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Your decision to set up a hedge fund is a bold step for any aspiring entrepreneur. No doubt, you have been doing extensive research to learn how to structure and operate a hedge fund. This article will provide you with some essential insights.
· How is a hedge fund commonly structured and operated?
· The most common hedge fund investment strategies.
· The legal and regulatory requirements that hedge funds must comply with.
What is a Hedge Fund?
A hedge fund is a pooled investment entity that uses investor money to purchase specific asset classes to make a profit. Hedge fund managers strive to deliver positive returns in both up and down markets. It's a; you win- we win mindset, which you will read further in this article.
When you mention a hedge fund, people may assume it's just another name for a mutual fund. By comparison, a mutual fund pools investor monies into a conservative long-term position mainly focused on stocks and bonds. Mutual Funds are also burdened with complex security laws and regulatory oversight. This creates ongoing expenses, reducing the investor's return on investment (ROI).
Hedge funds face significantly less regulatory handcuffs; for example, they are not required to file copious amounts of paperwork with the SEC or other state agencies. This begs the question, why do hedge funds have less burdensome regulations?
Simply put, not everyone can participate in a hedge fund. Instead, they are opportunities designed for sophisticated investors, i.e., accredited investors, institutions, and family-owned businesses. These higher net worth investors are more investment savvy, can tolerate higher risk, and have less liquidity in pursuit of potentially higher returns.
A hedge fund also differs from a mutual fund in that it often has lock-up periods and withdrawal restrictions, while most mutual funds offer daily liquidity. Hedge funds usually charge higher fees, including performance fees, based on profits generated. Think of it as a you win- we-win approach.
Absolute Returns
You will frequently find this term used: absolute returns – the ROI an asset delivers over a given time frame. The manager is not looking at how the investment performed relative to other investments or indices but only at its actual return, whether a loss or a gain. It doesn't matter if the market is going up, down, or flat. What is of primary importance to a fund manager is that the investments are experiencing positive returns irrespective of how the market is performing.
After all, the fund manager is the captain of the financial ship and, as such, is responsible for guiding the fund towards success.
Some of these responsibilities include.
Strategy Formulation:
· Developing the fund's overall investment strategy and targeted returns.
· Identifying market opportunities and potential areas for generating returns.
· Determining risk tolerance levels and setting risk management parameters.
· Refining the strategy in response to changing market conditions.
Portfolio Management:
· Managing ongoing investment decisions for the fund's portfolio.
· Reviewing the research and analysis conducted by the investment team.
· Monitoring existing positions and re-balancing the portfolio as needed.
· Proactive risk management strategies to protect the fund's assets.
Investor Relations:
· Communicate with investors to apprise them about the fund's performance to date.
· Addressing individual investor concerns and maintaining solid relationships.
· Increasing investment capital by attracting new investors.
Operational Oversight:
· Managing the fund's day-to-day operations with a hands-on approach.
· Directing the fund's team of analysts, traders, and support staff.
· Ensuring current compliance with regulatory requirements and industry standards.
Performance and Risk Management:
· Achieving the fund's performance targets.
· Implementing risk management strategies to protect the fund's assets.
· Regularly scheduled evaluations optimize risk-adjusted returns.
To sum up, the role of the hedge fund manager must bring together investment skills, strategic thinking, team leadership, and investor-client management.
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Over 900 hedge fund managers have graduated from Fund Launch training and have more than $2.7 billion AUM combined.
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Hedge Fund Structure: Key Components
Hedge funds are most often structured under one of these two types of legal structures:
1. Limited Partnerships (LPs)
2. Limited Liability Companies (LLCs).
Each structure has its advantages and disadvantages:
Limited Partnerships (LPs)
LPs are the most common structure for hedge funds, especially in the United States.
Advantages
· Limited partnerships feature pass-through taxation, thus avoiding the dreaded double taxation of profits. In addition, there is also a degree of liability protection for the limited partners, which are the investors. There is flexibility in profit allocation and management structure, which is a benefit, especially for new funds.
Disadvantages:
· The hedge fund manager is a general partner and inherits unlimited personal liability. It's also important to note that hedge fund investors cannot be involved in management duties. If so, they would lose their limited liability protection.
Limited Liability Companies (LLCs)
· LLCs are becoming increasingly popular for hedge funds, notably smaller ones with a limited investor base.
Advantages:
· A limited liability company features pass-through taxation. Another primary consideration is that the limited liability protection of an LLC applies to all members, including the fund managers. Due to the increasing popularity of LLCs, most states have made them more accessible to set up and maintain.
Disadvantages:
· Some states may impose restrictions on LLC formation, purpose, or operation. If a manager anticipates significant funding from international investors, less favorable tax treatment is possible.
Most future fund managers prefer the LLC as it offers broader liability protection for all members, including managers. Generally, there is also much less regulatory filing and compliance requirements. Both LPs and LLCs offer pass-through taxation, which may depend on the jurisdiction.
In practice, many hedge funds use a combination of structures. For example, a fund could be structured as an LP in the United States, with the general partner being an LLC to provide liability protection for the fund managers.
Choosing between an LP and an LLC will depend on the end goals of the fund, its managers, and its target investors. It's imperative to consult with legal and tax professionals to determine the most appropriate structure for a particular hedge fund.
Regulatory Environment
Earlier, I mentioned that a hedge fund is not burdened with the same regulatory handcuffs that control Mutual funds. This doesn't mean it's doing as you please for hedge fund managers. There are still regulatory waters to navigate, and a severe misstep could sink your dreams.
The big dog agency is the Securities and Exchange Commission (SEC). However, until you're a big dog, the SEC won't be much of an issue. When do you pop up on their radar? *When you have $150 million+ in AUM.
If you plan to trade commodity futures and derivatives, say hello to the Commodity Futures Trading Commission (CFTC), which monitors hedge funds involved in these strategies.
Financial Industry Regulatory Authority (FINRA) will require compliance filings if your investment activities require registering you as a broker-dealer.
Whether or not these regulatory agencies become a part of your life depends on the type of investment strategy and your fund investments. Here is the best advice we can give you. Make it a standard operating procedure to permanently preserve investor paperwork and fund investment records.
Manage the business side of your hedge fund as if one of these agencies could walk in the door tomorrow to conduct a surprise audit. Being prepared is the best antidote for the stress that accompanies a fast-growing hedge fund.
Dodd-Frank
In your research, have you run across the Dodd-Frank Wall Street Reform and Consumer Protection Act? This legislation was enacted to protect investors against fund managers' unrestrained activities, which is a good thing. The good news is that the increased filing and reporting requirements do not kick in until your fund crosses that $150 million AUM threshold.
Anytime you are starting a relationship with individuals who have decided to invest in your fund, it is imperative that you keep permanent records of all signed disclosures, including all electronic communications with each investor. As your fund grows, this type of compliance will fall under the purview of a Chief Compliance Officer (CCO).
Know-Your-Customer (KYC)
This is the process a hedge fund must adhere to when verifying the identity of each new client. The documentation must be permanently retained by the hedge fund manager, which is required before any money is accepted from a new investor.
Anti-Money Laundering (AML)
This does not apply to funds doing business only in the US. However, most financial institutions have adopted AML compliance as a best practice. This additional verification step is designed to weed out bad actors engaged in fraud or other corrupt or terrorist activities.
When digging into KYC & AML, you will run across mentions of filing forms ADV and PF. Again, these requirements affect hedge funds with $150 million plus AUM. Before you get to that size, you will have hired a CCO, so life will be good, right?
Setting up a Hedge Fund - The Basics
- Develop a Comprehensive Business Plan
- Define Your Investment Strategy
- Create a Legal Entity and Choose a Name
- Secure the Necessary Capital and Investors
- Register with Regulatory Authorities
- Develop Investor Agreements and Fund Documentation
- Establish Operational Infrastructure
- Implement Risk Management and Compliance Frameworks
Or, you can choose to use a proven step-by-step system and shorten your time to market by applying to get started with Fund Launch here: https://www.fundlaunch.com/training
Common Hedge Fund Strategies
When launching a new hedge fund, there are no historical returns for a potential investor to consider. Instead, the experience of the fund manager and the management team must be presented in such a way as to instill a level of confidence. The most successful funds are open and transparent and communicate with their investors regularly.
Here is a pro tip: You can't over-communicate. Instead, this flow of information is the most powerful element to alleviate investors' concerns during the inevitable bumps a fund will encounter
The success of your new hedge fund hinges on a crystal-clear investment vision. This is not just a nice-to-have; it's a must-have. You need to articulate your vision in a way that any qualified investor can understand. If your investment philosophy is meant to impress and position yourself as the expert of all experts, you will accomplish your goal and then be left wondering why no one is investing.
What do you want? To massage your ego and impress people or to have people excited about participating in your fund? Here is a pro tip. If your mother can read your investment vision and explain it to you, you are ready to share it with others.
Remember that your potential investors are probably discovering you and your fund for the first time. Like any new acquaintance, it will take a beat or two for them to process the information and for you to establish a personal connection, and that, my friend, is the job of a well-written DRIP email series.
Fund Investment Model(s)
Your fund Investment strategy has to be clear and easily understood by any investor. You must either possess the personal experience to support your investment model or have the talent ready to come on board.
Here are some of the most common models.
Combining Long and Short Equity Positions
Hedging
An example of a long-short position is a situation where a hedge fund is long in a stock that the manager thinks is going to outperform the market and short in a stock that is going to underperform, the fund can therefore end up with only a minimal risk of market fluctuations.
Alpha Generation
To achieve alpha, which refers to generating returns that are higher than the market performance, the mispriced securities are identified. The hedge fund then plans to buy undervalued stocks (long positions) and sell overvalued stocks (short positions).
Global Macro
Global macro strategies require a top-down analysis where fund managers evaluate large-scale macroeconomic trends, geopolitical events, and policy shifts to identify profit scenarios.
Directional Trades
The asset class may go up or down, which is based on macroeconomic and political analysis. For example, you may go long on gold if the inflation is expected to rise or short the currency if economic indicators suggest a decline.
Relative Value Trades
These involve identifying the price mismatches between the assets that have a historical correlation and taking long positions in the undervalued ones while shorting the overvalued ones.
Opportunistic Trades
They are the trades around specific economic events, policy changes, or anticipated volatility, such as the yield curve arbitrage.
Event-Driven
An event-driven investment strategy is one that finds and takes advantage of the pricing inefficiencies that occur due to the emergence of corporate events or market changes.
Merger Arbitrage
The strategy mimics the purchase of the stock of the target company at a lower price than what was announced by the acquirer. However, the stock is not "bought" at the time of the transaction, but at a time when the share is still undervalued according to the market. Thus, the investor buys the target’s stock at a discount and waits for the deal to be completed to make a profit by selling the stock at a higher acquisition price.
Special Situations
Consists of the companies that are experiencing unusual changes such as spin-offs, divestitures, or reorganizations. The investors will benefit from the possible mispricing of the company stock as the market gets used to the changes.
Exploiting Pricing Inefficiencies
The approach is based on the market's habit of not evaluating securities properly when there is a material change in the status of a company. . For instance, if some merger news comes out then the stock price of the target company might have only partially appreciated, thus opening a window for an investor to go long or short.
Relative Value Arbitrage
A relative value strategy, widely used by hedge funds, is an investment method that capitalizes on short-term price differentials between securities in the same sector.
Equity Market Neutral
This strategy comprises buying stocks that are undervalued and selling overpriced stocks within the same sector or industry. The objective is to be neutral to the market; that is, the overall market exposure is reduced as the focus is on the relative mispricing of the two stocks.
Convertible Bond Arbitrage
This strategy will capitalize on the price differences between a company's convertible securities and its stock. Hedge funds invest in convertible bonds that are undervalued and short the respective overvalued stock, expecting the prices to converge.
Fixed Income Arbitrage
This is the identification of the mispricing between the related interest rates of the securities, such as treasuries, swaps, futures, and options of different maturities. For instance, if the yield spread between a long-term bond and a short-term bond is enlarged, then a hedge fund may buy the long-dated bond and sell the short-dated bond.
Distressed Securities
Hedge funds usually follow a distressed securities strategy that includes investing in the debt of companies that are in need of financial help, are on the verge of bankruptcy, or have already filed for bankruptcy.
Buying Distressed Debt
Hedge funds take advantage of the problematic companies' situation to buy the companies' debt at a substantial discount compared to their face value. This debt may include bonds, loans, and other credit instruments that are fetching low prices because of the high default risk of the issuer.
Debt-for-Equity Swaps
The hedge funds may adopt a new approach and switch their debt holdings to company shares during the reformation process. As a result, the company's debt is lessened, and the hedge fund is able to acquire a stake in the company, thus their interests are in line with the company's future.
Distressed Debt Trading
Hedge funds are buying and selling distressed debt in the secondary market with the intention of making money by following the price changes in the market. The strategy of buying depressed securities at low prices and selling when they gain value.
Your investor overview will then explain the targeted returns, performance goals, and the all-important risk management parameters. Always include how fund management will respond to a flat or falling market. Successful investors have a fallback plan if sunny skies turn to rain. Not disclosing how you will handle an adverse market will be a massive red flag.
An accredited investor expects your fund to have a solid legal structure. Many new fund owners choose the Limited Liability Company (LLC) because of the liability protection that each investor receives. Our Fund Launch training students always have questions about selecting the best legal structure. Once this hurdle has been cleared, implementing your fund launch steps becomes more manageable.
Hedge Fund Fee Structure
Here is an example of a hedge fund fee structure often called the two and twenty.
Management Fee
A 2% annual management fee is assessed to each investor based on the value of assets under management (AUM). This fee is collected regardless of the fund's performance. Think of it as insurance that pays for the fund's day-to-day operating expenses, including staff salaries, office rent, and operating expenses.
Performance Fee
A 20% performance fee is paid only if the fund earns positive returns above a certain threshold, commonly called a hurdle rate. This earned fee structure rewards fund managers by adopting a "The more you win - the more we win" mentality.
To bring this into focus, if your hedge fund has $100 million in AUM and generates a 10% return ($10 million profit) in a year, here is an overview of how the fees would be assessed.
· Management/Operations fee 2% >$200,000 (2% of $10 million)
· Performance fee 20% >$2 million (20% of $10 million profit)
· Total fees: $2.2 million
Are you beginning to realize that setting up a hedge fund can be daunting? However, with proper guidance and correct information, you, too, can step into an exclusive club of successful hedge fund managers.
Over 900 fund managers have benefited from our proprietary system to improve their skills and shorten their go-to-market efforts. Combined, these funds manage more than $2.7 billion in assets.
George Ekins is the co-founder of the American Dream Fund and had this to say:
"The best part about Fund Launch has been the live coaching calls, the access to other fund managers who can help you through issues, and the coaching to help navigate the early process of structuring and launching a fund."
To learn more, please visit Fund Launch via this link: www.fundlaunch.com/training
DISCLAIMER: This content is for educational and informational purposes only. It is not to be taken as tax, financial, or legal advice. You should always consult a legal professional before taking action. Furthermore, this is not a recommendation to buy or sell any security. The content is solely just the opinion of the authors.
