How to Start a Hedge Fund?

Want to be a dynamic hedge fund manager? A career in hedge funds can be a fascinating and challenging experience simultaneously. But, before going any further, let’s get clear about the basics ofhedge funds. Educating yourself about the features of hedge funds and the way they work with market dynamics helps lay the foundation to start and build a hedge fund venture.

What is a Hedge Fund and Who Invests in Them?

A hedge fund is an alternative investment option that shields portfolios from a market crisis using funds pooled from authorized investors to invest in several assets while also generating favourable results in up and down markets.

It’s a risk management technique that employs several strategies with earnest attempts to mitigate loss and maximize profits for investors during possible market uncertainties.

Authorized investors, also called accredited investors or sophisticated investors who can do away with the protection of mutual funds regulations invest in hedge funds. They are wealthy individuals with a net worth of over $1 million or whose income exceeds $200,000 per year for the previous two years.

In case of an entity, it should possess assets over $5 million. Hedge funds should not advertise their funds to the public but, can register with the Securities and Exchange Commission.

Reasons to Invest in Hedge Funds

Hedge funds investment offer quite a few worthwhile benefits to investors compared to traditional investment funds. These include:

  • They can generate positive results in rising and falling markets
  • They help in portfolio diversification, thereby reducing risk and increasing returns
  • They offer downside protection because of their ability to hold short and long positions in portfolios
  • They are uncorrelated with other asset classes and help investors to customize their investment strategy
  • They exclusively focus on achieving an absolute return and impact all types of markets positively
  • The exclusive management focus enables hedge fund managers to exploit market inefficiencies and successfully develop and apply strategies to earn active returns for investors
  • Hedge funds have fewer rules and regulations compared to mutual funds and other investment products

A Better Understanding of Hedge Funds

Hedge funds are typically established as private limited partnerships accessible to only a select number of accredited investors and demand a substantially large initial minimum investment. Investors should keep their money in the fund for a lock-up period of at least a year and are illiquid in nature. Withdrawals are also allowed only during select intervals like quarterly or bi-annually.

Characteristics of Hedge Funds

The leading characteristics of hedge funds are:

The investment latitude is much wider compared to other funds

Hedge funds can invest in almost anything ranging from stocks, derivatives and currencies to land and real estate and, can be both short-term and long-term. This can be risky at times and can lead to severe financial blow-ups.

They are more expensive and charge a higher fee compared to conventional investment vehicles

The fee structure for hedge funds includes expense ratio and performance fees. The “Two and Twenty” fee structure comprises of 2% asset management fees and a 20% cut off overall profits generated.

They are more flexible than any other investment instrument

In spite of the risk of wide latitude option, hedge funds are flexible enough to produce some of the best long-term returns.

Kick-Starting Your Hedge Fund Venture

Educating yourself about the basics of hedge funds is the most important requirement already discussed.

Starting a hedge fund is not an easy ticket as it sounds to be. It requires a start-up capital in the millions. You also need to be an entrepreneur and the portfolio manager while you shoulder administrative responsibilities too. And if that’s not enough, you have to face the constant scrutiny by investors and provide clear-cut solutions.

Study the local and federal rules of hedge funds

A hedge fund is about long-term financial investment featuring legal rules and regulations. There are tax restrictions at the local and federal level. So, make sure to gather all the knowledge about local and federal law before going forward. Otherwise, you will end up spending more than you expected.

Develop a clear vision and a solid plan

Having a vision for the future and planning accordingly is an important part of setting up a hedge fund organization. It’s advisable to come up with a name to form an intent and plan goals around the same. It can shape the future of your hedge fund and can sort out initial issues efficiently.

Do you have a strategy in mind?

You have to keep investors free from any doubt while planning and executing a strategy. You have to show them the strategy and prove it with a defined process. The strategies include:

Market Neutral Strategy: You purchase a group of investments that are likely to rise and shorten them by dollar-for-dollar basis by shortening the overall market. Only the portion that is likely to go up performs better than the short-sold portion, makes money.

Hedged Equity Strategy: In this case, only a select portion is shortened. This is useful in case of an anticipated market fall.

Global Macro Strategy: This strategy is devised to earn money from large economic trends like global economies and global economic trends. This includes a country’s stock index, interest rates and currency levels.

Do you have a track record?

You should have a track of all your previous strategies and how they have worked under several market conditions. You should also be able to show that your past performance can enable you to be a portfolio manager. In short, you should be able to audit your performance clearly.

Do you have the money?

Initial funds are extremely important to get you hedge fund vehicle going. Having your own money has its advantages. However, you can source funds from hedge fund seeders, family & friends, university endowments and funds-of-funds.

Having a significant amount of your own funds gives you a strong foothold to perform beyond expectations. Overall, you should have more than just a sufficient amount to fund the initial andongoing costs.

Got an office space?

Renting office space at the outset involves huge expenses, especially in top financial centres. It’s advisable to start off with cheaper options like your home or a hedge fund hotel set up by prime brokers.

You can also share an office space with other managers as long as you are not competing with them directly.

Got access to service providers?

A hedge fund requires external partners to keep operations running. The quality of your service providers reflects your credibility and, this can be a deciding factor in ensuring a successful journey.

Hedge fund attorney: This is the first and the most expensive option you need to fulfil when starting out. You have to shell out a fortune for the legal formation of the fund. An experienced lawyer will also provide you with other quality referrals. Your lawyer will also plan your hedge fund structure by considering investment terms and conditions. These can be the fee structure, lockup term, redemption terms and performance targets.

Auditors: External auditors will verify your performance regularly for institutional investors to study the same before investing.

Administrator: An administrator is needed to handle several back-office operations. Here also institutional investors will look for quality before going ahead with the investment.

Marketers: It’s important to tie up with third-party marketing firms who refer potential investors. They work as retainers for a specific period or receive a portion of the funds they raise on your behalf.

Prime brokers: They provide leverage and act as the custody to your assets. They also offer you securities and manage your brokers and dealers.

Technology providers:Bloomberg terminals and other technological support are required to ensure smooth functioning. Automated trading requires a higher computing power and a higher amount of cash.

Do you have cash for yourself?

It takes time for money to start coming in and, you need to be patient. You also need to get your assets under management substantially big before deriving profits. What’s more? Most of your profits are reinvested for a couple of years back into the fund.

Hence, to meet your daily and monthly expenses, keep an alternative source of income with substantial funds.

Complete all the required paperwork

So, you are all set to launch your own hedge fund vehicle? Get your paperwork done at the outset that also includes registrations, fee payments and a test. You have to take the Uniform Investment Advisor Law examination and then register with the Securities and Exchange Commission.

Register with the IRS and get your federal employer ID number that allows you to pay your employees and your taxes.

The Conclusion

Figuring a strategy, raising capital and kick-starting hedge funds operations are only the initial steps. It’s a gruelling process that also involves the planning of day-to-day strategies, hiring investment professionals, partnering with external authorities and more.

You also need to plan and develop an exit strategy if things don’t go as planned.

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