behalf, and providing you with what you need to do things like short sell stocks. They can also help you find investors for your fund.
Approach institutions like Goldman Sachs, Morgan Stanley, Bank of America, or any other investment bank for these types of services.
If your hedge fund is performing well and you feel comfortable enough to expand operations, its a good idea to start attracting talented brokers to expand your operation and start performing more transactions. You should to look for dedicated employees who want to make money in a fast-paced and competitive environment. Get the word out that youre looking for the best.
Growing doesnt necessarily mean taking on more employees. Some hedge funds are successfully in business as one-man operations.
As soon as you can afford it, move into a space appropriate for your business. Start small, but build a corporate office that will display the professionalism and spirit of your operation.
In terms of hedge funds, what is a prime broker?
Nope! When you start a hedge fund, its pretty typical that most of your anchor capital will come from you personally, even if youre not legally the general partner of the fund. But just contributing a lot of money to a hedge fund doesnt make you the prime broker.Pick another answer!
Yes! Somewhat confusingly, a prime broker is not actually a broker who works for the hedge fund. Instead, the prime broker is an investment bank that performs services like executing trades on the funds behalf.Read on for another quiz question.
Try again! The general partner of a hedge fund is the partner who is primarily liable for the funds obligations and debts. Its often a corporation, but even in that case, its not the same thing as being the prime broker.Pick another answer!
Michael R. Lewis is a retired corporate executive, entrepreneur, and investment advisor in Texas. He has over 40 years of experience in Business & Finance.
Successful hedge fund operators have superior financial analytical skills, an ability to identify and manage investment risks successfully, and excellent communication skills. The latter is necessary to convince potential partners to invest, reassure disgruntled clients during periods of average or poor performance, and encourage employees to stay the course. A placid personality and an iron-cast stomach also help.
What types of backgrounds or experiences does one typically have when starting a hedge fund?
As the above article explains, a hedge fund manager typically has years of industry experience. Such a person will need strong nerves because of the large sums of money and the many risky investment strategies involved.
What is the minimum amount of money required for a hedge fund? Does it vary by state?
Theoretically, you could try starting one with any amount of money, but I personally would recommend pooling around $10,000 (at least) with some close friends to start a very small hedge fund. You and your friends can then build your way up from there. And it could vary by state depending on said states tax laws and whatnot.
Is an apartment REIT the same as a hedge fund?
No. An apartment REIT invests in apartments (and perhaps other income-generating real estate). A hedge fund will make almost any kind of investment, engaging in greater diversification and leverage techniques than a REIT would.
Is there a fixed rate-of-return percentage of investment paid to investors by the hedge fund?
No. Although a hedge fund may offer a guaranteed minimum return, they would not promise a fixed rate.
Can a RIA/IAR firm start a fund that shorts, leverages and use other tricks of the trade without registering it as a hedge fund? Have had much success operating in this manner and Im about to INC.
What is the procedure for starting a hedge fund in Pakistan?
How much money you need to start a hedge fund by the law California?
Is it possible to set up a hedge fund for a real estate investment?
Include your email address to get a message when this question is answered.
Hiring a law firm to help you through the setup process can make things easier, but the costs can be substantial.
To start a hedge fund, decide if you want to create a limited partnership, limited liability company, or trust for the hedge fund. Next, name your hedge fund and register for a tax ID number. Register the company through the Investment Advisor Registration Depository, then register yourself as the Investment Advisor Representative. After that, start promoting your hedge fund and seeking capital!To learn more about attracting investors for your hedge fund, read on!
This article was co-authored byMichael R. Lewis. Michael R. Lewis is a retired corporate executive, entrepreneur, and investment advisor in Texas. He has over 40 years of experience in Business & Finance.
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