How to start a hedge fund

By Chainika Thakar

Have you ever considered starting your own hedge fund? If you're interested in finance and investing, it can be a tempting prospect. After all, hedge funds are known for generating impressive returns and providing a path to financial freedom.

However, there's more to starting a hedge fund than just earning profits. In fact, it can be a complex and challenging process, requiring careful planning and attention to detail. But don't let that discourage you! With the right approach and preparation, you can build a successful hedge fund and achieve your financial goals.

In this blog post, we'll explore the key steps and considerations involved in starting a hedge fund, so you can make informed decisions and set yourself up for success.

This blog covers:

Overview of the hedge fund industry and its potential for growth

The hedge fund industry implies such strategies that are created with a proper market analysis and backtesting that includes risk-adjusted return.

Let us find out a few more aspects of the hedge fund industry such as:

• Basics of hedge funds
• Types of hedge funds and strategies
• Growth potential of hedge funds

Basics of hedge funds

A hedge fund is an investment fund which implements trading strategies to help earn the maximum risk-adjusted returns for all its investors as soon as possible.

Since the focus is on short-term gains, hedge funds are known to use borrowed or leveraged funds to maximise the returns for the investors.

Because of the risk that leveraged funds are associated with, hedge funds in the U.S.A and Europe had to be regulated during the financial crisis of 2007-08 ⁽¹⁾. The main reason for the crisis was the housing bubble that led to a lot of people buying newly-built houses predicting a boom in the housing sector.

Instead, eventually US house prices began to fall and there were a huge number of borrowers that were unable to repay their loans.

Types of hedge funds and strategies

Hedge funds are mainly of four types and each is targeted at a particular kind of situation or circumstance for ensuring good returns. For example, global hedge funds try to find the opportunities from the market price fluctuations caused by a political or an economic event. The political event may be an expected increase or decrease of prices due to the anticipated change of government etc.

Now, let us discuss each type of hedge fund in brief detail. These different types of hedge funds are:

• Global hedge funds - As discussed above, these hedge funds target the market fluctuations and try to benefit from the same. We already discussed an example above for the same.
• Equity hedge fund - This kind of hedge fund can be either globally operational or specific to a country. Such a hedge fund invests in the stocks which see an uptrend over a period of time. Also, the equity hedge fund hedges against the anticipated downturn in equity markets by shorting the overvalued stocks.
• Relative value hedge fund - This hedge fund is meant for exploiting the differences in the prices of related securities. The relative value hedge funds take advantage of the inefficiencies in the price or spread.
• Activist hedge fund - This hedge fund aims to invest in businesses. The actions taken are to increase the stock prices of the particular businesses. Meanwhile, the investment helps the business to cut costs, restructure assets or change the board of directors.

Growth potential of hedge funds

The research ⁽²⁾ shows that from 1993 onwards, hedge fund capital under management has been growing at an annualised compound growth rate of 26%.

Also, a recent study ⁽³⁾ shows that the hedge fund grew at a lesser rate during the COVID-19 pandemic as compared to before the same. There were only around 900 new funds launched in 2022 compared to a record of more than 2000 in each of the previous two years according to a new analysis.

Skills or prerequisites required for starting a hedge fund

There are some skills that are the prerequisites for starting your own hedge fund, and these are:

Quantitative analysis

Starting a hedge fund requires you to hold an important skill, that is, the skill to do quantitative analysis. For acquiring this skill, one can opt to learn economics or finance.

Portfolio management

Portfolio management is most integral to an individual starting a hedge fund. You must be ready to manage investments for a hedge fund since it requires a lot of past experience in managing invested capital.

Sound at discussing technicalities

In order to be able to discuss with the investors aptly, you must have a sound knowledge of the analytical and technical aspects of the hedge fund. This knowledge will help you have a word with your investors in layman terms.

Strong mathematical and statistical skills

Some knowledge of mathematics and statistics may be needed for applying various quantitative methods in your work. Hence, the mathematical and statistical knowledge is a must.

Risk management & compliance

Managing risks is an important part of a hedge fund since hedge funds may have a high-risk nature which implies higher the risks, higher the returns.

Apart from the above-mentioned skills or prerequisites, the individual starting a hedge fund must have enough capital and knowledge of the legal structure required.

Steps to start a hedge fund

Now, let us see the steps to start a hedge fund which include the following:

1. Formulate a trading strategy
2. Determine the fund structure
3. Legal and regulatory requirements
4. Selecting the right service providers
5. Develop marketing and fundraising strategies
6. Launch the fund and begin operations

Formulate a trading strategy

One of the most important steps for a hedge fund startup with respect to the beginning period is an investment strategy. The strategy is the most important factor of success or growth potential for any hedge fund. The investment strategy is usually created by the hedge fund owner or the manager.

While formulating the trading strategy, the nature and place of its investors and the total amount of assets expected to be raised are taken into special consideration.

Determine the fund structure

Hedge funds are structured on the following factors:

• The hedge fund is registered in the domestic country so it’s where the fund is domiciled or the domestic country is an important factor.
• The location of its investors. Both domestic and offshore.
• The hedge fund’s investment strategy. This is the core of a hedge fund.

There are different types of fund structures and may vary based on geography. Some of the fund structure types, say in the U.S, are:

• Side by side
• Master feeder
• Standalone

Side by side

In the side-by-side domestic structure, U.S investors invest in a limited partnership organised in their country. A side-by-side hedge fund runs parallel to a structure which is located in a foreign location and is usually known as the offshore structure. The offshore hedge fund also follows the same strategy as the domestic fund.

This implies that the side by side structure aims at achieving an equivalent performance return in both funds.

Also, this assumes the similar investment strategies for both domestic and offshore funds and the trade executions are usually on the basis of capital in each fund. Both the hedge funds are also responsible for paying their own expenses.

The offshore is used for non-U.S investors and U.S tax exempt investors also to avoid Unrelated Business Taxable Income (UBTI) which usually shows up if the fund buys securities on margin.

Master feeder

A typical master-feeder structure consists of three entities. It consists of a master fund, usually domiciled in an offshore location, and two feeder funds, one a U.S domicile and the other an off-shore.

The criteria is that the feeder funds always invest the assets in the master fund. Then, the master fund makes all the investments and is accountable for the same.

Each feeder fund executes the investments on the basis of their capital balances each.

Similarly, the expenses that are borne by both the funds are always paid by the master fund. The non-resident or non-U.S investors prefer to not expose themselves to U.S income tax.

Standalone

Standalone fund structures invest without the feeders. This is the most common structure for offshore managers with no U.S presence or only those U.S residents who want to exempt the taxes.

Legal and regulatory requirements

First and foremost, hedge funds are subject to securities laws and regulations ⁽⁴⁾, just like any other investment product. This means that they must register with the appropriate regulatory agencies, such as the Securities and Exchange Commission (SEC) in the United States.

Hedge funds must also comply with anti-fraud laws and regulations, which prohibit them from making false or misleading statements to investors or engaging in other types of deceptive practices.

In addition, hedge funds are typically subject to a number of operational and disclosure requirements. For example, they must provide detailed information about their investment strategies, fees, and performance to their investors. They must also maintain detailed records of their activities and provide regular reports to regulatory agencies and investors.

Hedge funds may also be subject to specific regulations based on their investment strategies or the types of assets they invest in. For example, funds that invest in commodities or derivatives may be subject to additional regulations under the Commodity Futures Trading Commission (CFTC) in the United States.

Another key regulatory requirement for hedge funds is the need to limit the number of investors they accept. In the United States, for example, hedge funds are generally limited to no more than 100 "accredited investors," who are individuals or institutions with a certain level of wealth or sophistication.

This is designed to protect less-sophisticated investors from the potential risks associated with investing in hedge funds.

Finally, it's worth noting that regulatory requirements for hedge funds can vary significantly depending on the country or region where the fund is located. For example, hedge funds in Europe may be subject to different regulations than those in the United States, and funds that operate globally may need to comply with regulations in multiple jurisdictions.

Last but not the least, to sum it up, hedge funds are subject to a wide range of legal and regulatory requirements, designed to protect investors and ensure the stability of the financial system.

These requirements can vary depending on the fund's location, investment strategies, and other factors, so it's important for hedge fund managers to stay up-to-date on the latest regulations and compliance requirements.

Selecting the right service providers

Now, let us get to what you’ll need to set up your legal structure.

You will be requiring the service providers such as auditors, administrators, lawyers and compliance specialists for setting the legal requirements.

Although it may be tempting to choose less expensive providers for your fund, doing so could be a costly mistake if the providers you choose do not meet the necessary legal or compliance requirements, potentially causing your fund to fail.

Also, potential investors would want to find out if the providers in your hedge fund are good with experience and have a good reputation.

Moreover, the legal requirements to start a hedge fund are different for every state and country. So, you will need to figure it out based on your location.

Apart from the lawyers, you’ll need:

• Auditors to monitor your performance
• Administrators to handle trade reconciliations and allocations
• Marketers to find more investors
• Brokers or dealers for trading
• Compliance staff to manage reporting requirements.

There are different regulations for different countries. For example, in India, hedge funds are known as Alternative Investment Funds (AIF). An AIF is required to be registered with the Securities and Exchange Board of India (SEBI) ⁽⁵⁾.

For registering an AIF, the applicant is required to go through the SEBI (Alternative Investment Funds) Regulations, 2012 for making sure to include everything required for setting up an AIF.

Similarly, in Singapore, the hedge fund is known as Licensed Fund Management Company (LFMC), and the registration of the same requires a minimum capital of 250,000 SGD. Also, every LFMC is required to maintain risk-based capital of 120% of the total calculated risk.

There are other office-related requirements as well as compliance functions ⁽⁶⁾ that one must be knowledgeable about before registering an LFMC.

Develop marketing and fundraising strategies

One of the most crucial aspects of beginning a hedge fund is finding and convincing the investors. Hence, attracting investors requires a significant investment in marketing.

By implementing a good marketing strategy, one can attract these investors. Marketing strategies are divided into two broad categories namely, direct and indirect.

Direct marketing targets identified potential investors or groups of investors by directly sending them communications via calls and emails. Indirect marketing focuses on creating general brand awareness among the public.

The costs associated with marketing depend upon the type of marketing employed. It could include print media, website and online presence, and television as well as radio commercials.

Also, raising the capital is essential for starting a hedge fund. Since you will be needing the capital for several things, you must shortlist all the things you would be requiring capital for. That way, you can create the marketing strategies for those particular aspects and raise capital.

Coming to where all you will be spending the raised funds, basically, you’ll need office space, which is expensive in some developed cities such as New York and London.

You have the option of starting from your home first or sharing a space with other startups for lowering the capital requirements.

Going forward, you’ll be needing a rough idea about which departments you’ll be needing in your hedge fund and also the employees that you’ll be hiring. This will help you include the expense of paying the salary to the employees.

Similarly, there will be such expenses relating to the bonuses of the employees, management, maintenance, etc.

Launch the fund and begin operations

This is as straightforward as it sounds.

Once you’re set with the fund structure, the service providers and the marketing strategies for fundraising, the only remaining step is launching the fund and creating a successful beginning!

Key considerations for a hedge fund

Let us now find out the key considerations for a hedge fund, which are:

• Regulatory compliance
• Adequate capitalisation
• Trading/Investment strategies
• Risk management
• Talent Acquisition
• Operational infrastructure
• Investor relations

Regulatory compliance

As discussed earlier, hedge funds are subject to a wide range of legal and regulatory requirements. It's essential to carefully research and understand these requirements before starting a hedge fund. Failure to comply with these regulations can result in significant fines and penalties, as well as damage to the fund's reputation.

Adequate capitalisation

Hedge funds typically require significant amounts of capital to start and operate successfully. It's important to ensure that the fund is adequately capitalised from the outset to cover startup costs, ongoing expenses, and potential losses. Insufficient capitalisation can lead to financial difficulties and even bankruptcy.

Trading/Investment strategies

Hedge funds use a variety of investment strategies to generate returns, but not all strategies are equally effective or appropriate for all market conditions. It's important to carefully consider the fund's investment strategy and ensure that it's well-suited to the current market environment. And you should also have plenty of trading strategies.

Risk management

Hedge funds typically take on greater investment risks than traditional investment vehicles, but it's essential to have robust risk management policies and procedures in place to minimise potential losses. This includes monitoring portfolio risk, setting risk limits, and implementing hedging strategies.

Talent acquisition

The success of a hedge fund often depends on the quality of its personnel, including portfolio managers, analysts, and other key staff. It's important to recruit top talent with relevant experience and a strong track record of success.

Operational infrastructure

Hedge funds require robust operational infrastructure to support their investment activities, including IT systems, accounting and reporting systems, and compliance monitoring tools. It's essential to invest in high-quality infrastructure from the outset to ensure the smooth operation of the fund.

Investor relations

Hedge funds rely on attracting and retaining investors to generate capital and support ongoing operations. It's important to establish strong investor relations and communication channels to keep investors informed about the fund's performance and address any concerns or questions they may have.

Costs in general and capital required

Hedge funds are heavily regulated by the Securities Exchange Commission (SEC). There are numerous requirements for registration and disclosure to regulatory bodies and investors. You will need to hire a legal firm that has expertise in compliance requirements.

Let us now take a look at different costs for owning a hedge fund, they are:

Fund administrator costs

The hiring of a fund administrator will be needed to handle the accounting and reporting of both domestic and offshore entities. The fund administrator will generally be an organisation. The organisation will also provide a piece of extensive advice and guidance on running fund operations.

The trained staff members and software packages help the administrator with the process and operations. As the hedge fund grows and acquires more assets under management (AUM) and investments, the work of an administrator becomes more of a challenge.

Audit and tax costs

Regulatory requirements often require hedge funds to undergo a private audit. You will need to work with an auditor who is familiar with hedge fund operations.

The audit cost depends on -

• The number of investments as well as the amount of the same.
• The number of domestic and offshore entities.
• The need for organising accounting records.

Equipment and technology costs

The fund will need to invest in the furnishing of the premises, the equipment including a computer set up, the software etc. It must also be noted that the software services or the technology related services can be quite expensive.

The fund is also required to be able to professionally host the communications as well as the trading services. Moreover, it is a must that the encryption and backups are done in an adequate and appropriate manner.

Also, there must be compliance measures for security purposes which is a must if the company employs software to undertake automated trading.

Conclusion

We discussed various aspects of starting a hedge fund such as the step-by-step process as well as the costs associated with the same. Starting a hedge fund surely brings a lot of wealth to the owner but, at the same time, the hedge fund owner must remember that a new hedge fund might fail. The reasons may be that the investors do not fund your strategy anymore because they had a bad year, or it could be anything else.

Nevertheless, keeping a backup plan is always the best!

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