How to Start a Hedge Fund
How to set one up, plus the legal requirements and risks
If you want to know how to start a hedge fund, it’s important to understand the financial and legal requirements first. Because of the risks and capital requirements, starting a hedge fund is not the same process as starting a business. Here’s what you need to know about the basics of starting a hedge fund.
What Is a Hedge Fund?
A hedge fund is an investment structure that is typically set up as a limited partnership or a limited liability company (LLC). Hedge funds are similar to mutual funds in that they are pooled investments. However, hedge funds tend to hold alternative securities, like real estate or currencies, and often employ complex investment techniques like leverage and short-selling. They tend to be less popular with everyday investors than mutual funds.
Hedge funds get their name from the original strategy of employing a combination of long and short strategies in order to “hedge” risk for the investors. This strategy aims to obtain reasonable returns no matter which direction the stock market moves. Most investors in hedge funds are accredited investors, meaning that they must meet or surpass certain net worth and minimum initial investment requirements.
Why Start a Hedge Fund?
Hedge funds are typically started by money managers or registered investment advisors that are skilled at hedging strategies. These skills and strategies are then used to attract investors and make a profit. As with other products and services, someone might start a hedge fund because of demand in the marketplace. According to Hedge Fund Research, hedge fund assets reached a record level of $3.235 trillion globally in July 2018.
Though risky, hedge funds often attract high-net-worth investors, and that means assets have the potential to grow at a much faster rate than mutual funds or exchange traded funds (ETFs). This growth potential often motivates money managers and advisors to start hedge funds. Hedge fund managers can also command high fees, often around 1% to 2% of assets and 20% of gains above a certain target return.
3 Steps to Start a Hedge Fund
The process involved in starting a hedge fund shares some similarities with starting a business. However, starting a hedge fund is more complex—and is becoming increasingly challenging.
Here are four basic steps to start a hedge fund.
- Choose a strategy. Although hedge funds generally share similar objectives, there are multiple hedging strategies to consider. Before you start a hedge fund, you need an idea or compelling strategy that prospective investors can get behind. Will your fund be a long/short equity fund or a market-neutral fund? Will you employ a global macro style and base it on the economics and politics of different countries or their macroeconomic principles? Or will you focus on an event-driven or value strategy? And what about arbitrage?
- Find legal help. Hiring the right kind of attorney may be one of the biggest start-up costs for hedge funds, but it’s also possibly the most important initial investment. A hedge fund attorney can help you to word key terms for service agreements with clients, including performance fees. They can also help with properly registering the hedge fund with your state or the SEC, if required.
- Secure financing. Start-up costs for hedge funds can range from $50,000 to $100,000. Similar to other business types, the start-up costs depend on several factors, including the building/location, number of employees, and legal costs. Financing can come from friends, family, angel investors, banks, hedge fund seeders, crowdfunding, or possibly a small business loan.
- Understand the risks. When you own, manage and operate a hedge fund, not only are you bearing the risks of business ownership, but you’re also bearing market risks, including interest rate, geopolitical, principal, and currency risks.
The Bottom Line
Starting a hedge fund is not just for anyone with a good hedging strategy. It’s likely you’ll need start-up capital in the tens or hundreds of thousands of dollars, plus a hedge fund attorney. Also, your strategy and how it performs in the current market conditions may determine the success of your hedge fund. In simpler terms, you’ll need money, investing skills, a specialized attorney, and some luck to start your hedge fund and find success.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.