How to Start a Hedge Fund

Articles From: QuantInsti
Website: QuantInsti

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
  • Basics of hedge funds
  • Types of hedge funds and strategies
  • Growth potential of hedge funds
  • Skills or prerequisites required for starting a hedge fund
  • Steps to start a hedge fund
    • Formulate a trading strategy
    • Determine the fund structure
    • Legal and regulatory requirements
    • Selecting the right service providers
    • Develop marketing and fundraising strategies
    • Launch the fund and begin operations
  • Key considerations for a hedge fund
    • Regulatory compliance
    • Adequate capitalisation
    • Trading/Investment strategies
    • Risk management
    • Talent acquisition
    • Operational infrastructure
    • Investor relations
  • Costs in general and capital required
    • Fund administrator costs
    • Audit and tax costs
    • Equipment and technology costs

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.

Stay tuned for the second installment to learn about the legal and regulatory requirements.

Originally posted on QuantInsti blog.

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Disclosure: Hedge Funds

Hedge Funds are highly speculative, and investors may lose their entire investment.