So You Think You Can Start a Hedge Fund? How to Become the Next Ken Griffin, Part 1 – Getting Up and Running
First, the bad news: you haven’t picked the best time to start a hedge fund.
It was much better to get into the game early before everyone else also wanted to start their own funds.
But if you have your heart set on becoming the next Ken Griffin, Ray Dalio, or John Paulson, I can’t talk you out of doing it.
I can point out, however, that hedge funds require start-up capital in the millions or tens of millions, eye-popping legal bills, and entail constant scrutiny by current and potential investors. It’s a tough business that’s only getting tougher as the government piles on more and more regulation.
So if you want any chance of success at all, you’d better have a novel, workable idea and the ability to raise tons of money.
Starting a hedge fund because it sounds like an easy ticket to models and bottles, because you can’t find another buy-side job, or because you think you have a brilliant investment idea but haven’t tried it yet are all surefire ways to lose money.
You also need to be entrepreneurial – as the founder of your own hedge fund, not only are you a portfolio manager, you’re also a small business owner. Thankless tasks like managing overhead, IT, HR, and marketing will fall on your shoulders. Even if you hire people to do this for you, expect to spend 20 – 30% of your time on administrative matters.
If you still have your heart set on starting your own fund, though, here’s what you need first:
Got a Strategy?
Your investors will want to know exactly how you plan on making them money. Just saying you’re a global macro fund or a value investor won’t cut it – you need to show that you have a different way of executing those strategies with a repeatable process.
Got a Track Record?
You also have to prove that your strategy has worked in the past under a variety of different market conditions. This is harder than it looks because you may be prohibited (by your firm and/or the law) from using your past performance record in marketing materials for your new fund.
Institutional investors (endowments, pensions, etc.) usually look for a 3 year-long track record. Funds-of-funds, family offices, and high-net worth individuals are comfortable with a 12 to 18-month long track record.
If you can use your old numbers, they’ll need to reflect your investment decisions and show that the strategy used was similar to what you’re using in your new fund.
If you were a research associate at a long-only dividend fund, don’t pretend that your performance there means that you can be the portfolio manager of a long/short international growth strategy fund.
And if you can’t use your old numbers or you’re not coming from the buy-side, invest your personal account with your strategy and have the performance audited by a top firm – expect to pay around $10,000 USD for a Big 4 firm to do it.
As one hedge fund manager told me, “If you can’t afford to audit your performance, you aren’t that good.”
Got Money?
You’ll need initial investors to get going. These initial funds could come from:
- Your own money
- Friends and family
- Family offices
- University endowments, pension funds, and foundations
- Hedge Fund seeders
- Funds-of-Funds
Investors like to see that the managers’ own money is a significant portion of the fund: having skin in the game increases your incentive to perform well.
You investors will probably have to meet the SEC definition of an ‘accredited investor’, although this varies a bit from state to state; international requirements may also be different.
There’s no minimum amount that you have to raise, but you should consider the startup and ongoing costs of the fund, your fee structure, and work backward to a level of assets under management (AUM) that can support that.
As a starting point, most prime brokers won’t work with funds under $5 million in AUM.
The optimal situation is to be a superstar at a traditional firm and get money from them to start your new fund. Hedge fund seeder firms operate the same way: they give you capital in exchange for a portion of your fee income.
And don’t think that your fundraising efforts end when the fund launches: marketing, fundraising, and yes, networking, are crucial to growing your fund.
Even the biggest hedge fund managers with dedicated marketing departments can’t escape it – they’re still brought it at the end of the pitch to close the deal.
Got Office Space?
Some creative ideas for office space:
- Your house. Ken Griffin started Citadel this way, and Michael Burry of The Big Short ran his fund from home.
- A hedge fund hotel. Usually set up by prime brokers, managers get office space at below-market rates in exchange for steering brokerage business to the hotel’s host firm.
- Sharing space with other managers. Make sure you get along and aren’t directly competing with each other.
Renting an office can be a huge expense, especially in financial centers like New York and London, so you’re much better off going with cheaper options when you first start out.
When you get to $100 million in AUM and you have $2 million per year in management fees to cover your office, consider upgrading – but until then, frugality is the name of the game.
Got Service Providers?
Even a single-person hedge fund must rely on a team of external partners to make the fund run. Be prepared to pay for quality – institutional investors will consider the reputation of your service providers a reflection of your credibility.
So if you don’t spend enough on the right providers, you’ll have trouble growing your fund and getting better-known investors on-board. Here’s who you’ll need:
Lawyers
A good attorney should be your first call when you decide to start your own fund. Your fund lawyer will guide you through the whole startup process and provide referrals to other service providers.
Though the best-known hedge fund law firms are in New York, any city with a bulge bracket bank presence will have a local firm or two known for hedge fund law.
The actual hedge fund structure depends on whether your investors are taxable or tax-exempt, whether or not they’re US citizens, and the investment terms. Some points to consider:
- Fee Structure. The standard fee structure used to be “2 and 20”, meaning a quarterly management fee of 2% and annual performance fee of 20% on the gains. The trend now is for lower management fees and higher performance fees. And some funds are even more aggressive – SAC Capital famously charges “3 and 50,” the highest fees in the industry.
- Lockup Term. This is the length of time that investors’ money has to remain in the fund before it can be withdrawn. It should match your strategy – a global macro fund trading ETFs all day will have the liquidity to support a short lockup term, whereas an activist fund needs a longer lockup term to reflect the longer time it takes to realize the strategy.
- Redemption Terms. How much notice do investors need to give when they want to take their money out? Usually funds only allow redemptions at the beginning of an accounting period (quarterly or annually).
- Performance Targets. Are you trying to outperform a particular index? Is there a rate of return you have to beat before collecting performance fees?
You may have to register as an investment advisor with your state or the SEC if your fund meets certain criteria.
For example, all hedge funds have to register as investment advisors in Louisiana, but funds in Massachusetts are exempt if all of their investors are accredited investors. Outside the US, registration requirements vary wildly so you’ll have to do your own research there.
For a simple hedge fund setup, expect to pay between $10,000 and $50,000. More complicated setups can go into hundreds of thousands of dollars.
Auditors
Outside auditors will also have to verify your performance on a regular basis, and institutional investors will demand to see that performance before investing money.
Administrator
An administrator handles the majority of your back office operations, like trade reconciliation and allocation. Again, institutional investors will be looking for a quality, reputable administrator – you can’t ignore this just because it’s “the back office.”
Marketers
Third-party marketing firms find potential investors and pitch on your behalf. They either work on retainer for a specified time period or get paid a cut of the funds they raise for you.
Prime Broker
Prime Brokers provide leverage, let you borrow securities to short, and custody your assets. They also manage the brokers and dealers you trade through.
Smaller funds (under a billion dollars) may prefer to use an introducing broker, who’s partnered with a major prime broker but who customizes the services for smaller funds.
IT and Technology Providers
You’ll also need Bloomberg terminals (around $1,500 USD per month, each) and possibly other technologies to support all the trades you make.
The good news here is that IT expenses tend to be much lower for fundamentally-oriented funds with little active trading; if you’re a quant fund or you’re doing any kind of automated trading, though, you’ll need serious computing power and serious cash to pay for it.
Got Cash for Yourself?
Don’t expect millions to come rolling in after you flip the switch on for your fund – most managers don’t even pay themselves a salary until their AUM gets big enough for management fees to cover overhead with plenty of room to spare.
And even if they get amazing returns in their first few years, they’ll re-invest most of those performance fees back into growing the fund itself.
In the meantime, you still need a place to live and food to eat. So make sure that you have enough savings or another income source to cover your daily living expenses – and remember that it may take years to establish the AUM you need for long-term success.
What Next?
Raising capital, setting up everything above, and figuring out your strategy are just the first steps of a long and grueling process when starting a successful hedge fund.
You’ll also need to plan your day-to-day strategy, hire investment professionals, and figure out your own exit strategy if things don’t quite work out – all of that and more is coming up in parts 2 and 3 of this series.
Hetty MacIntyre grew up in Western Europe and the Deep South before attending a liberal arts college in the Northeast. She worked at a large pension and endowment fund manager before starting her own value-oriented private investment fund.
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Great article. What would be some examples of investment strategies? I’m just starting to read about investing so I’d like an example or two of commonly known investment strategies.
Thanks
Examples: global macro (predicting things like FX rates, commodity prices, etc. based on global trends), long/short equity (buying / selling stocks based on valuation and/or events), event-driven (trading based on M&A activity or other special events), relative value (see the value investing article).
Great article – very interesting to read about the practical nature of setting up a fund. More articles like this would be greatly appreciated!
Thanks! More on HFs coming up in the near future.
Well i have read a bit of ‘Boomerang’ by michael lewis.He talked about his friend Kyle Bass.Bass made a fortune in wall street before the crash of about 10 Million USD , went back to texas ,raised another 500 million USD and started his hedge fund.And now he owns a ranch and guns , uses the latter to shoot racoons everyday
I think this article has broken up very well the resources required and the ground reality
Kyle Bass is the man and he owns TV commentators.
http://www.youtube.com/watch?feature=player_embedded&v=VBWiQlS5Qg0
http://www.youtube.com/watch?v=4HW8J59rQNQ&feature=related
He’s also pretty damn brilliant
http://vimeo.com/18920437
Hey yeah, I just read that. Apparently he was a bond salesman before he went off to do his own thing.
“if you’re a quant fund or you’re doing any kind of automated trading, though, you’ll need serious computing power and serious cash to pay for it.”
actually i disagree on this one. it really depends on the trading strategy – whether automated or not.
You’re right — so much about a fund’s overhead depends on the strategy and execution method. Data feeds get more expensive as you get into more niche markets.
Great article. It’ll be great if you could publish an article on setting up a PE fund.
Hedge Funds, PE funds, and VC funds have the same legal structure and fall under the same SEC registration requirements. PE funds would need a higher AUM to get off the ground and would need access to capital for deals (LBOs, etc), unlike HFs.
Would a hedge fund with 50 million AUM be considered moderately big and how would the management play put for smaller funds with less then 100 AMU?
$50M AUM is a good amount to raise in this environment if you don’t have institutional backing but is by no means ‘big’. Most prime brokers think you’re big once you have $1BN AUM. It also depends where you are — $50M in nothing in the NYC/Conn/Boston corridor but substantial in Dallas.
Can you clarify what you mean about how the management would play out (I think that’s what you mean) for funds <$100M? Are you asking about personnel, fee structure, economics, something else?
For the second part of the question i was meaning more along the lines of how is management compensated on a personal scale. Thanks.
Theoretically, 2% of $100MM = $2 million but in reality a good portion of those fees will be eaten up by infrastructure, employees, and other expenses. You would still probably get something in the six-figure range but you usually won’t make a ton just from management fees until you get bigger.
Your website has literally been shaping and guiding my career path since my college days. Your website is by far the most comprehensive source for anything finance related. Not to mention, your articles provide the most depth and insight regarding some of the most pressing questions/issues within the financial industry. This past article was just fantastic.. Where else on the internet are you going to find a road map for starting your own hedge fund?? If my future hedge fund hits it big, I almost feel bound to make a donation to this site. Thanks again for providing me and countless other young finance professionals with direction and advice.
Thanks! Also, FYI, I (Brian) did not write this, Hetty, one of our contributors did, and also I have a real name (Brian, not Inquisitor – dropped that in 2008/2009).
I always thought Inquisitor was such a catchy name (especially for this site) though, but I guess Brian’s a great name as well. Also, why did you get rid of the noose? That background was subtle wittiness at its best, yet still very appropriate for this industry…
I just lol’d at “inquisitor.”
What are “Hedge Fund seeders” and can you give examples of some Hedge Fund seeders?
Investors who invest in HFs. Examples – think of HNW individuals, SWFs etc (I’d suggest you to refer to online sources to check what these terms mean)
There are also seeder firms that will give you a large amount of money to manage in exchange for a stake in the management company — i.e., they get a cut of the management and performance fees.
Hetty – thank you very much for writing this. Right now, I am thinking about starting my own hedge fund. Why?
‘… you’d better have a novel, workable idea’
I think I have some.
‘you need to show that you have a different way of executing those strategies with a repeatable process’
I think I can.
I’ve had a lot of ideas this year, some of them just minor thoughts, but some I’m in the middle of developing into a tangible strategy, which I can later test.
Do you hear a lot of kids (I’m in my early-mid 20s) say that they’ve got profitable trading strategies? What usually happens to them?
Hetty might have better answers for you. I personally haven’t heard of many though I’ve heard of few. Don’t know what will happen to them after cause they are still trading now!
I know plenty of young people who eventually want to run a fund, but know that they have to really develop their track records and strategies first. Try working at a fund with a strategy similar to what you have in mind first, perform well, work your way up to running some money for them and then you can make your move to implement your own strategy.
Hi Hetty,
I have to ask a related question and would love for your advice.
For many years, I have wanted to start my own fund for very unconventional reasons. It could be a hedge fund or private investment fund. Here’s the catch. I can raise about 50k max, have no connections, have no 4.0 GPA from top schools, and have no related work experience.
The only experience I have is that I am a retail forex trader for 6-7 years, but my track record is horrendous.
It was only in recent months that I decided to be more disciplined and started tracking and managing my account’s progress.
Many of what you do in a day is what I do for my little account, and I enjoy it. But without 10 out of 10 requirements you mentioned, my dream seems to be getting out of reach. What do you suggest I do?
Go work at a bigger fund first – with that amount of capital and no connections, you can’t really start your own HF. We’re running additional parts in this series very soon, and you’ll see what it takes nowadays (several years post-financial crisis and regulations).
What exactly do hedge fund managers and their employees do during the trading day? Is the hedge fund just watching the markets and analyzing how their strategy is playing out or are there trading desks where traders have their own P&L? I know there are jobs for traders at hedge funds, but what exactly do they do?
http://www.mergersandinquisitions.com/hedge-funds-institutional-asset-management/
How exactly do Bloomberg terminals work? I know they give a user specific market information, stock info etc. But does the Bloomberg terminal have to be linked to a prime broker in order to carry out trades?
Not 100% certain of that one, but yes I believe it needs to be linked to a prime broker… if you don’t have that, you can never trade substantial volume. So it’s a critical component for all trading firms / HFs. Other than that, they let you pull up tons of real-time information on stock and bond pricing, performance, yields, and more.
Great Article … Was part II of this ever released?
http://www.mergersandinquisitions.com/start-hedge-fund-part-2-day-in-life/
I am a computer guy and I have a partner who is a portfolio manager. We plan to start a HF, based on algo trading that I implemented. I worked on it for about 2 years, and recently started discussing forming a company / a HF with that other gentleman. He is prepared to invest $100K of his own funds into the HF, however when I asked if the 1% mgt fee + 20% of profit will be paid to our company out of his investment returns, he said “founders’ investments don’t get charged any fees”. I disagree with that based on the fact that most of the HF will be based on my work, and I expect him to pay to the company as if that money would be from outside investors, or possible a bit discounted. What do you think is fair/proper approach – let him “ride free” with his investment or charge the funds some reasonable fees?
I believe readers will have better insights into your question
It is OK to charge a seed investor some fees. They can be lower than standard though. 1/20 sounds reasonable to me. If you have sufficient funds to support infrastructure and fixed costs then you may offer 0/25, i.e. you get only a portion of the profit and no fixed charges.
Alternatively a seed investor can be offered a stake in an advisor.
Hello m&i,
I am a young adult (19-21) and I was wondering how I coul go about starting a hedge fund. I have a massive knowledge about finance and I am an excellent trader. How would someone go about starting a hedge fund as a teenager. I have been thinking about starting a fake portfolio to should investors that I am able to make money. I am motivated to do this a need the steps I should take. I don’t want to here people say you can’t do it. Please tell me how you would do it if you had to. It would be much appreciated!!Will my age make it impossible to do this or is it possible? Lastly, where should I be looking for investors and how do I get the bank to leverage my fund?
I’d suggest you to work for a HF first before you contemplate starting your own fund!
Hetty et al,
Thanks for the great article. Can you provide any resources for learning more about audits of past performance? Is there an equivalent process for real estate portfolios? I’ve worked in boutique RE PE for years and am thinking of starting my own fund or REIT, so I’m curious how someone would go about demonstrating RE acumen.
hi great article, just some questions i would like to ask.
do hedge funds have to receive outside money or can the capital all come from one person. E.g say a person has $50 mill, could you basically run a one man hedge fund or is there really no point in doing so.
Great question. I believe most HFs have various source of capital though some investors may invest more than others. There may be certain rules and regulations on the # of investors etc. I’d suggest you to refer to sources such as http://www.seclaw.com/centers/hedgefunds.shtml
I’m a young guy who wants to get into hedge funds one day and I wanted to ask do they recruit at graduate business schools like Columbia, Harvard, or Wharton?
Yes they do
Is it easier to start up a hedge fund with an analyst background or with a trader background?
Good question. I think it depends on your track record and the network of investors you know (unless you already have assets you can put in the HF)
Hi: I’m investigating utilizing my own rollover IRA to invest. Does anyone have any info/insight regarding using an IRA to fund personal HF, forming C-corp. and paying myself a salary? Appreciate it – thanks
I think readers may have better insights to your questions.
AuM, had become so overwhelming issue, and most books and articles are so negative for start-ups.
Mind as-well watch CNN!
Hi
This may be asking out of turn, but what return on investment do most hedge funds average per annum? What is considered exceptional performance?
http://online.barrons.com/public/page/9_0210-hedgefundperformance_aug-hedgefundperformance.html
I have a question. I want to set up a hedge fund around an options strategy that has been working personally for 6+ months. My 2 main questions are: 1. What is the best way to set it all up offshore. If we only took expat money ans only from sophisticated investors not in the usa and 2. To keep costs down can I not just start a company somewhere offshore, open an account with interactive brokers and start?
http://www.barclayhedge.com/research/educational-articles/in-depth-articles/starting-a-hedge-fund.html may help
“For a simple hedge fund setup, expect to pay between $10,000 and $50,000. More complicated setups can go into hundreds of thousands of dollars.”
Do you mean pay the lawyer $10-$50000?
I believe that is the total fee required for the lawyer + all other registration requirements.
Dear Brian,
My husband has been a hedge fund lawyer at a top law firm for eight years. He made partner about a year ago. He wants to start his own hedge fund. Does he have enough experience? If not, what can he do to gain experience?
Thanks
Depends on his investment track record – if he doesn’t have one, it will be very tough regardless. He needs to come up with trading/investing strategies that work at scale and use evidence of that to raise funds.
I majored in economics at Dartmouth, taking an internship at a top hedge fund for all summers. I then worked there as an analyst for three year. I am now at Turk. Do I have enough experience to start a hedge fund right when I graduate?
Depends on your long-term investing record… I believe usually you need more experience than summer internships to do this.
I do have more experience; after college and before business school, I worked there as an analyst for three years.
OK. Maybe, but most likely you will need a partner with a much longer track record… 3 years still isn’t a whole lot vs. people who have been doing it for decades.
Wait, but aren’t “institutional investors comfortable with a three year-long track record”?
Yes, but that assumes you were in a more senior role at the fund and/or had more decision-making power.
I have never started a fund before, so I do not know the specifics.
However, we are extending this series in the future and will be answering questions like the ones you raised. The author here will be answering those detailed questions and telling you more about specifically what’s required, so I would encourage you to read that upcoming set of articles.
I am starting a hedge fund. all the legal work is currently done by an associate at Skadden. When should I start to hire an in-house counsel?
Not sure of that one, but I don’t think you need an in-house counsel until you get significantly bigger… perhaps $100M+ AUM, but I could be wrong. Anyone else feel free to correct this.
You say in the beginning “you haven’t picked the best time to start a hedge fund.” Yet, you don’t even have a date as to when this article was written.
This was written just over a year ago (late 2011).
Hi, I’m thinking of starting a tiny hedge fund with less than a million AUM would you recommend that?
Its mostly my own money and to find clients will take some time I do not have and I have also a question about Track Records, what should a Track record look like? Just a account excerpt? And all single trades that have been made?
I will Trade only currencies can I do that on any Market or is it better to do that only on a Exchange like the CBOT/CME?
Thanks
Sam
This article should answer your questions on track record – http://finance.fortune.cnn.com/2011/01/06/why-its-a-great-time-to-launch-a-hedge-fund-2/. I believe it details the fund performance since its inception (or your performance of managing a previous fund since you were there).
Please refer to http://www.investopedia.com/articles/forex/06/sevenfxfaqs.asp#axzz2MWzC0KYM for your last question.
Thanks for sharing, this is really helpful.
It seems that track record is the most important in persuading prospective investors. However, one of the most important disclaimer in fund management is “past performance is not indicative of future results”. If this is the case, isn’t track record not a useful tool in attracting investors?
There’s always an element of uncertainty; I think fund houses put this disclaimer there so investors would have an understanding that despite their decent track record, there may be a few misses. If the fund underperforms (vs. past performance), investors can’t pursue legal action given this disclaimer. I may be wrong here. Track record is the most important aspect of attracting investors of course, but it is not a guarantee that the fund will perform well going forward.
So when was this article published or the comments posted ? I don’t see a single timestamp on the page
Late 2011. Just over a year ago.
Great insight article. I am curious on the operation side: what is the typical hedge fund in terms of number of employees/founders? My thought goes this way: say average worker pay is $350K/yr (analyst, trader, etc included), payroll is easy to reach $2M mark annually if there are more 3 founder/employees included. That means $100M AUM. I haven’t count office cost, IT, etc yet. These numbers seem unrealistic. Is my math way off? I would suspect the average pay $350K is too high for $100M fund.
Checking the links on Barron’s there are a lot funds have much less than $100M AUM. How do they survive? Is there real example how the funds are run?
I am not 100% sure regarding the numbers, but the average pay you suspected wouldn’t be too high – it depends on your level and your performance I believe.
In regards to your last question, I don’t have a real example of how the funds are run, though this should address why some smaller funds outperform the market. “Fearing failure, new managers are determined to generate strong returns, according to Mr Ellsworth. And less encumbered by the size of their asset bases, in sluggish markets where liquidity is constrained, smaller funds navigate better, take on niche investments and adjust positions more quickly than larger funds.” http://www.ft.com/cms/s/0/1c681bb0-1dc2-11e2-8e1d-00144feabdc0.html#axzz2OWLMIIFZ
Hi, I would like to know how to get my personal investment account audited. Should I contact any of the big 4 or how can I do it.
Thanks
I am not 100% sure but a CPA should be able to help you. I think big 4′s division serving individuals may be able to help you. Otherwise, I’d go for smaller independent auditors
I am currently in the retail industry getting a degree in finance part time. I have been in the retail industry for about 15 years working for various retailers; by the time I complete my degree in finance I will be 50. I want to go into buy side equity research and then after getting my CFA and possibly MBA. Would like to start my own Hedge Fund which I am figuring I will be about 60 years old once I have gotten about 10 years experience in the industry. My question is is this an unrealistic goal being that once I start in the finance realm I will already be 50 years old; since most of my co workers will be at least 25 years younger than me? Will the top Hedge Fund companies even consider me because of my age? Will equity research firms even consider me?
If you have had experience in the retail industry, I presume you have solid operational experience. You may want to check out PE firms that may be interested in this background http://www.mergersandinquisitions.com/private-equity-recruiting/
You may be on the older end re HF roles, but you can still give it a shot. You’ll just have to be very good at the markets and show results, almost immediately.