4 Things to Consider When Starting a Hedge Fund

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In the modern securities markets, hedge funds are a formidable force to reckon with. The hedge funds, talking about pooled investment funds that invest in relatively liquid assets, are responsible for a great deal of trading in the everyday markets and thus are a major influence in it.

The idea of starting a hedge fund seems so out of reach, but it’s not really so. Hedge funds can manage from as small as a few million dollars all the way to billions, so there’s opportunity for every size. One could even begin with a few thousands.

The modern hedge funds of this era are usually investment partnerships with pooled funds that make extensive use of complex trading and risk management techniques when making investments. This high risk trading is possible because hedge funds are subject to less regulation than other types of funds, e.g. mutual funds, and thus they can take more risky bets.

For the fact that modern hedge funds can take risky bets, they target their fundraising at high net worth individuals and institutional investors with higher appetite for risk.

Who can start a hedge fund?

Answer is anyone, well almost anyone, but not plainly so. While the only universal requirement to start a hedge fund is an ordinary business license, one needs expertise in finance and then connections to raise capital so this narrows down the list from just anyone. Usually, people who start hedge funds first work at one for a few or so years and learn the act of the trade before branching out on their own.

There are many examples of successful hedge funds started by people who decamped from bigger and successful hedge funds, sometimes with commendation and investment capital from their former employer, such as;

  • D1 Capital, $30 billion+ AUM, started by Dan Sundheim, the former chief investment officer of Viking Global ($60 billion AUM)
  • Tiger Global, a foremost investor in technology companies, started by former employees of Tiger Management. In fact, Tiger Management has given birth to a series of other successful hedge funds started by ex employees, such as Lone Pine Capital, Viking Global, and Blue Ridge Capital.

What’s needed to start a hedge fund?

Many things are needed to kick off a hedge fund, but some of these things are more important than others. The most important things when considering starting one include;

  • Budget
  • Legal and regulatory framework
  • Capital – Fundraising and investment strategies
  • Front/Middle-/Back office infrastructure

Budget

Starting a hedge fund requires a suitable budget to kick off operations, and this budget varies depending on the level of operations. To give professional advice;

“With respect to establishing a U.S. hedge fund, average hedge fund startup costs range from $50,000 to $100,000, and first year operational costs usually total $75,000 to $150,000.” – Grant Thornton. This gives a good estimate of the total costs (legal and infrastructure) of setting up a new hedge fund. It could be cheaper, or costlier, in countries outside the US.

Legal Framework

Starting a hedge fund requires adherence to regulatory laws, which most times vary from country to country and state to state, so it’s of utmost importance to ensure an attorney is consulted in order to comply with the laws and not get sanctioned. Particularly, the US Securities and Exchanges Commission (SEC) regulates hedge funds in the US and running afoul of their laws could bring grave consequences.

While consulting an attorney is usual and advised, there are also fund incubation platforms and template services from existing law firms that make the starting process easier. Here, instead of building your own legal framework from the ground up, you can leverage those set up by others to build upon.

Capital

Of course, no hedge fund can operate without capital to invest, so it’s of utmost importance to raise capital for a fund. This is where connections come in, connections usually built while working in the hedge fund industry. The connections is what eases the process for traders to decamp from their hedge fund and launch their own as they’ve built rapport with the people with capital.

Sources of capital for new funds include;

  • Personal funds
  • Family Offices
  • Institutional investors, e.g. endowments, pension funds, asset managers etc.

To secure capital, you’ll likely have to pitch your investment strategies to the people funding you so it’s necessary to develop a framework for that, the type that’ll lure capital to your coffers.

Front/Middle/Back Office Infrastructure

After building a legal framework and securing capital, you’re nearly ready to go. But importantly, you’ll need to set up infrastructure for the front, middle, and back office operations of your fund. These office classifications are described as thus;

  • Front Office – These are the main guys, the guys that earn money for the funds. They include the traders and portfolio managers of invested capital, analysts who search for market signals from heaps of information out there, and sales people who go out to pitch and raise capital.
  • Back Office – These are people vital to the hedge fund’s existence by supporting the operations of those in the front office. They include accountants, HR, and compliance etc. They are cost centers rather than revenue generating centers.
  • Middle Office – In between the front and back office lies middle office roles. They are the links between the front and back offices, drawing resources on both sides. Usually, middle office roles are for risk managers and IT staff.

Now, linking the front, middle, and back offices to easily work together to run your fund requires solid technical infrastructure. For that, hedge funds usually hire technical people and computer programmers to set up their infrastructure from the ground up, or use ready made solutions out there.

For new hedge funds and especially those with smaller capital, it’s advised (by the Alternative Investment Management Organization) to use ready-made solutions rather than build new ones from scratch because of the high technical costs. It’s advised to first use ready-made solutions, then move on to custom-made infrastructure if you exceed certain limits.

One of the ready-made infrastructure for hedge funds that’s out there is MetaTrader 5. It’s an all-in-one software platform to run a fund on the go, with features including administrative control, access to many global exchanges and markets, scalability, algorithmic trading, and access to a community of like-minded investors.

Administrative Control – It incorporates a very useful  Administrator Terminal, whereby fund administrators can easily oversee the operations of their fund on the go. To differentiate, an administrator in a hedge fund is a person whose primary role is to provide audits and record-keeping services for the fund. It’s different from a fund manager whose primary role is to allocate capital invested in the markets.

You can easily add new investors (limited partners) to the administrator terminal, where they’ll be able to see their required data online at all times as provided by the fund administrator. The data includes assets under management (AUM), Net Asset Value (NAV), and percentage increases or decreases, the type of stuff every investor in your fund would like to to know on a regular basis.

It means your investors don’t have to regularly hassle you for data on the performance of their investments when they could access it on the Administrator Terminal so far they have an internet connection and a device.

Fund administration is very key to keeping your fund afloat with capital and keeping investors happy, so this feature is paramount.

Scalability – It’s very capable of handling growth from smaller levels to higher levels, so it’s ideal to use while starting small with the expectations and hopes to grow bigger.

Global Trading – It’s important to many traders that they’re able to place trades across markets around the globe, e.g. an American trader buying and selling Chinese equities, or a UK-based trader buying American equities. This global link is a major driver of the stock markets worldwide and thus a paramount requirement for traders, available on the software.

Algorithmic Trading – Algorithmic and quantitative trading is something many hedge funds prefer to adopt, and MetaTrader 5 delivers well in that end. The platform offers access to certain tools that power quant trading, including the MQL5 high-level programming language for creating trading algorithms, paired with an online community of algo traders with access to distributed computing resources to test and analyze their trading strategies on historical or real-time data.

Community – On MetaTrader 5, there’s the MQL5 online community of like-minded algo traders around the globe whose strategies and ways you can learn from. This comes in handy mostly when trading in foreign markets.

Concluding, starting a hedge fund is no easy feat, but there are solutions set in place to make the process less difficult. This article is a brief walkthrough on the process of setting up a hedge fund that we hope you can really learn from.