There are many ways to start up a hedge fund. In this thread I will share my experience with the process in the hopes that it may help someone in a similar situation. As a bit of background, I have been trading about 18 years. I presently trade equities and their options, but I have also traded futures and currencies in the past. About 4 years ago I first developed a trading methodology that was extremely robust and consistently profitable. Its average position time was 45 days, had a max drawdown of 14%, and generated a 32% annual return. I was pretty impressed with myself so I tried to raise $5-10 million to start a hedge fund (attempt #1). Why not? Well, I soon learned why not...I was told I did not have a long enough track record, what was there occurred during a bull market when everyone makes money, so it didn't count, and even if it did, there wasn't enough money being traded. (Sound familiar?) I ended up raising nothing...zero...zilch. I explored every option of raising capital in which to trade and stumbled upon Proprietary trading firms. I did my research and decided to join a firm. The catch was that due to my limited capital (from which I liquidated my successful trading account to raise) I was restricted to trading only equities (no options) which meant I could not use my trading methodology. I was also expected to day trade. No problem I thought. If I could profitably trade the markets in one way, how hard could it be to trade it another? Even worse, I started out really well and doubled my money in the first couple of months! That just confirmed my really high opinion of my trading prowess! Fortunately, after losing all of my money twice, I was humble again and able to think clearly. (I also learned I am NOT a daytrader!) Armed with a new knowledge of risk management gained from my prop trading and a healthy respect of the crushing power of the markets, I went back to developing my original trading system and "robustifying" it against black swan and angry pelican events. I was flat broke at this point and actively seeking a job in the real world so I posted the system on a site that tracks the performance and permits people to subscribe to it for trading signals. All funds on this site are virtual so performance can be established, but no capital is required. I posted all of my trades for over a year and the excellent performance continued despite a very turbulent market. I thought it was perfect until I went looking to raise capital again (attempt #2). Investors do not like virtual performance results and such results have zero credibility. Also, about this time, all the equity dried up and no one had anything to invest (sound familiar?) anyways. In frustration I gave up trading the system through the virtual site, and began trading it again with a very small amount of my own capital. I figured it was better to trade it with real capital than no capital. As always, I continued to fine tune it. I had given up on my dream that I could ever start a hedge fund. A few months later, I was talking to my friend and he was catching me up about a man we both knew. This man is very wealthy, having sold his company for a LOT of money, and my friend told me that this man was looking for places to invest his money. I had known this man for years, but never approached him. The more I thought about it, the more I was tempted to do so. However, my gut told me to wait and so I did (I have learned to listen to my gut and it doesn't steer me wrong-unless I am driving and then I need to do the opposite of whatever it suggests). Eventually, my gut told me the timing was right and I requested a meeting with this man and we met. For the first hour I did not say much, I just listened as he talked about things going on in his life. When the opportunity was presented, I showed him the spreadsheets and told him how I trade and some of the key aspects of my system. Apparently, he liked what he saw and agreed to invest US$100K. He told me that it didn't matter if he lost such a small amount and he was willing to risk it. I still laugh about that. Einstein was right when he said everything is relative! There are several key points to understand about this meeting and this man's decision: 1. In my first two attempts, I was trying to start the hedge fund with US$5-10 million. That is a big commitment for investors to make for a guy with no formal experience or pedigree. I may have a degree in Finance, but that doesn't count for much. 2. By attempt #3 I had modified my game plan to beginning with an incubator hedge fund and seeking to establish an audited track record first. My minimum to start this was only US$100k which is much more attainable for poor, unestablished people like me. 3. The man decided to invest ultimately, not because of what he saw from my spreadsheets, but because he had known me for several years and my character was well spoken of by third parties. As Christians, we also share the same faith, and I think that had something to do with it as well. For that I give thanks to the Lord. 4. He liked the fact that I have a full time job which means that I have a source of income. This allows me to be careful with the money and not take crazy chances because I need to expedite the process. So after three years and three attempts (third time is the the charm apparently), I was able to raise almost $125k. I shopped around for an attorney who specialized in hedge funds that I liked and paid about US$4k to get an incubator hedge fund established. An incubator fund does not permit me to charge any kind of fees nor agressivelly pursue investment capital. In fact, I am limited to raising capital from friends and family. However, it does permit me to establish a track record that I can pay to have audited. This is what I think of as stage 1. After several years of hopefully successful trading, it is quite possible that the investors I currently have may wish to add to their capital and possibly even refer me to their friends (wealthy people tend to know other wealthy people). If I can get assurances for a minimum of US$5 million, I will be at a breakeven point for conversion into a fully operational hedge fund. This is what I think of as stage 2. I will not consider conversion until the funds are lined up due to the costs once this transition is made. Once initiated, and assuming continued successful performance, I anticipate spending another 5-10 years in stage 2 building up assets to US$100 million. (Its like they say, a million here and a million there and it begins to amount to something). I currently work a full time job, and my trading style allows me to work around my work schedule. As much as I would like to quit my job so I can trade and manage the fund full time, I will not do so until it is in stage 2 and I have fees equivalent to 2-4x my annual salary already in reserve. My philosophy is that this fund has to earn my attention, time and energy. I also think it is important to have my own money invested in the fund. I am currently in the process of liquidating my 401K so that I can transfer it into the fund. If I don't belive in what I am doing, why should I expect my investors to? I go into this with a patient, long term perspective. I place risk management BEFORE profits. I use a system that I have used for years and know very well. I accept the fact that I don't know everything, and that I need to be careful, prudent and continue to learn as much as I can. I have one shot to establish a reputation and I don't want to squander it. This has been my experience in a nutshell and I know I have left many things out. As you can see I have had my ups and downs, as will you. Ultimately, I am glad it was so difficult to get started, because I probably wouldn't have been ready had it happened earlier. But once trading gets in your blood, and you start to feel like the casino rather than the player, it is really hard to leave behind. I'll continue to post to this thread as I progress. I wish you all the best of luck!
Best of luck to you in the new venture. My take-away from your story is that you may have a strategy with alpha, but it needs time to mature. I'd suggest you carefully monitor for style-drift, don't take short-cuts, and instead focus laser like to *this* strategy: what makes it work, what are the inherent risks and how can they be hedged, etc. If the model doesn't pan out over time, be honest and give the money back until you have something else specific in mind. Your investor would respect the hell out of that.
Are you selling covered stock calls? You are right, the key to survival is risk management. Unfortunately, some people I knew took just one chance raising their risk and immediately blew up. They are waiting for you around the corner. One thing I did not understand is why you mentioned not being able to daytrade with a prop firm when your system was position trading anyway? Good luck.
I sell puts to establish positions and sell calls when I am assigned. As far as the prop firm is concerned, it was geared towards day trading and I am a position trader. They did not like long term exposure that wasn't in a long/short balanced portfolio. They also frowned upon options and required a much higher minimum balance with special authorization to trade options. Due to my small balance, I could not qualify and therefore could not use the trading methodology I had developed. What I meant about the day trading was simply that I do not have the psychological profile to be an effective daytrader. Thanks.
I think you are on the right track. Do well by one investor with a smaller amount and you will be in a position to grow. Too many without the experience want to start too large and consequently are never able to get started.
Vanity Fair has an interesting article abt how to start a hedge fund: http://www.vanityfair.com/business/features/2010/09/hedge-funders-201009
Thank you all for your kind comments and encouragement. I debated about creating this thread because I have seen others with the same intention get attacked, but hopefully, it will be prove to be beneficial to all involved. Two additional items I forgot to mention in my initial post pertain to reporting and institutional funds. I have investigated numerous methods of reporting my fund's results to my investors and settled upon sending out a quarterly email with a report attached that contains key analytics and performance statistics. I found a service called HedgeCo which seems to have exactly what I need and it is a whole lot less expensive (about $100/month) and complex than another service called Pertrac (about $5,500/year). In my case, I only needed a reporting capability (Pertrac does a whole lot more), so it was a no brainer. The report can also be modified the information I want. I am still going through the process of getting it setup now so Ill let you know how it goes. At one point I was looking for a prime broker. I thought I had to have one as a hedge fund. I quickly learned that no prime brokers are interested in incubator hedge funds and I ended up going with OptionsXpress (they gave me a great deal on commissions, though it was a real pain to get the account setup). Not wanting to lose the opportunity, I have been asking the Prime Brokers if they would like me to add them to my quarterly distribution list so that they can monitor the performance of my fund over time. All have been very friendly and helpful and have agreed. So now I have a number of big firms watching my fund. It doesn't cost me anything and who knows where it might go down the road...(hopefully not the toilet)! The other topic I forgot to mention is the importance of Institutional funds to the growth of my hedge fund. You see, apparently, there is some kind of regulation that requires any institutional fund to go through all kinds of crazy hoops if it ends up investing more than 50% of the AUM of a fund. Perhaps someone out there can provide more information about this. In either case, many institutional funds avoid exceeding the 50% threshold. So if my fund is at $10M AUM, a single institutional investor would invest no more than $5M. In other words, I do not believe it likely that some institutional investor would come along and invest $100M into a fund with only $10M. (please correct me if this assumption is wrong-I hope so!) The flip side of this coin is that institutional investors tend to follow each other's capital for the most part (this may also be wrong, but I have no institutional investor experience as yet to build a baseline, please comment if able). It is safer for them to do so and helps them to justify their investment choices to their investors (the everyone else is doing it mentality). So I view institutional investment capital as the key to growth for my fund, although I expect it to grow exponentially due to the 50% restriction. This might explain why big funds tend to attract so much money. Unfortunately, I have heard that institutional investors tend to require certains minimum levels of infrastructure to monitor and support their investment and this can make the cost of doing business go up substantially (I am cheap by nature). The timing of the transition must be carefully chosen to ensure sufficent capital reserves and matching of cashflows. That's my story and I'm sticking to it. Thanks.