How to start a Hedge Fund

square-mile-london-hedgethink How to start a Hedge Fund

Starting a hedge fund can be a route to unimaginable riches – but if it was easy, everyone would be doing it. Here, we have provided a step-by-step guide to starting your own hedge fund. Obviously, we have had to skirt over quite a lot of detail here, as the actual ins and outs of starting a hedge fund could fill several large books, but it does at least give you an idea of what is involved and some avenues for further investigation and study.

Choosing a name

You can call your hedge fund anything you like, but historically most of the successful firms have named themselves after a location in a major financial centre -such as Thames River Capital (London) or Pershing Square Capital (New York) – or they have gone for something aggressive or imposing-sounding, such as Tiger Capital or the Quantum Fund.

The bigger financial firms, that operate several hedge funds, tend to go for long streams of relatively meaningless words, although this approach does not automatically instill trust in investors, especially after the collapse of Bear Sterns funds such as “high-grade structured credit strategies enhanced leverage fund” which went from $642m to zero in the space of a trading day.

Register your fund

Although the majority hedge funds are situated in major financial centres such as London or New York, nearly all of them are registered legally in tax havens such as the Cayman Islands or Bermuda to avoid paying taxes and reduce the regulatory burden. Although it is possible to register a hedge fund in a country such as the UK or the USA, in practice this almost never happens. However, this could all change with the incoming modifications to the FATCA legislation in the US, which is set up to prevent tax evasion by means of offshore investment vehicles, which could see more hedge funds being registered domestically in future.

Set your fees

Fees are where a hedge fund makes its money – and a successful hedge fund can be virtually a license to print money. The most common arrangement for hedge fund fees is “two and twenty”, which means that the fund manager takes 2% of the client’s  money up front to cover the basic costs of running the fund, and 20% of the profits made with the client’s money. If the fund is successful, this arrangement can be highly lucrative. For instance, if a fund has $1 billion in assets under management and achieves a 25% rise over the course of the year, the hedge fund company makes a cool $52m. Some high-profile hedge fund managers charge even higher fees, on the basis that they will be able to make more money overall.

Fundraising

This is probably the hardest step of all, as you need to raise a substantial sum, and you will have to do so at the expense of the thousands of established hedge funds that are out there. In order to have any credibility, you need to have at least $50m to begin with, so it can help to be wealthy in the first place, or have very rich and trusting friends and family. Because hedge funds can’t be directly advertised to the public, the bulk of the fundraising is done privately via conferences, presentations, and contacts. It’s essential to have good relations with big investment banks, as these will often arrange introductions to potential investors for hedge funds in exchange for choosing them as a broker.

As a rule, you should only ever accept money from extremely rich people, as you don’t want somebody tying their whole life savings up in the fund and stressing out at you about it every day. Minimum entry requirements vary from one country to another, but in the US potential hedge fund investors are required by the SEC to have assets worth $1m or more and an annual income of $200,000 or more. For more about fundraising, take a look at our guide to Capital Raising Tools and Resources for Hedge Fund Managers.

Rent an office

The opulence of your office serves as an important visual cue to would-be investors that you know how to make serious money from the markets. That’s why most hedge funds have incredibly high-end office spaces in prestigious locations such as Mayfair in London or Lower Manhattan in New York. While it might cost hundreds of thousands of pounds a year to rent, if your fund isn’t making enough to make this look like small change, then you will find it hard to attract investors.

Recruit staff

One of the silver linings of the recent financial crisis is that it’s never been easier to recruit good staff with a strong track record in the financial services industry. In the wake of the credit crunch, big-name investment banks such as Bear Sterns, Merrill Lynch and Citigroup laid off thousands of extremely well qualified staff. To begin with, it makes sense to outsource your back office and accounting functions to a company that specialises in providing these to the hedge fund industry, as you will have enough on your plate trying to make money without having to recruit and marshal an administrative team.

Select an approach

There are as many different approaches to trading as there are hedge funds, but pretty much all of them can be categorised as being largely quantitative or fundamental in their approach. Quantatitive or ‘quant’ trading is a relatively new, high-tech approach involving complex software algorithms that are used to make lots of short-term automatically-executed trades in an effort to turn an aggregate profit. These algorithms might be used to evaluate variables such as price/earnings ratios and price history to determine the trades they make, or they might take advantage of arbitrage opportunities that would be nigh-on impossible to spot by manual detection methods.

While quant trading techniques can be highly profitable, and some of the biggest hedge funds use these techniques exclusively with impressive results, when they go wrong the results can cause chaos in the markets. For example, in 2008 a Goldman Sachs quant fund lost a third of its value – some $1.8bn – after hundreds of quant programs dumped stocks simultaneously in what has been dubbed a “herd mentality” phenomenon.

Trading with an approach centred on the “fundamentals” is something that hedge fund managers (and other traders) have been doing for as long as there have been capital markets to trade. Funds that take this type of approach invest a lot of time and resources on doing research into the prospects of currencies, commodities, and currencies in order to identify profit opportunities. This might entail talking to analysts, attending shareholders’ meetings, or meeting with corporate management, alongside other information-gathering tactics. For more information on this topic, take a look at our guide to Types of Hedge Funds.

Adopt a strategy

Again, there are countless strategic approaches to hedge fund investing, and no two hedge funds will employ the exact same strategy. Traditionally, hedge funds used a ‘long/short’ strategy, which involves making simultaneous long and short positions on complimentary financial instruments in order to ‘hedge’ against risk. While the majority of hedge funds still use this strategy to a greater or lesser degree, it is no longer the only strategy commonly employed by hedge funds.

Other strategies include “distressed”, which involves taking big risks on struggling companies while the price of their securities is at a level that reflects their current difficulties, “convertible arbitrage” which identifies and exploits discrepancies in pricing between the common stock and the convertible debt (bonds with the option to be converted into stock) of a company. “Global macro” funds base their trading decisions on wider economic trends rather than the specifics of certain securities, while an “event driven” strategy involves trading on the market volatility that can occur after a major news event or economic release. For a more detailed look at the various hedge fund strategies, read our ‘How do hedge funds work?‘ guide.

Hope for the best

Ultimately, the success or failure of your hedge fund could be down to wider economic forces. During the financial crisis, for example, very few hedge fund managers managed to turn a profit, and there were hundreds more who were forced to shut down due to massive losses. However, during the boom years of the 1990s, many of these same managers made record-breaking profits year after year. Although hedge funds are, by definition, structured as “absolute return” investment vehicles, in that they have the freedom to make money from bear markets as well as bull markets, in practice it is far easier to make money during the latter.

So, even if you have all the right ingredients in place, there is still no guarantee of success. You can, however, take comfort from the fact that hedge fund managers tend to do rather well for themselves – for example, 28 of the 400 richest people in the world in 2013 (according to Forbes) made their money as hedge fund managers, and the richest of them all – George Soros – has an estimated worth of over $20 billion. So it might be incredibly stressful, but if you can pull it off, there is some serious money to be made by running your own hedge fund.

 

4 thoughts on “How to start a Hedge Fund

  1. $ 52 Mil. is cool but $ 70 Mill. is even better if there was better math. 2 & 20 means 2% of $ 1000 Mil as fees = $ 20 Mill. as fees. In the hypothetical 25% return, 20% (1/5) of that is 5% – & 5% of $ 1000 Mil.= $ 50 Mill. Total take (loot) is $ 70 Mill. ( 50+20=70) in the first year. WOWIE ZOWIE.

    I understand that in real life it is difficult to raise $ 50 Mill. even, so $ 1000 Mill is a pipe dream……

  2. “The opulence of your office”
    Smart Investors should be impressed by outsize returns not outsize offices.
    One hedge fund returned 68% last year and beat S&P500 index by 10% per year over last 7 years. and it operates from a basement.
    All the ‘opulence’ you need in inbetween the ears of the head man…….