There are many reasons why starting a hedge fund has become the new American dream. Almost everyone has read the stories about hedge fund billionaires. Their faces are in the mainstream media almost daily. And yet, the secretive and exclusive nature of the hedge funds they created is a draw in itself compared to many other areas of finance and investing, which can seem mundane.
With a little bit of capital, it is relatively easy to start a hedge fund. However, implementing risk controls, growing assets, hiring staff, and running the organization as a profitable business while producing positive performance is very challenging.
- If you want to start a hedge fund, think of it like any other business startup: build it like a business.
- Clearly define your investment strategy and get ready to communicate it effectively to staff and initial investors.
- Develop a marketing plan and start looking for sources of startup capital and talented employees.
The Hedge Fund Rollercoaster
First of all, you'd better be sure you know what you're doing. The hedge fund industry as a whole has had its ups and downs, and many of the players in it fold, year after year.
In 2018 alone, $88 billion was withdrawn from hedge funds by their investors, and more than 400 funds were liquidated, according to CNN. Poor performance combined with high fees spelled death for those funds. Yet hedge funds as a whole still had an estimated $3.2 trillion under management.
In 2019, the industry roared back. The HFRI Fund Weighted Composite Index, which tracks the industry as a whole, returned 10.4% for the year, its best year since 2009. Hedge funds performed very well again in 2020, returning 9.8% for the year.
Tips for Hedge Fund Startups
It's important to realize that a hedge fund is a business, and it must be approached with the same systematic approach and long-term perspective. Here are seven big factors to work through.
1. What's Your Competitive Advantage?
Your hedge fund must have a competitive advantage over others in the market. This can be a marketing advantage, an information advantage, a trading advantage, or a resource advantage. A marketing advantage might be close relationships with hundreds of high-net-worth investors. A resource advantage could be a connection to an asset-management firm that might invest heavily in launching a hedge fund.
2. Define Your Strategy
Some hedge fund startups underestimate the importance of clearly defining the fund's investment strategy. Define your strategy and hone it until you can explain it succinctly to your own team and initial investors. The strategy must be repeatable, defensible, and profitable after paying the costs of running the hedge fund.
Ideas that have not been tested in the real markets don't hold much water with investors and consultants, who see hundreds of wannabe hedge fund managers every year.
Conduct as much competitive research on your competitors as you are able to, ethically and legally.
Do some hedge fund performance research so that you know which strategies are currently doing well, which are not, and why this might be the case.
Are you launching your fund at a time when your strategy is in very high demand or has the pendulum swung the other way? Start building a list of hedge funds that run a similar strategy and conduct as much competitive intelligence on them as you are able to, ethically and legally.
3. Find the Seed Capital
It is important that your new hedge fund be adequately capitalized. The amount of assets your fund will need to manage to become profitable will depend on three things: your team size, your investment partners, and your unique cost structure.
With respect to capital, according to the hedge fund law firm Seward & Kissel, the amount required to launch a hedge fund is increasing. In its 2019 New Hedge Fund Report, the law firm stated that hedge funds required significantly higher minimum commitments from their investors compared with funds launched in prior years. Seed funds for new launches were sometimes well over $100 million.
In 2018, Steven B. Nadel, who was the lead author of the Seward & Kissel report that year, said that rising investment minimums were partly to help new hedge funds get on the radar of institutional investors. “Some of the big institutional allocators, they may not even talk to you unless you have $100 million or more under management,” he said.
The number of hedge funds liquidated from 2015 to 2020.
4. Develop a Marketing and Sales Plan
In any business, nothing happens until a sale is made. It is important to develop a sales plan for raising assets before you open your doors for business.
One of the first steps is deciding where you will try to raise assets. There are many potential sources of investors, including:
- Seed-capital providers
- Family and friends
- High net-worth individuals
- Financial advisors
- Wealth-management offices and RIAs
- Single- and multi-family offices
- Fund of hedge funds
- Foundations and endowments
- Sub-advisory relationships
Small hedge fund startups typically rely on seed capital providers, family and friends, and high net worth individuals (directly or through their financial advisors). Working with institutional-quality investors who might invest $25 million to $100 million at a time can be difficult unless you have a track record and more than $100 million in total assets under management.
Your toolkit must contain all of the basics that any solid business today has. That means a website, a two-page marketing piece, a 20-page PowerPoint presentation, a professionally-designed logo, letterhead, and business cards, plus folders with the logo on it for presentation at business meetings.
These may sound like Business 101 details, but they are often overlooked or poorly executed. Anyone who can really help your business sees hundreds, if not thousands, of hedge fund managers a year, and it is easy for them to see which managers have invested their time and effort and which have thrown something together at the last minute.
All marketing and sales materials should be produced under the direction of your chief compliance officer or compliance consultant, as there are many limitations and details that need to be approved and reviewed.
5. Consider Risk Management
Risk management is an important piece of the puzzle when running a successful hedge fund. Your firm must have a concrete and competitive method for managing both business and portfolio risk or you will not be viewed as serious about your business or long-term growth goals.
Hedge funds often utilize leverage or derivatives, or else engage in complex trading strategies in novel asset classes. This means that a hedge fund's risk exposures will be different than traditional funds and may indeed be unique to a particular hedge fund. Professional risk managers are key to ensuring that risk is properly hedged and accounted for and that surprises are kept to a minimum. Market and strategy risk is one piece but you must also pay attention to model risk, operational risk, counterparty risk, and more.
There are many consultants and consulting firms that do nothing but advise hedge funds on portfolio and operational risk-management issues.
6. Get a Great Lawyer
Hiring good legal counsel is an investment. An experienced hedge fund lawyer can help you avoid pitfalls and build relationships and bring you into networking events such as private-capital introduction dinners.
It will also show others in the industry that you are investing in your own business because you aim to be in the industry for the long haul.
7. Decide on a Prime Brokerage
Many startup hedge fund managers underestimate the importance of choosing a prime brokerage firm, which can act as a partner to the business.
The prime broker is an integral part of how your hedge fund will trade and operate. You could take several weeks or months to evaluate your options and weigh the costs and benefits of doing business with the various firms you meet with.
It is wise to choose a prime brokerage team that is very motivated to serve your needs, but not so small that they cannot meet all of your trading and prime brokerage requirements. While capital-introduction services can be a great thing for your prime broker to offer, be aware that they often require a nine- to 12-month track record before they can do much beyond helping explore seed capital sources.
Once your team has proven itself, a good prime broker will help make introductions if you have great performance and a solid team behind the portfolio.
8. Build Out Your Technology
Today's trading is mostly done with a technological backbone. You need to decide whether or not you will build your trading systems in-house or if you will purchase systems from a vendor. If you build in-house you'll have more flexibility and maintain secrecy over your strategy but will also need to hire capable programmers and software engineers.
More and more financial firms are utilizing cloud-based systems to run their platforms instead of housing their own servers. Regardless of how you house your own IT or outsource it, you will need to keep a keen eye on security and disaster recovery if systems fail.