How to start a hedge fund in the US? Any advice?

[meiroy]

 

But after learning investing for so many years, I am more interested in doing it on my own instead of joining a hedge fund and work for them.

 

But I'd rather join another fund first.

 

This is 100% the way to go in my opinion. If you have no professional experience, just about any place where you can practice and learn about finance (yes even a sell side shop!) will be better than jumping immediately into your own start up hedge fund. We're not all Michael Burry.

 

This is 100% wrong.  It's like saying to any young entrepreneur to avoid starting their own company and instead work for other people first.  I know several people who have jumped into their own hedge funds without any prior formal experience and they are quite successful.  Plenty of books around to learn the basics.  Having said that, one exception would be if you could work for one of the masters or find an amazing teacher. That would be worth it.

 

 

 

[Ham Hockers]

 

But after learning investing for so many years, I am more interested in doing it on my own instead of joining a hedge fund and work for them.

 

But I'd rather join another fund first.

 

This is 100% the way to go in my opinion. If you have no professional experience, just about any place where you can practice and learn about finance (yes even a sell side shop!) will be better than jumping immediately into your own start up hedge fund. We're not all Michael Burry.

 

This is 100% wrong.  It's like saying to any young entrepreneur to avoid starting their own company and instead work for other people first.  I know several people who have jumped into their own hedge funds without any prior formal experience and they are quite successful.  Plenty of books around to learn the basics.  Having said that, one exception would be if you could work for one of the masters or find an amazing teacher. That would be worth it.

 

I don't think it's wrong to say most people would be better served learning and practicing a lot more in a professional setting before they go out on their own. Most entrepreneurs fail many times before they are successful. You don't get a lot of chances to fail running money.

 

How many of those success stories had access to connections that made money raising much easier than for the average person? How many of those already had experience starting a successful company? The average person without deep pocketed connections who has no experience with finance/investing is very likely going to crash and burn if he goes out before he's ready.

[Packer16]

Another option is to continue your day job and do this on the side with your savings.  This will allow you to see if you have an edge and provide another option if it turns out you do not.  I would also encourage to benchmark yourself against an appropriate benchmark to see if you are adding value.  If you are investing in the primarily distressed small value stuff we talk about here the Vanguard SCV at 8bp fees is a good benchmark.

 

Packer

[oddballstocks]

Agree with Ham Hockers and Packer.

 

Working for someone else can be excellent experience, especially if you filter it through what you want to do.  If you go into a job with the expectation that you want to learn everything possible to start your own firm I think your experience will be much different than someone who looks at it as just a job.  Things like accounting or back office, normally boring aspects will be interesting because you're trying to learn these things.

 

Packer's suggestion is excellent.  If Microsoft will let you why not just run it while you work there?  Start a small RIA and see what you can do.  You're already doing the work, and the back office isn't going to be too burdensome initially.  This way you can get your feet wet.  Managing someone else's money is different from managing your own.

 

I have wanted to start a business for years.  I tried and failed in 2006/2007 with some friends.  We didn't have any experience, or enough experience.  Fast forward six years later and I had a much different experience.  Why?  I had a series of failed ventures that I learned from.  I also had a lot of varied professional experience that I learned from.  In 2006 speaking to a C-level exec would have intimidated me.  But I was able to gain some experience on my day job doing so.  Now that sort of thing is fine, but I had to learn it.  And I was able to learn on someone else's dime.  Same with product development.  In 2006 I thought I knew what went into product development end to end.  But I didn't.  Then I learned this on someone else's dime and have done it successfully on my own.

 

When you work for someone else you're limiting your risk.  This is big.  I don't know your family situation, but if things don't work out as quickly as you expect (and they never do) are you prepared to live off credit cards or savings in a tiny apartment eating ramen?

 

Two last points.  The first is when you're doing this full time there will be a lot of administrative work.  You are not just investing full time.  You're talking to clients, marketing, doing accounting, reconciling accounts etc.  Maybe investing is 60-70% of your day.  Do you enjoy those other things?  In my business I enjoy making products, but to make money I need to sell and market.  Product development is maybe 40% of the day at most, sometimes for weeks it's 0%, with a few weeks of 70%.  Keep this in mind, every entrepreneur I've talked to has echo'ed the same thing.

 

Last point.  If you're going the full time route the biggest indicator of success is going to be how much you can raise and how quickly.  If you can raise $10-20m right off the bat you'll do alright.  If you open the doors with $150k and at the end of the year have $500k I'd consider calling MS back.  If you can't raise a lot of capital to start do this on the side until you reach critical mass.  I believe benhacker did this, he worked and invested until he'd raised enough funds.  This is the smart way to do things, limit your opportunity cost.

[muscleman]

oddball, that's exactly my plan. Keep my current job (or switch to another employer who's less demanding), and start the RIA on the side. Eventually when big enough, do it full time.

I will have partners to do the other things of marketing and sales. I will focus on trading.

[constructive]

By the way, I wouldn't refer to the structure as "RIA". The investment fund structure and the managed separate account structure both require RIA registration (unless it is very small scale, then either structure can qualify for an exemption).

[muscleman]

By the way, I wouldn't refer to the structure as "RIA". The investment fund structure and the managed separate account structure both require RIA registration (unless it is very small scale, then either structure can qualify for an exemption).

 

Got it. I thought RIA means managed separate account LOL.

[kfh227]

I thought about doing something like this.  The large financial players set up a lot of berries to entry.  See all the hoops you need to go through as a little guy?  That's not because of the government caring about people.  It's because the large players have lobbyists and they want these regulations to keep you out.

 

I gave up.

 

To you, I wish the best of luck!

[gfp]

The regulations really are designed to protect the investors - who are usually much less savvy than the manager or potential manager.  You can become a registered investment advisor and manage separate accounts for a % of portfolio value very very easily and inexpensively.  It gets a LOT more complicated if you want to take custody of client assets and I think that is for good reason.  I'm not sure why the government doesn't allow pay for performance or hurdle rates for small investors, since it is less conflicted than taking a fixed % regardless of performance, but that is how they drew the line.

 

I thought about doing something like this.  The large financial players set up a lot of berries to entry.  See all the hoops you need to go through as a little guy?  That's not because of the government caring about people.  It's because the large players have lobbyists and they want these regulations to keep you out.

 

I gave up.

 

To you, I wish the best of luck!

[benhacker]

I'm not sure why the government doesn't allow pay for performance or hurdle rates for small investors, since it is less conflicted than taking a fixed % regardless of performance, but that is how they drew the line.

 

I used to think this too, but then I was told something.  Performance fees allow a scheme such as this:

 

1) Find 1000 idiots

2) Make highly assymetric bets (I win +100%, or lose -100%), do 500 folks one direction, the other half the other.

3) Repeat for 250, 125, etc.

 

You would make a tremendous amount of money, and at the end have a handful of folks who think you are Buffett.

 

This was done in the 1910-1920's IIRC... and was the motivation for higher regulatory scrutiny of %-of-profit fee models.

 

I too think that some level of performance fee could be created in certain cases (like where the manager is investing the same way as his clients, and has only one strategy), but it doesn't seem like a trivial thing to do.  Perhaps a simpler alternative is to have the performance fees that are available to mutual funds, where the fee is 0.5% or something, but it's 1.5% if performance is above a hurdle.

 

The latter has timing / look back problems for mutual funds and separate accounts... but perhaps avoids the real risk I highlight above.

[Travis Wiedower]

I used to think this too, but then I was told something.  Performance fees allow a scheme such as this:

 

1) Find 1000 idiots

2) Make highly assymetric bets (I win +100%, or lose -100%), do 500 folks one direction, the other half the other.

3) Repeat for 250, 125, etc.

 

You would make a tremendous amount of money, and at the end have a handful of folks who think you are Buffett.

 

This was done in the 1910-1920's IIRC... and was the motivation for higher regulatory scrutiny of %-of-profit fee models.

 

I have often wondered why the government is so anti-performance fees. Still don't like it but this does make sense. I learn something new every day  :)

[RadMan24]

Wait...if I open up a RIA and I wanted to have a hurdle of 6% return before I take an asset under management fee of 1% , would this be allowed? Or no because it is considered performance-fees?

[Munger_Disciple]

if I open up a RIA and I wanted to have a hurdle of 6% return before I take an asset under management fee of 1% , would this be allowed? Or no because it is considered performance-fees?

 

It's a performance based fee as I understand it.

[Hielko]

if I open up a RIA and I wanted to have a hurdle of 6% return before I take an asset under management fee of 1% , would this be allowed? Or no because it is considered performance-fees?

 

It a performance based fee as I understand it.

What if you have a 1% fee, but decide to waive it (because you think your performance wasn't good enough?)

[Munger_Disciple]

What if you have a 1% fee, but decide to waive it (because you think your performance wasn't good enough?)

 

You should probably talk to a lawyer (I am not one). If it is in the sole discretion of the manager it is probably ok. But if it is in the advisory agreement it is probably considered a performance based fee. For instance if the agreement states that the manager must refund the fee if the performance is  below some threshold.

[Tim Eriksen]

What if you have a 1% fee, but decide to waive it (because you think your performance wasn't good enough?)

 

You should probably talk to a lawyer (I am not one). If it is in the sole discretion of the manager it is probably ok. But if it is in the advisory agreement it is probably considered a performance based fee. For instance if the agreement states that the manager must refund the fee if the performance is  below some threshold.

 

In my state (WA) you can waive fees, but if you do it for one client you must do it for all.  If it is expressly stated in the agreement based on returns I think they would clearly deem it a performance fee.  Even if not expressly stated, regulators aren't stupid, they would figure out if it is really just a creative way to charge a performance fee.    A few mutual funds have received approval for a "fulcrum" where the fee adjusts a bit (25 to 50 bps) based on rolling performance versus a benchmark, but I don't know if any states would let an RIA do that in managed accounts.     

[muscleman]

The regulations really are designed to protect the investors - who are usually much less savvy than the manager or potential manager.  You can become a registered investment advisor and manage separate accounts for a % of portfolio value very very easily and inexpensively.  It gets a LOT more complicated if you want to take custody of client assets and I think that is for good reason.  I'm not sure why the government doesn't allow pay for performance or hurdle rates for small investors, since it is less conflicted than taking a fixed % regardless of performance, but that is how they drew the line.

 

I thought about doing something like this.  The large financial players set up a lot of berries to entry.  See all the hoops you need to go through as a little guy?  That's not because of the government caring about people.  It's because the large players have lobbyists and they want these regulations to keep you out.

 

I gave up.

 

To you, I wish the best of luck!

 

Wait... You said if I register as an RIA and do managed individual accounts, I would not be allowed to charge performance fees at all?

[racemize]

I think under sole discretion it is largely ok.  That way, under the agreement, investors/partners expect a certain fee and it doesn't change. 

 

Two opposite things to say though:

1) In my series 65 book, they indicated that waiving fixed fees weren't allowed as it could turn into performance fees pretty easily;

2) In talking to our lawyers, they said that people waived fees all the time and that regulators didn't have a problem with it.

 

For what it is worth, we're currently waiving our management fees as we think that the overhead costs are too high relative to AUM.  We also have been visited by a state regulator while doing this and they did not have any objection to it (nor should they, of course).

[racemize]

Wait... You said if I register as an RIA and do managed individual accounts, I would not be allowed to charge performance fees at all?

 

Depends on the state/jurisdiction. 

[gfp]

In my state you can charge performance fees if the investor is a qualified purchaser or accredited.  Not for everybody else.

 

Wait... You said if I register as an RIA and do managed individual accounts, I would not be allowed to charge performance fees at all?

 

Depends on the state/jurisdiction.

[Tim Eriksen]

The regulations really are designed to protect the investors - who are usually much less savvy than the manager or potential manager.  You can become a registered investment advisor and manage separate accounts for a % of portfolio value very very easily and inexpensively.  It gets a LOT more complicated if you want to take custody of client assets and I think that is for good reason.  I'm not sure why the government doesn't allow pay for performance or hurdle rates for small investors, since it is less conflicted than taking a fixed % regardless of performance, but that is how they drew the line.

 

I thought about doing something like this.  The large financial players set up a lot of berries to entry.  See all the hoops you need to go through as a little guy?  That's not because of the government caring about people.  It's because the large players have lobbyists and they want these regulations to keep you out.

 

I gave up.

 

To you, I wish the best of luck!

 

Wait... You said if I register as an RIA and do managed individual accounts, I would not be allowed to charge performance fees at all?

 

In order to charge performance fees the investor must be considered a "qualified investor" meaning having a net worth of $2 million or greater excluding their primary residence), or at least $1 million invested with the advisor.  The requirement is the same for clients whether in a hedge fund or separate accounts.  The figures were raised in 2014, it was $1.5 million and 750k, respectively.

 

You can have accredited investors ($1 million minimum net worth, excluding primary residence, or income of $200,000 plus, or $300,000 combined with spouse) in a hedge fund but you cannot charge them performance fees. 

[muscleman]

The regulations really are designed to protect the investors - who are usually much less savvy than the manager or potential manager.  You can become a registered investment advisor and manage separate accounts for a % of portfolio value very very easily and inexpensively.  It gets a LOT more complicated if you want to take custody of client assets and I think that is for good reason.  I'm not sure why the government doesn't allow pay for performance or hurdle rates for small investors, since it is less conflicted than taking a fixed % regardless of performance, but that is how they drew the line.

 

I thought about doing something like this.  The large financial players set up a lot of berries to entry.  See all the hoops you need to go through as a little guy?  That's not because of the government caring about people.  It's because the large players have lobbyists and they want these regulations to keep you out.

 

I gave up.

 

To you, I wish the best of luck!

 

Wait... You said if I register as an RIA and do managed individual accounts, I would not be allowed to charge performance fees at all?

 

In order to charge performance fees the investor must be considered a "qualified investor" meaning having a net worth of $2 million or greater excluding their primary residence), or at least $1 million invested with the advisor.  The requirement is the same for clients whether in a hedge fund or separate accounts.  The figures were raised in 2014, it was $1.5 million and 750k, respectively.

 

You can have accredited investors ($1 million minimum net worth, excluding primary residence, or income of $200,000 plus, or $300,000 combined with spouse) in a hedge fund but you cannot charge them performance fees.

 

Got it! I wonder if that's why Arlington Value Management started with a 2% annual fee structure and then changed to 1/10 later? They probably started small and couldn't charge performance fees.

[Mephistopheles]

This thread made me look into SMAs and I really like how cheaper and simpler they are to operate. One con of this structure vs a hedge fund is that you can't take advantage of carried interest, as far as I know. Can anyone comment on this?

 

If true this must mean there is a certain AUM where hedge fund makes more sense. (unless you have no long term positions; but then you wouldn't be on this board)

[Tim Eriksen]

This thread made me look into SMAs and I really like how cheaper and simpler they are to operate. One con of this structure vs a hedge fund is that you can't take advantage of carried interest, as far as I know. Can anyone comment on this?

 

If true this must mean there is a certain AUM where hedge fund makes more sense. (unless you have no long term positions; but then you wouldn't be on this board)

 

SMAs are cheaper to operate since it avoids the legal costs of an offering document.  You still have to register as a RIA, create an advisory agreement and Form ADVs to file, etc.  With SMAs you do lose out on carried interest.  You also have more paperwork.  For example every trade must be recorded for each account. So a hedge fund is one account and you record everything for it.  For SMA's you are going to have a spreadsheet for each account.  Billing each account is a pain.  Interactive Brokers is nice because you don't have to have a certain level of AUM in order to do auto billing, but there statements and interface are horrible.  And my experience is that a high number of clients will watch, some will copy trades in another account, and they will question mistakes much more strongly than crediting successes.  My experience has been that the hedge fund client retention rate is far higher than the SMA rate.  By focusing on SMA's you may have much higher office costs - rent, utilities and staff versus possible working at home.   

[muscleman]

This thread made me look into SMAs and I really like how cheaper and simpler they are to operate. One con of this structure vs a hedge fund is that you can't take advantage of carried interest, as far as I know. Can anyone comment on this?

 

If true this must mean there is a certain AUM where hedge fund makes more sense. (unless you have no long term positions; but then you wouldn't be on this board)

 

SMAs are cheaper to operate since it avoids the legal costs of an offering document.  You still have to register as a RIA, create an advisory agreement and Form ADVs to file, etc.  With SMAs you do lose out on carried interest.  You also have more paperwork.  For example every trade must be recorded for each account. So a hedge fund is one account and you record everything for it.  For SMA's you are going to have a spreadsheet for each account.  Billing each account is a pain.  Interactive Brokers is nice because you don't have to have a certain level of AUM in order to do auto billing, but there statements and interface are horrible.  And my experience is that a high number of clients will watch, some will copy trades in another account, and they will question mistakes much more strongly than crediting successes.  My experience has been that the hedge fund client retention rate is far higher than the SMA rate.  By focusing on SMA's you may have much higher office costs - rent, utilities and staff versus possible working at home. 

 

SMA means individually managed accounts? Yeah I am aware of these cons. Do you think it is a good idea to start as an SMA and convert to HF later? What about mutual fund? Will that be cheaper?