Some experienced traders have started hedge funds as a way to increase the amount of assets they trade and to earn additional income with their trading prowess. But are hedge funds a viable option even for successful private traders with established track records?
At its most basic level, a hedge fund is the pooling of investments from multiple individuals and/or entities, such as an IRA, into a single brokerage account. The hedge fund manager attempts to achieve investment results that match the objective of the hedge fund, rather than the objective of any of the individual investors.
Even with the downturn in the economy the last few years, there are many more individuals who think they are ready to make the leap from private trader to money manager. Because of this interest and the “buzz” surrounding hedge funds, the media increased its coverage of the industry and made even more people aware of the opportunities in this arena.
The hedge fund allure Successful hedge fund managers can earn substantial income — beyond the scope of trading profits. Let’s say you have $2 million under management, and your hedge fund has a 1-percent management fee and a 20-percent performance allocation.
Let’s also assume the fund was started the first day of the year and gained 30 percent ($600,000) as of year-end. Under these conditions, the hedge fund manager would have gross income of $140,000. The management fee would be $20,000 ($2 million * 1 percent) and the performance allocation $120,000 ($600,000 * 20 percent). A hedge fund with $5 million under management and all of the same assumptions would generate $350,000 for the hedge fund manager.
Additionally, you probably have a significant portion of your own money invested in your hedge fund — your
prospective investors will like to see that you are putting your own money at risk. So you benefit from the 30 percent you gained for the fund as well.
Compliance and regulations
Aside from the requisite skill and experience, there are several barriers to entering the hedge fund world. The Securities and Exchange Commission (SEC) considers a hedge fund a security. The rules for this kind of security are defined in Regulation D of the Securities Act of 1933. Generally, securities must be registered with the SEC and/or states where they are sold (an expensive and time-consuming process). But the rules allow for several exemptions from registration.
As defined in the various regulations discussed in this article, your hedge fund can have up to 100 investors,
but no more than 35 of those investors can be “nonaccredited.” Regulation D provides numerous examples
of accredited investors, but the two most common for hedge fund investors are :
- Aperson whose individual net worth — defined as the excess of the fair market value of total assets (including home, home furnishings and automobiles) over total liabilities (including mortgages) — or joint net worth with his or her spouse, at the time of purchase, exceeds $1 million.
- A person who had an individual income exceeding $200,000 in each of the two most recent years, or joint income with his or her spouse in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same income level in the current year.
Investment advisers are the gold standard
Since the hedge fund manager is making investment decisions and is being compensated for those decisions, he or she is subject to the rules of the Investment Advisers Act of 1940 and the Investment Company Act of 1940. In some cases, the hedge fund manager must register as an RIA (Registered Investment Adviser). Additionally, state laws may also impact you.
The Investment Advisers Act provides exemptions from registration. The one that would most likely apply to you is the 15-client limit. The 15-client limit exempts any adviser who has had fewer than 15 clients over the past 12 months, does not promote himself to the public as an investment adviser and is not an investment adviser to a registered investment company or business development company.
A business entity that receives investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, etc., may be counted as a single client. Each state (except Wyoming) has created rules relating to Investment Adviser activities. Some of those state rules will take precedence over federal rules. For example, in many states (including populous states such as Texas and California), if you have a business presence in the state and have a single client who is compensating you for investment adviser activities, you must register as an Investment Adviser. In any event, determining whether you need to become an RIA should be one of the first steps you take in the process of forming your hedge fund.
Usually, becoming an RIA means you can only charge your performance allocation to your “qualified investors” — those investors with a higher level of wealth than accredited investors. Although there are several examples of qualified investors, the one that most often applies is an individual (or an individual combined with a spouse) with net worth of more than $1.5 million.
The RIA rules exist to protect the prospective investors. However, some people look at the regulations as a negative to being an RIA. There is no question that being an RIAincreases your regulatory structure. However, the RIA title tells your prospective investors that you are serious about protecting their assets and that you are taking the extra step to register. You can use the restriction on the kind of fees you can charge to non-accredited investors to make a decision to not accept them into the fund. If you do not accept these investors into your fund, you can spend more of your time trading the fund, doing research and searching for new prospective investors (small investors often require the most hand-holding).
Plus, being an RIAputs you ahead of the game if the law changes and all hedge fund managers are required to become RIAs (there are no current proposals to that effect, but it’s not something that can be entirely discounted).
Pool or fund?
If you trade commodities or futures in your hedge fund, you will probably need to set up a commodities pool that is regist e red with the National Futures Association (NFA). The Commodity Futures Trading Commission has delegated most of its day-to-day regulatory duties to the NFA. There are a number of additional regulations associated with commodity pools, but they can be handled with no problem.
There are two exemptions that allow you to make futures and commodities trades without the required registration. If you have a very small commodities pool (total investments of $400,000 or less), you are exempt from NFA registration. The pool can grow to more than $400,000, but as long as the initial
investments don’t exceed that level, it doesn’t need to be registered. (There are caveats to this exemption, so be careful.)
The second exemption is not a total exemption — it still requires you to register with the NFA (and take the Series 3 commodities exam), but it significantly reduces your regulatory oversight from the NFA/CFTC. The exemption requires all of the investors in the pool to meet a standard of wealth called Qualified Eligible Person — basically, they need to have at least $1 million of net assets and own securities with an aggregate market value of at least $2 million. If your investors meet that standard, you can cut down on the regulatory burden.
Marketing and attracting capital
Once you start a hedge fund, it follows that you want to tell the world about it. If you do that, though, you eliminate your exemption from registration. Hedge funds should be sold to friends, business associates and people you meet in your everyday activities.
Under the rules, you cannot announce in a group setting that you are accepting investors for a hedge fund. You cannot place an ad in the phone book or print business cards that say “investment adviser” on them. Basically, you cannot do anything that publicly promotes the fact you are accepting new investors for a hedge fund.
All of these rules are purposely designed to make finding prospective investors difficult. The objective of the
regulators is to restrict investments in hedge funds to individuals who are knowledgeable and understand the risks. The best way to market your fund is via word of mouth. Understanding these restrictions needs to be an important part of your business plan.
There are additional restrictions on advertising. You cannot provide a onepage summary of your offering documents or a chart of your performance results. Your offering documents must stand “on their own” — i.e., without embellishment. No other material can support your securities offering — no slick folder, no charts, no cover letter. Again, this makes finding prospective investors difficult, but that is part of the barrier to entry.
Plus, you don’t want your less-savvy investors to think that the chart represents some rate of return that is guaranteed to be achieved in the future. You can create a Web site for your hedge fund, but prospective investors should only be allowed to see the home page. All other content should be password-protected. You can ask prospective investors to fill out a form and provide you with information that would help you determine whether they are valid prospective investors. If you gain an understanding of their financial situation
and then allow them password access to your Web site, you are complying with the rules.
You can also use the Web site to provide your investors with updated information about the fund performance. However, you need to be careful to ensure that you are not using the Website to advertise the existence of the fund.
Part of the value of setting up a hedge fund is that it serves to protect your personal assets. You want to make sure you follow these marketing and advertising rules to maximize your protection from malicious lawsuits. An increasing number of hedge funds are being more aggressive in marketing and advertising than they should. Be very careful.
The regulators are getting restless
Over the past few years, there have been a number of hedge funds that have failed. Some were spectacular failures , such as Long Term Capital Management.The failure of some of these hedge funds and the resulting losses for investors caused the SEC to start to rethink its regulatory structure in the hedge fund world. In early August, the SEC had already completed public hearings re g a rding the regulation of the hedge fund industry.
No preliminary indications of the SEC’s direction have been published as of press time. One wire service newsstory indicated the SEC is considering requiring hedge funds to meet certain to-be-defined standards of disclosure .Even after the hearings, some of the commissioners were still searching for additional information, such as the degree to which hedge funds have become part of the retail investment environment.
Tax implications
There are many decisions to make when it comes to hedge fund taxes, as there are various options, pitfalls and opportunities.
Ready to go?
There are numerous rules and regulations involved with starting and running a hedge fund, but the process isn’t rocket science. You can form a fund without making a huge investment, but you need to know the ongoing costs. Running a hedge fund is a business, and you must have a business plan to determine how and when the fund will start generating a reasonable income.Find a trusted adviser that is focused on client service, and you can have your fund set up in about two months.www.activetradermag.com
