How to Start a Home-Based Hedge Fund (Without Even Knowing It)

We all admire hedge fund managers. I mean, who hates living in a big mansion, driving fancy cars, touring in yachts, and giving millions of dollars to charity? No one.

Most of us fear hedge fund managers. This is because of the jargon they use. For example, on financial TV, you will regularly hear them talk about arbitrage, liquidity, yields, EBITDA, and rebalancing among others.

The truth is, in the real world, these words don’t mean a lot. For example, arbitrage is a simple term that means buying and selling similar financial assets at the same time. EBITDA is jargon for a company’s earnings before everything (interest, tax, depreciation, and amortization) is subtracted from it.

In simple terms, hedge funds are companies that receive money from investors like high net-worth individuals, pension firms, and sovereign wealth funds to manage it. After receiving the money, they charge their clients an administration fee which is usually 2%. Every year, they charge another fee called incentive fee which is usually 20% of their annual profits.

This arrangement is usually very lucrative for hedge fund managers. A ‘small’ hedge fund that manages $1 billion is usually guaranteed to make $20 million from the administrative fee alone. If it generates returns of just 10%, then its total annual gross revenues will be $30 million.

Considering that many hedge funds pay little taxes, employ very few staff, and rent very small office spaces, their model is very attractive. For example, David Einhorn’s Greenlight Capital which manages more than $10 billion employs less than 50 people.

You too can start your own hedge fund even if you don’t know anything about hedge funds, finance, or investing by following these steps.

Have interest in finance

If you want to start a hedge fund, you must have a lot of interest in finance. This applies to all industries that you might think of getting into. How can you be a successful teacher if you have no interest in teaching or spending time with kids? Not possible.

Therefore, if you enjoy watching Bloomberg TV, Fox Business, or CNBC and reading Wall Street Journal, Bloomberg Businessweek, and company filings, then starting a hedge fund is something you can succeed in. If doing any of these does not interest you, then I recommend you find another career.

Read about Investing

It is impossible to succeed as a hedge fund manager if you are not committed to reading. All hedge fund managers that I know became successful mostly by reading.

Fortunately, there are many books on finance and investing that you can find on Amazon. Some of the books I recommend are:

• Fooling Some of the People all of the Time by David Einhorn. While this book focuses on his battle with a company called Allied, the first part explains how he started his hedge fund.
• Intelligent Investor by Benjamin Graham.
• The Big Short by Michael Lewis.
• Black Edge by Sheelah Kohlhatka
• The Spider Network by David Enrich
• Octopus by Guy Lawson
• One up on Wall Street by Peter Lynch
• Money Maverick by Lars Kroijer

These books will teach you everything from how to start a hedge fund, how people fail in the industry, and how to do your analysis.

Create a Strategy

All hedge funds have a strategy. It is this strategy that hedge fund managers sell to potential investors when they are fundraising.

Some of the most common hedge fund strategies are:

• Activist investing. This is where they acquire substantial stakes in companies and pressure management to make changes. A good example of an activist investor is Nelson Peltz of Trian Partners. This is not recommended if you don’t have a lot of money.
• Value Investing hedge funds. These are funds that identify good companies that are undervalued and invest in them with the hope that the share price will appreciate. A good example is Warren Buffet.
• Long/Short hedge funds. These funds buy undervalued stocks and while shorting (betting that the stock price will go down) other stock. A good example of a long/short investor is David Einhorn of Greenlight Capital.
• Event-driven hedge funds. These are funds that wait for unique events to happen before they invest. For example, risk arbitrage hedge funds make money during mergers and acquisitions. A good example is Ken Griffin’s Citadel Investments.
• Quantitative Hedge Funds. These are hedge funds that use algorithms and artificial intelligence to allocate capital. A good example is Jim Simmons of Renaissance Technologies.
• Macro hedge funds. These funds invest in different products like currencies, commodities, interest rates, and bonds. They base their investment thesis on the prevailing economic activities. A good example is Ray Dalio’s Bridgewater Associates.

When you are starting out, some of these strategies – like quantitative and activist investing – might not work out. For example, to be an effective activist investor, you need to have a lot of capital while to start a quantitative fund, you need to have knowledge of coding. So, I recommend you start a long/short fund.

Invest your Money First

To be a successful hedge fund manager, you should first invest your money. This is a step all successful hedge fund managers followed to become successful.

This is because no one, including your spouse or any family member, will invest with you before seeing your track record.

The good thing is, you don’t need to start with a lot of money. If you start with just $1,000 and generate good and consistent returns with it for a long period – like one year – the chances are that someone will listen and possibly invest in you.

Quick tips:

• Always, write down the reason why you entered or exited a position.
• Use a low-cost broker. I recommend using Robinhood which charges no fees.
• Always stick to your strategy. Doing this will make it easy for you to pitch your investment style to investors.
• Don’t quit your job yet.
• Always be patient. At times, it takes time before your investment thesis turns out to be right.
• Don’t pay for financial services yet (unless you can afford the $2000 monthly fee for Bloomberg Terminal).
• Use free apps like Bloomberg, Reuters, and Webull to follow the news.

Pitch Your Fund to Family and Friends

If you have invested in your fund for about a year successfully, now is the time to pitch your fund to your family and friends.

In the pitch, you should describe carefully your investment style and share with the investors the notes I mentioned above. They will use these notes to assess your investment style and whether it matches their financial goals.

Don’t expect a lot of money at this stage but be content with the little that you get. Then, invest it carefully also for another period, say a year.

On a regular basis – I recommend quarterly – I recommend that you send letters or emails to your investors explaining your investments and your returns.

Pitch your Fund to Investors

If you have been successful by now, then you will possibly be a successful hedge fund manager.

This is where the hard work starts.

Assuming you have given your fund a name and registered it using the SEC guidelines, you should now start talking to large investors.

A good way to start is to visit one of the big investment banks like Goldman Sachs and Morgan Stanley. These firms have access to virtually all potential investors in the world. In your meeting with them, you should share your investment style and your track record.

If they like your style and performance, the chances are that they will connect you with some of their clients.

Remember, at this time, most investors will turn you down and ask you to see them after you invest for some more time. However, if your returns have been good, you will definitely get some people investing with you.

Quick notes for this stage:

• If you are successful in your raise, you can now quit your job.
• Get a small office where your investors can visit you. (this is not mandatory though)
• Always be transparent to your investors. If you lose money, just tell them that you lost it. You don’t want to be another Madoff.
• Always, send them quarterly and annual letters sharing your investments. You can find a good letter here.
• Always be disciplined in your investments.
• Be humble. You don’t want to be the talk of the investment world if you fail.
• Don’t be in a hurry to raise a lot of money.
• Engage a lawyer during the investment deliberations. Your investors need to know that they can lose their money.
• Don’t rush to hire many people.

Final Thoughts

As seen, starting a hedge fund is not very difficult. The hard part is coming up with a good strategy that works for the long-term. If you create a strategy and test it over a long period, the chances are that you will be a very successful hedge fund manager.

Also, you should always be humble and honest with your investors. In the past, we have seen hedge fund managers make headlines for their investment fails. Often, the people who make these headlines are people who are always on the news and events for one reason or another. For example, Bill Ackman, one of the most outspoken hedge fund managers has been in the news after his big fails in Herbalife and Valeant Pharmaceuticals. If he was just a normal manager, no one would be talking about him.