When discussing investments in the market, the word “risk” tends to come up... a lot.
It’s understandable, especially if you’re just starting out — you want to know what you’re getting yourself into.
There are many reasons why someone would want to start a hedge fund. Before that, though, we should look back to 1933.
The '30s are always associated with the Great Depression. After the 1929 crash, the stock market was, in modern parlance, a dumpster fire.
FDR was trying to find a solution amongst all the chaos. You see, there wasn’t as much security backing an investment back then.
So the Securities Act of 1933 was passed on May 27, 1933. This provided buyers of securities, or tradable financial assets, more security and more accurate information on their chosen purchase. If a company registered under the act, they had to disclose audited financial statements and were under strict liability for any inaccuracies.
This also took away state legislatures' power over the stock market and instead placed the responsibility over it upon the federal government.
The act was one of the first steps toward cleaning up the mess caused by the Depression. This prevented fraud and was intended to increase a growing confidence in investing again. Maintaining confidence in investors led to more support in the stock market. Obviously, it didn’t happen overnight, but the regulations made then are upheld to this day.
Now, what does this history lesson have to do with hedge funds and the risks that follow them?
Alfred Winslow Jones is credited with coming up with the idea of hedge funds in 1949.
Taking into account the market investing risks that materialized, the influence of the market changing prices wasn’t something Jones found particularly appealing.
Instead, Jones achieved “market neutrality” by buying assets he believed would succeed in the market while also selling short assets he believed would fall.
Achieving this balance also increased confidence in investors and by the 1950s, Jones created his first hedge fund.
Fast-forward to now, and hedge funds are extremely popular. One reason why is because they manage investing risks and they provide better, more reliable returns.
Via Managed Funds
Usually, you’ll find the starting process both lengthy and expensive. That’s a common misconception. You don’t need six figures to start a hedge fund.
Why Start a Hedge Fund?
You know when the Super Bowl comes around and multiple groups of people pool their money together to bet on their desired outcome?
A hedge fund is basically a pool of investors who have a desired outcome. Those in a hedge fund believe in taking a lawful neutral approach to their investments; they invest in common stock or private equities rather than betting on a volatile market. They hold both long and short stocks — they don't discriminate.
There are the investors, the manager, and the legal team.
The hedge fund manager oversees the decisions made on investments and all the operations within the hedge fund.
The investors are the ones pooling together money.
The legal team is pretty self-explanatory.
Stocks, bonds, real estate, food, currency — you name it, a hedge fund invests in it.
The whole point of one is to make sure your gains are high and your risks are low.
Hedge fund managers are only allowed 35 nonaccredited investors for their firm or partnership (this is if you want to get your friends and family involved with your investing).
Usually, accredited investors are those who have a certain net worth or income.
However, the rules are changing on that.
So if you want to learn how to start a hedge fund, we can map it out for you!
Step 1: Learn your Laws
We have to get through the scary part first.
Always keep in mind that hedge funds are a product of an exception of a federal law.
Remember that Securities Act of 1933? Hedge funds trade privately, which means their strategies, investments, and structures are exclusive to trusted partners.
Getting people to partner with you means you have to make your fund sound as appealing as possible — but you have to be 100% transparent with your audience.
The margin of error has to be as thin as a toothpick.
You’re not going to fall under most regulations, but you’re not completely in the clear either.
Before you make any moves, you must understand there are things for which you are going to be held personally responsible.
We know your heart is in the right place; you don’t have any ill intent — you just want to make some money.
An easy way to land in mounds of trouble over something small is not properly disclosing details about your company.
Refer to the laws that brought hedge funds into the world — full disclosure is crucial. Disclosing all the risk factors associated with your hedge fund could save you a lot of legal trouble.
Omissions and partial truths could land you in trouble with both federal AND state regulators.
If the U.S. Securities and Exchange Commission detects any sort of misstatement on your own accord, fines can go up to $5 million.
This is exactly why you need to put a lot of thought into the private placement memorandum needed to start a hedge fund. This statement on your hedge fund will protect you from unintentionally making any statements that are considered misleading.
The memorandum requires you to be as specific as possible. Think of it as going to the doctor. You don’t want to leave out the gory details about any concern you have when seeing a medical professional or your health could be compromised. Keep that same energy with your memorandum.
Bernie Madoff is a name that lives in notoriety because of his development of arguably the biggest Ponzi scheme in history.
In 2008, the SEC and FBI discovered Madoff's wrongdoing and that he owed the people who invested in his scheme a whopping $7 billion — not counting everyone else he scammed as well.
All these investors were brought in with promises of “high returns” from an accredited Wall Street broker who just ended up taking the money he received and putting it in his own bank account.
Madoff is the best example of what NOT to do with a hedge fund. The fraud he committed will live forever in notoriety.
Obviously, the scale of his "oopsie" is astronomical compared with others, but the whole gist is the SEC takes fraud very seriously, and the last thing you need is to get on its bad side just because you missed a minor detail.
Madoff was even chairman of the National Association of Securities Dealers at one point. He had the high status, the large net worth, and everything you think is required to start a successful hedge fund — and he’s doing 150 years in federal prison.
The scary part is over. Be thorough. Don’t be Bernie Madoff.
Step 2: A Good Foundation and a Strong Structure
Hedge funds typically enforce a “2 and 20” ratio.
This is where the hedge fund manager is given 2% of the assets paired with 20% of the yearly profit.
Say a hedge fund manager invests $1 million — $20,000 goes to the hedge fund manager. If the investments in the fund double, the manager would receive an additional $400,000.
There are also quite a few different types of hedge funds, so you have to decide what suits your goal best.
One of the most popular — and successful — fund structures is an equity, or a long/short.
Managers invest in undervalued stocks long term rather than selling them quickly. If a fund puts money into an underperforming stock and a stock on the rise in the same industry, the fund faces few-to-no losses.
This structure demonstrates a diverse portfolio of stocks through the range of valuation displayed.
Paired trades in an equity are where a fund buys or sells two stocks in the same industry.
A market-neutral stance in an equity is where a fund evenly divides into long and short stocks.
The term long bias is pretty self-explanatory: The majority of the investment goes to long stocks rather than short.
If a manager wants to increase a fund’s position in long stock investments for positive exposure to markets, a long/short with leveraging would most likely suit them better.
Long/short with leveraging requires a little more math going into the strategy. Say you want to invest 70% of your funds into a long position and 30% into a short. Your net exposure is the difference between the two, so you’re at 40% with net exposure. Your gross exposure would be 100%. Since there’s no excess over 100%, you have no leverage.
The idea of a leveraged long/short is to make sure the money you’re given turns a profit, so instead you put 80% into long and 30% into shorting. Adding them up would make up 110% and turn a 10% leverage.
Then there are relative value arbitrage hedge funds.
This is where you buy securities while short selling securities — typically from a different company but still within the same industry — that are expected to decrease in value.
Managers in these funds assume prices of these securities will revert to the market value over time, selling the security that’s overpriced and liquidating the trade at a profit.
Macro hedge funds tend to dabble with overseas economies more than other hedge fund structures.
They follow any trends with global trade, policies, or interest rates. These take in a lot of borrowed money but could be subject to the occasional Wall Street bust.
Currency strategies in a macro means watching patterns in policies following monetary growth or interest rates in other countries. The payoff on the foreign exchange rates between two countries is what provides the fund with lucrative returns.
A macro’s stock index strategy focus is mainly on the equity index of a chosen country.
Interest rate strategies tend to focus on sovereign debt interest rates. Governmental debts are the most common financial instruments.
Distressed hedge funds are associated with loan payouts. They focus on assisting companies by buying securities with the intent that they will increase over time.
If a company is facing difficulties, it will sell its securities at a discounted price.
Underperforming loans or other types of debt can be sold by banks to hedge funds at a discount to make better investments.
Passive investing in a distressed fund is buying distressed securities with intent to hold until they increase. This is usually a long-term investment.
An active investor attempts to influence the refinance process in a more “hands-on” approach. This requires more legal expertise.
A convertible arbitrage strategy includes long stances on bonds and short stances on common shares.
Usually in a convertible arbitrage, you would steer toward a more neutral position so that shares and bonds could offset one another in the case of a fluctuating market.
This is one of the structures that flourishes the most on market volatility.
It’s important to note that in 2020, 77% of the hedge fund launches were stock-centric funds.
The objective of a diversified equity fund is to achieve the rate of return of the broad equity market by investing mainly in U.S. companies but also in foreign companies.
Step 3: Raise Capital
It would be wonderful if your hedge fund just materialized before you, wouldn’t it?
Whether or not it meets the 35-person max of “non-accredited investors,” you need to make sure you compose your strategy and deliver it to your intended partners so you’re all in the same boat.
The main priority for the hedge fund manager is to deliver results and make investors confident in what they’re putting their money into.
You obviously don’t want to give your money to just anyone, right?
Developing a partnership is also a common way to help you raise capital.
You could divide the profits and managerial obligations with your partner, which would develop a limited partnership.
In a limited partnership, there are at least two people. One could take on more responsibility and serve as the general partner while the limited partner holds no authoritative role.
While this may sound like an uneven distribution of work, the playing field is leveled out because the general partner faces unlimited liability whereas limited partners are faced with limited liability.
Now, you’re probably processing all of this and trying to find the part where there isn’t a $50,000 hole burnt in your pocket.
This is where you develop what is called a “hedge fund incubator.”
Remember those two partnerships mentioned above? Think of them as different tiers.
Through the limited partnership, that is where a hedge fund manager uses their own trading capital and builds credibility.
You save a lot of money on startup fees when starting a hedge fund incubator, as well as decrease the likelihood of losing your prospective investors' money.
An incubator could cost as much as 10% of what a full-on hedge fund would cost to start.
Think of the incubation as a sort of trial period. At this time, you’re testing out new funds. This is all to diversify your portfolio in a shorter period of time so when you’re ready to convert to a full-on hedge fund, all you have to do is present your returns.
After you’ve set a target price for your portfolio, you can choose to convert into a fully fledged hedge fund that follows any of the structures listed above.
Paying back partners in the general partnership is also something you can manage after you reach your targeted price. Once they’re paid off, they can just invest into your hedge fund as limited partners, receiving the returns but not being hands on with you in the driver’s seat.
Incubating funds is a fraction of the price of what it actually costs to develop a hedge fund. The money you save starting up a hedge fund can go to bigger investments that will have you looking even better.
Step 4: Manage Your Risks
Running your own hedge fund is exciting! People have done it without the credibility of a degree or net worth and succeeded with just smart money management.
But like anything else, there are some things you need to watch out for.
Obviously, we’ve seen what can happen when you get in over your head like Bernie Madoff.
Long-Term Capital Management was a widely successful hedge fund in the late '90s. In 1998, it hedged on a then-predictable volatility in foreign markets, using the macro hedge fund structure.
When Russia defaulted on its bonds after announcing the devaluation of its currency, LTCM took a massive blow — 50% of LTCM’s capital investments were gone the same month of the announcement.
Then 14 banks pooled together over $3 billion to bail out LTCM but with a cost — 90% ownership of the fund.
Here’s where they messed up: Warren Buffett himself offered the LTCM shareholders $250 million to keep the fund running.
Unhappy with the price and the idea of Warren Buffett managing them, the shareholders refused.
International banks had been trading through LTCM, so if it defaulted, the global economy would have been affected.
To avoid this, LTCM had no choice but to let its creditors take over.
LTCM had excessively leveraged — or borrowed — money. Through balancing out its trading, LTCM issued multiple “repurchase agreements” on short-term trades.
As large as LTCM was, its risk management was extremely sloppy and fell victim to a volatile market rather than profiting off it.
Melvin Capital, the catalyst of the GameStop frenzy, announced its position on shorting GameStop in early 2021.
This caused rookie online investors to swarm to purchase shares of GameStop and caused the share price to skyrocket in what is called a “short squeeze.”
Because of the squeeze, Melvin Capital lost 53% on its GameStop investments.
Melvin Capital publicly disclosed its short position, and that was its downfall.
It’s completely fine to share a diversified portfolio, but leaving out breadcrumbs about your strategy could leave you vulnerable to copycats or to a squeeze.
Step 5: Do Your Research
Say you have everything set up for your fund. Your partners look at you and ask you, “Well, what next?”
As the captain of your ship, you’re going to know where to steer it.
Depending on the chosen model for your fund, you have to know where to place your fund’s capital.
One thing Alfred Winslow Jones didn’t have was the power of the internet.
Think of Energy and Capital as your secret weapon.
There, you’ll find updates, trends, and expert information on up-and-coming investment opportunities.
Keeping up to date with us will be your advantage in diversifying your portfolio.
Taking that first step is the hardest part. When it comes to which direction you're going, you want to make sure you're heading the right way.