Fact checked by Katrina Munichiello
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There are many reasons why starting a hedge fund is the new American dream. Almost everyone has read the stories about hedge fund billionaires. 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.
Key Takeaways
- 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
The best fund managers hold professional and educational credentials. Depending on the state in which they work, they may be required to hold Financial Industry Regulatory Authority (FINRA) licenses.
Despite this, the hedge fund industry as a whole has its ups and downs, and many of the players in it fold each year. Reports indicate that as much as $100 billion was pulled out of hedge funds by investors in 2023. This was largely due to market volatility and changes in sentiment, as investors sought more liquid assets. Yet hedge funds as a whole still had more than five trillion in assets under management (AUM) globally in 2023.
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 eight big factors to work through.
Note
The HFRI Fund Weighted Composite Index, which tracks the industry as a whole, returned 13.88% for the year as of November 2024.
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. 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.
Important
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 with a similar strategy and conduct as much competitive intelligence on them as you can, ethically and legally.
3. Find the Seed Capital
New hedge funds must 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.
A seed investment can give you the capital you need to get your fund up and running. This figure can range anywhere between $25 to $200 million. Investors who pledge Seed capital funding make the original investment with the hope of getting a portion of the profits or revenues. It can take as long as two to three years for the investor to redeem their investment.
415
The number of hedge funds liquidated in 2023. This figure is the lowest since 2004
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 (HNWIs)
- Financial advisors
- Wealth-management offices and RIAs
- Single- and multi-family offices
- Fund of hedge funds
- Corporations
- Foundations and endowments
- Pensions
- Sub-advisory relationships
Small hedge fund startups typically rely on seed capital providers, family and friends, and HNWIs (directly or through their financial advisors). Working with institutional investors who might invest millions of dollars at a time can be difficult unless you have a track record and more than $100 million in total AUM.
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 for presentation at business meetings.
These may sound like Business 101 details, but they are often overlooked or poorly executed. Anyone who can 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 limitations and details 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, 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.
What Does a Hedge Fund Do?
Hedge funds are pooled investments for private investors. Capital is pooled from these investors and actively managed by a hedge fund manager. These funds are riskier and provide greater returns than other investments like mutual funds. Because of the high investment threshold, hedge funds are generally accessible by accredited investors, such as high-net-worth individuals and pension funds.
What Are Some of the Top Hedge Funds?
The biggest names in the hedge fund world include Citadel, Bridgewater, and AQR. These three firms have hundreds of billions in assets under management (AUM) and provide investment services to a variety of accredited investors like pension funds and institutional investors.
What’s the Difference Between a Hedge Fund and a Mutual Fund?
Hedge funds and mutual funds are investments that pool capital from multiple investors. But, they are distinct from one another. Hedge funds are typically invest in specific securities and are meant for accredited investors like pension funds, governments, and institutional investors rather than ordinary investors. They also carry a greater degree of risk, which is why they can promise greater returns. Mutual funds, on the other hand, have a specific investment focus and are geared to ordinary individual investors. While they may come with some risk, they are generally considered a safe investment and may not necessarily come with minimum investment requirements.
The Bottom Line
Running a hedge fund can be financially rewarding. But, it requires a great deal of research and capital. If you follow the steps we’ve outlined above, you may be on the road to success. Keep in mind that you must adhere to certain state, federal, and legal regulations to operate your fund.