How do hedge funds work?
Hedge funds employ various investment strategies in an effort to generate an active return, known as alpha, through the use of investors’ pooled funds, and sometimes borrowings. To do this effectively, seasoned and sophisticated investors are hired as hedge fund managers that will aim to bolster returns through the use of leverage and derivatives.
A key part of a hedge fund’s strategy is ‘hedging’, which is typically used to offset the risk of losing money by taking an opposite position in a related asset. As hedge funds’ tactics are often high-risk — as their goal is to generate high returns for investors — it's imperative that they reduce risk wherever possible.
Unlike mutual funds, investing in a hedge fund is restricted to wealthy individuals and/or institutions that are required to keep their investment for a minimum length of time. In essence, hedge funds are investment partnerships that can invest in virtually anything, provided their investors are made aware of the strategy beforehand.
Up until the 2008 financial crisis, hedge funds were less regulated than mutual funds but they have since been met with greater scrutiny in an attempt to make their processes more transparent. As a result, they are now highly regulated and are more complex to establish in the UK compared to other countries.
In fact, due to the complexity, many new firms seek the expertise of outside companies to assist with setting up the fund in an effort to ensure that it complies with local laws and regulations.
How to start a hedge fund
The first step of establishing a hedge fund is understanding the rules and regulations of the local regulator – for example, in the UK, the Financial Conduct Authority (FCA) – the country’s governing body that regulates hedge funds. In addition, under the Financial Services and Markets Act 2000, hedge fund managers are legally required to gain approval from the FCA in order to establish a new fund. The approval process can take up to six months, and a new fund may be monitored for up to a year afterwards.
While there are various factors that are taken into consideration when it comes to approving a new hedge fund, part of the process requires the investment manager to prove they have the financial resources as well as the appropriate staff, systems and controls needed to manage the fund.
The hedge fund’s potential staff also have to demonstrate their competency by passing an exam that is either fully or partly based on management experience outside of the UK.
There are also other factors that the founders of new hedge funds need to consider, such as the structure that the fund will operate under and providers that will manage it.
Regulations will differ by territory and market, so it’s vital to refer to local regulators for clarity in all cases.
How to structure a hedge fund
The structure of a hedge fund is determined based on the types of investors it wishes to work with and their needs, such as tax status, voting rights and ability to use leverage. Typically, there are three main structures that dominate the hedge fund sector, including stand-alone, master/feeder & umbrella funds and segregated portfolio companies.
A stand-alone structure is when a hedge fund plans to operate as a single fund, the shares of which can be sold to investors. On the other end of the spectrum, you have segregated structures, which are treated as separate legal entities whereby each investor has a separate fund account with its own assets and liabilities.
Then, as a kind of middle ground between the extremes of the stand-alone and segregated structures, you have master/feeder, or umbrella, structures. These are used when the requirements of each investor, such as tax status or leverage restrictions, differ from one to the next. This structure works by creating separate feeder accounts – that differ depending on the needs of each investor – which feed into the master fund, which trades on behalf of the separate funds.
Managing a hedge fund
While many hedge funds will seek to employ the services of a management company, a self-managed fund can save a lot of time and money. In such a scenario the management team act as the appointed officers of the fund, but it’s worth noting that the fund must have at least two independent directors based offshore in UK law.
That being said, if an investment manager meets certain criteria they can be based in the UK under the Investment Manager Exemption (IME). In order to be eligible for the IME, the manager must act independently when providing investment management services, for which they must receive a fee. All transactions would also need to be conducted in the ordinary course of business. It’s worth noting that the investment manager can’t own more than 20% of the hedge fund’s total assets.
As well as an investment manager, founders will also need to appoint an administrator, an independent auditor, a custodian and/or prime broker, legal counsel and a tax advisor. These will be the fund’s providers – the personnel that control and run the hedge fund.
In summary, there’s more than one way to go about creating a new hedge fund. Founders may choose to outsource the knowledge and experience of a third party to establish a new fund and/or manage it. Whichever way one goes about starting a new fund, it’s imperative that they are familiar with the local regulator’s protocols and the appropriate laws around managing an investment vehicle.
