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

[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)

 

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.   

 

IB does billing, but they also automatically record the trades into each client's account, right? I agree IB interface is atrocious. Are there any other brokers that offer SMA service that allows you to manage all accounts at once, at not much more of an expensive cost?

 

Would you mind outlining the start up and operating costs if you're looking to run it very lean (no rent or staff)? I just want to compare it side by side with a hedge fund cost. You do save a lot by not needing audit, admin, or tax services I believe. And I think the legal starting costs are also significantly cheaper.

[gfp]

Schwab is another that offers services to a lot of RIAs.  My wife worked at a firm that uses Schwab institutional and they stuck with it so it must not be too bad.

 

https://si2.schwabinstitutional.com/SI2/SecAdmin/Logon.aspx

 

Interactive brokers gets criticism for the user interface / reporting, but I haven't had any issues with it.  Both have improved over the years, and from the advisor's side I really love it.  Trader Workstation may be daunting at first, but I've been using it for over a decade and it's second nature now.  Very powerful and much faster than any web-based interface.  I use the stand alone java application, downloaded to my computer.  You can make one trade and allocate percentages to each account you manage, or make individual trades in individual accounts, which is common since new accounts come in from time to time.  The reporting can be as nice as you wish, since you can customize and white-label (or whatever they call the branding) the portfolio analyst reports into really nice looking PDF statements.  Conversely, accounts I manage for people at other brokerages don't usually have a good performance reporting function - Fidelity is OK but delayed which is ridiculous since it's just a computer calculation.  Lots of brokers don't report performance since they don't want you comparing your results with benchmarks.  IB makes it easy.  I haven't used the Schwab institutional so I don't know how good they are on performance reporting - but I remember my wife's previous firm used an expensive stand alone software package to do their performance reporting.  They were also aggregating clients entire financial picture, including account at other custodians so that may have been the reason.

 

The main issue for IB is that unsophisticated clients don't like the two-factor authentication log-in - but some of my clients love it and tell me it makes them feel cool to need that.  It's hard for a client in their 90's or 100's.  But the internet is hard for them anyway.  I think you can opt out of the two-factor log in and use the web-only interface and it is not too much different than any other online broker from the clients perspective.

 

On second-guessing clients and trade-copiers - That's on you to clearly communicate what you are going to do for them.  I don't mess around when I am considering a new client.  You don't have to take them all and you need to be clear on what services you are offering.  I've only had one client (actually the partner of a client) copy trades and he was so bad at it (and the security so illiquid) that he drove the price way up on himself and I likely sold some of his girlfriend's shares to him on the spike...  You can always dump a client.  The quality of your clients is very important when a bear market or extended flat market comes.  How they behave will affect your performance.  I've been really lucky but my wife had some horrible clients that inherited their fortune and just couldn't bear to watch it shrink any further in 2009 - predictably liquidating all their equities at the bottom and going all cash...  She found the self-made clients had no problem staying the course or even adding to their equity allocation during the crisis. 

[muscleman]

Schwab is another that offers services to a lot of RIAs.  My wife worked at a firm that uses Schwab institutional and they stuck with it so it must not be too bad.

 

https://si2.schwabinstitutional.com/SI2/SecAdmin/Logon.aspx

 

Interactive brokers gets criticism for the user interface / reporting, but I haven't had any issues with it.  Both have improved over the years, and from the advisor's side I really love it.  Trader Workstation may be daunting at first, but I've been using it for over a decade and it's second nature now.  Very powerful and much faster than any web-based interface.  I use the stand alone java application, downloaded to my computer.  You can make one trade and allocate percentages to each account you manage, or make individual trades in individual accounts, which is common since new accounts come in from time to time.  The reporting can be as nice as you wish, since you can customize and white-label (or whatever they call the branding) the portfolio analyst reports into really nice looking PDF statements.  Conversely, accounts I manage for people at other brokerages don't usually have a good performance reporting function - Fidelity is OK but delayed which is ridiculous since it's just a computer calculation.  Lots of brokers don't report performance since they don't want you comparing your results with benchmarks.  IB makes it easy.  I haven't used the Schwab institutional so I don't know how good they are on performance reporting - but I remember my wife's previous firm used an expensive stand alone software package to do their performance reporting.  They were also aggregating clients entire financial picture, including account at other custodians so that may have been the reason.

 

The main issue for IB is that unsophisticated clients don't like the two-factor authentication log-in - but some of my clients love it and tell me it makes them feel cool to need that.  It's hard for a client in their 90's or 100's.  But the internet is hard for them anyway.  I think you can opt out of the two-factor log in and use the web-only interface and it is not too much different than any other online broker from the clients perspective.

 

On second-guessing clients and trade-copiers - That's on you to clearly communicate what you are going to do for them.  I don't mess around when I am considering a new client.  You don't have to take them all and you need to be clear on what services you are offering.  I've only had one client (actually the partner of a client) copy trades and he was so bad at it (and the security so illiquid) that he drove the price way up on himself and I likely sold some of his girlfriend's shares to him on the spike...  You can always dump a client.  The quality of your clients is very important when a bear market or extended flat market comes.  How they behave will affect your performance.  I've been really lucky but my wife had some horrible clients that inherited their fortune and just couldn't bear to watch it shrink any further in 2009 - predictably liquidating all their equities at the bottom and going all cash...  She found the self-made clients had no problem staying the course or even adding to their equity allocation during the crisis.

 

How to get good clients is a very important factor here. What do you mean by "self-made clients"? Do you mean they came to you to sign up instead of you poaching them?

[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.   

 

IB does billing, but they also automatically record the trades into each client's account, right? I agree IB interface is atrocious. Are there any other brokers that offer SMA service that allows you to manage all accounts at once, at not much more of an expensive cost?

 

Would you mind outlining the start up and operating costs if you're looking to run it very lean (no rent or staff)? I just want to compare it side by side with a hedge fund cost. You do save a lot by not needing audit, admin, or tax services I believe. And I think the legal starting costs are also significantly cheaper.

 

I love IB's billing.  I know IB has a feature that allocates trades into each client's account but that is not the same as recording every entered trade, whether executed or not.  As an RIA you have a fiduciary responsibility so you have to have a reason for the trade, unlike a broker/dealer who is just subject to suitability standards.  Other brokers do offer SMA service just that some have minimum AUM requirements to be on the system, for example Scottrade.  You would need to call each to find out. 

 

A mutual fund has a higher startup and yearly cost than a hedge fund.  Breakeven is $10 to $15 million in AUM if costs are tightly controlled.  Even then the fund's  annual expense ratio wold probably be around 2%. 

[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)

 

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.   

 

IB does billing, but they also automatically record the trades into each client's account, right? I agree IB interface is atrocious. Are there any other brokers that offer SMA service that allows you to manage all accounts at once, at not much more of an expensive cost?

 

Would you mind outlining the start up and operating costs if you're looking to run it very lean (no rent or staff)? I just want to compare it side by side with a hedge fund cost. You do save a lot by not needing audit, admin, or tax services I believe. And I think the legal starting costs are also significantly cheaper.

 

I love IB's billing.  I know IB has a feature that allocates trades into each client's account but that is not the same as recording every entered trade, whether executed or not.  As an RIA you have a fiduciary responsibility so you have to have a reason for the trade, unlike a broker/dealer who is just subject to suitability standards.  Other brokers do offer SMA service just that some have minimum AUM requirements to be on the system, for example Scottrade.  You would need to call each to find out. 

 

A mutual fund has a higher startup and yearly cost than a hedge fund.  Breakeven is $10 to $15 million in AUM if costs are tightly controlled.  Even then the fund's  annual expense ratio wold probably be around 2%. 

 

Thanks for the response. Isn't SMA different than a mutual fund? Do you happen to know the costs for SMA - startup and operating?

[Mephistopheles]

 

How to get good clients is a very important factor here. What do you mean by "self-made clients"? Do you mean they came to you to sign up instead of you poaching them?

 

He just means those who earned their own wealth vs. those who inherited it.

[Tim Eriksen]

 

Thanks for the response. Isn't SMA different than a mutual fund? Do you happen to know the costs for SMA - startup and operating?

 

Yes SMA is different than a mutual fund.  I shouldn't try to respond in one post to two different posts by two different people.

 

SMA costs can totally vary.  You could run it out of your house and focus on friends and family.  You could probably do that on $1,000.  Or you could open up an office and advertise, then you may need staff plus the costs of the office.  You may spend $50,000 or more per year in overhead. 

[gfp]

Yes, what mephistopheles said.

 

 

How to get good clients is a very important factor here. What do you mean by "self-made clients"? Do you mean they came to you to sign up instead of you poaching them?

 

He just means those who earned their own wealth vs. those who inherited it.

[Travis Wiedower]

SMA costs can totally vary.  You could run it out of your house and focus on friends and family.  You could probably do that on $1,000.  Or you could open up an office and advertise, then you may need staff plus the costs of the office.  You may spend $50,000 or more per year in overhead. 

 

As Tim said, startup costs for SMAs can be super low--mine were definitely under $1,000 (I'd guess $750ish). Easier to do it super lean when you're only opening up with friends and family. Raising outside capital will probably require audit costs and stuff like that. I only opened shop in February but I can already see the benefit of managing one fund over separate accounts. If I ever grow to the tens of millions I'd definitely be converting to a hedge fund.

 

I also don't understand the hate for IB's interface. Took me a couple days to get used to it but I love it now--buying/selling for multiple accounts (or one) is so easy, reporting/billing is great too.

[tnp20]

I am in the process of setting up an incubator fund. This is a pre-cursor to a fully blown hedge fund. It costs about $3000 to get the incubator fund set up.

 

We are in the process of setting up brokerage accounts. My team consists of me and my partner. We have the investment strategy down to a pat as my partner has been successfully investing with this particular strategy over the last 30 years. His returns are in the order of 15% over this period without a losing year...but this is in his personal account and now we are trying to leverage that with outside funds.

 

Here is our rough game plan:

 

(i) Set up brokers accounts and start investing incubator funds. This is only our money at this stage.

                - We have identified and interviewed a Fund administrator and a Fund auditor/accountant. We will probably only use the auditor to produce certified fund track records so we can sell the fund record when the time comes. The fund administrator will be hired later.

 

(ii) Whilst we develop an audited track record for the next 12 months we intend to do the following:

                  - Get an indication of interest from family members, friends colleagues....absolutely no advertising or marketing at this stage

                  - prepare for series 65 exam. Not sure about series 7 as only my partner and I intend to run the fund and solicit clients.

                  - Take what ever steps necessary to become a Registered Investment advisor  and register with state and federal agencies to be able to start soliciting clients legally ....some of it might be state specific so we have to figure out where bulk of our initial investors are coming from.

 

(iii) Some point down the road, convert from an Incubator fund to full Domestic Hedge Fund

              - This is an additional $20-$30K in legal fees and have to prepare a fund prospectus

              - Meet other registration and solicitation requirements with state and federal (I believe the levels depend on asset size...$25M is one level of regulations, next one is $100M when you have greater legal scrutiny from the regulators)

 

(iv) Start marketing the fund track record and strategy

                      - we will let out numbers and unique strategy do the talking. Our real focus is institutional and ultra wealthy individuals as clients. We only want a handful of clients. We don't want mom and pop investors in the long run to manage the absolute number of clients.

 

(v) Hire a fund administrator  - doing the fund accounting is time consuming and so would rather pay a fund administrator $600-$1000/month to manage all of that.

 

(vii) Institutional clients want additional structure and controls in place --> prepare fund for institutional clients ...this may take another year.

 

 

Many thanks for lot of folks on this board to get us started. We used their advice to get started....and are in progress right now. Here is the old link of how we got started, the delay has been due to personal situation.

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/setting-up-an-investment-fund-need-some-advice/

 

 

Any tips on the rough game plan would be greatly appreciated.

 

I want to emphasis that the "Investment" and "Strategy" part of this has been nailed town to a large degree as we have been doing this with our private money for many years. Yes, there is an issue of capacity and size, but we think our strategy can scale and absorb lot more money without a significant degradation in returns....so the only new part to us is the hedge fund process, operations and the marketing/sales side.

 

[bennycx]

If your partner had 15% compounded for past 30 years, wouldn't he have enough to set up a hedge fund straight? Or would have >25 mil in assets already?

[tnp20]

My partner has sizable assets. Mine are more modest but well above multi-million.

 

We do plan to increase the amounts we put into our Hedge fund over time. Technically my partner doesn't need to do this as he is already financially very secure. But this is his hobby and loves to trade/invest... he has been doing this for the last 30 years. I made my money with a different strategy but his strategy on a risk adjusted basis is way better than mine and with a more solid, consistent and absolute track record and we think his strategy is a better one for institutional and wealthy clients as it is highly differentiated to what nearly everyone else is doing.

[tnp20]

Lots of useful commentary on this thread too about the challenges of Hedge Fund or RIA....

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/stevens-fund-2012-annual-report/

 

[hillfronter83]

It seems that many money managers charge a quarterly fee if it's a fixed percentage based on market value. I don't know how this is done with performance fee. To those of you manage OPM with performance fee, do you charge your fee all at the end of the year? Thanks.

[Travis Wiedower]

It seems that many money managers charge a quarterly fee if it's a fixed percentage based on market value. I don't know how this is done with performance fee. To those of you manage OPM with performance fee, do you charge your fee all at the end of the year? Thanks.

 

In my case, management fee is quarterly and performance fee is yearly. Both in arrears.

[Evolveus]

If you just wanted to start an incubator fund to develop an auditable track record is something like the IB Friends and Family structure a viable low cost / low regualtion option?

 

Here are some snippets from IB's website about the Friedsn and Family Structure:

 

Manage 15 or fewer* multiple accounts of varying types under a single login, including:

Individual, Joint, Trust, IRA, UGMA/UTMA, Corporation, Partnership, Limited Liability Corporation, and Unincorporated Legal Structures

 

* Only Advisors who are exempt from registration are eligible to open a Friends & Family account. Generally, most jurisdictions require that an advisor have 15 or fewer clients in order to qualify for exemption from registration. However, registration requirements can vary among jurisdictions. For example, advisors residing in the U.S. may be required to register under either State or Federal law if they meet certain criteria (e.g., total assets under management, number of clients, whether they receive compensation, etc.).

 

It looks like they are saying that if you have less than 15 'clients' and are under a certain AUM then you may not have to register as an advisor.  It also seems like this may vary by state. 

 

As far as just getting something off the ground to start the clock on a record that could be audited and not considered a PA, is something like this an option?  In my case I would be doing it without collecting a fee in order to keep things simple from a regulatory standpoint and not cause any conflict of interest with my current employer. 

 

Thanks!

[constructive]

It just depends on how much you're willing to spend on accounting and audit. If you run an investment fund for free for a couple of years that will chew up money, even if you don't want to pay for one time RIA registration.

[oddballstocks]

If you just wanted to start an incubator fund to develop an auditable track record is something like the IB Friends and Family structure a viable low cost / low regualtion option?

 

Here are some snippets from IB's website about the Friedsn and Family Structure:

 

Manage 15 or fewer* multiple accounts of varying types under a single login, including:

Individual, Joint, Trust, IRA, UGMA/UTMA, Corporation, Partnership, Limited Liability Corporation, and Unincorporated Legal Structures

 

* Only Advisors who are exempt from registration are eligible to open a Friends & Family account. Generally, most jurisdictions require that an advisor have 15 or fewer clients in order to qualify for exemption from registration. However, registration requirements can vary among jurisdictions. For example, advisors residing in the U.S. may be required to register under either State or Federal law if they meet certain criteria (e.g., total assets under management, number of clients, whether they receive compensation, etc.).

 

It looks like they are saying that if you have less than 15 'clients' and are under a certain AUM then you may not have to register as an advisor.  It also seems like this may vary by state. 

 

As far as just getting something off the ground to start the clock on a record that could be audited and not considered a PA, is something like this an option?  In my case I would be doing it without collecting a fee in order to keep things simple from a regulatory standpoint and not cause any conflict of interest with my current employer. 

 

Thanks!

 

Exemption really depends on the state.  Most states have an under five clients rule.  For example if you're in Texas you can have 4 Texas clients, 5 Oklahoma clients, 5 Alabama clients etc.  And a hedge fund counts as a single client. 

 

But in Pennsylvania they count clients in other states towards the five limit.  So as a PA resident I can only have 5 total clients across the country before I'd need to register.

 

I don't think registration is all that difficult or costly.

[Guest Schwab711]

It's called the Private Fund Advisor Exemption:

https://www.law.cornell.edu/cfr/text/17/275.203(m)-1

[Evolveus]

I agree - registration is not costly nor difficult.  i work in wealth management and have my licenses (7, 65, 66), but I want to build my on track record that could be audited and legitimate using some outside money (not a PA).  My main concern is a conflict of interest with my employer, aka getting fired, which is why i likely would accept no fees initially. 

 

I guess my question would be more of whether a structure like this (audited) would be considered more legitimate in the eyes of prospective future clients since it would not just be money in my personal account. 

 

I thought what Racemize did in writing quarterly letters, even though it was just him and his wife, shows an extra level of commitment.  I've done the same for quite some time.  I also have a dedicated LLC set up for this.  Even though its not a ton of dough, I felt like putting together the LLC and writing quarterly letters (basically to myself) shows a certain level of dedication above and beyond saying 'hey, look at my IRA.' 

 

I'm OK with spending a couple grand in the early years - I want to get the clock started on something that can be audited without getting myself fired. 

 

 

 

[Gopinath]

Anyone remember filling the Form U10 for series 65 application? What do I fill in for the details "Firm information" and "Regulatory Agency" as I am not affiliated with any firm as of now.