If you’re thinking about starting a hedge fund, you will need to understand what it is and how it operates so you can be sure it will succeed. Simply put, hedge funds are alternative investment funds in which investors pool money and purchase certain investments. They aim to bring investors greater returns than they would normally get in the stock market or other types of funds.

However, unlike other investments, hedge funds are restricted to accredited investors, and they’re also considered risky investment choices. But if you want to know how to start a hedge fund, you will first need to understand the step-by-step process for legally starting one so you can make the best decisions for your business.

Read on to learn more about hedge funds and how to start one.

Types of hedge funds

Hedge funds are private investment funds, whose managers use high-risk tactics such as short selling and leveraging the market to make money. They’re lightly regulated by the federal government, in terms of what they are required to disclose to the Securities and Exchange Commission (SEC). Hedge funds usually charge higher fees than conventional investment funds.

Since hedge funds are private investment vehicles, they can do whatever they like so long as they are upfront about their strategy to their investors. Hedge fund strategies usually focus on macro, equity, relative value, and event-driven. Equity is the most common hedge fund strategy, and it balances long and short positions in the public markets to drive higher returns and reduce risks.

Key characteristics of hedge funds

Hedge funds exclude small investors

Hedge funds often accept money only from accredited investors with an annual income that exceeds $200,000 for the past two years or a net worth that exceeds $1 million. Keep in mind that some set their minimums higher. SEC imposes the rules because it doesn’t strictly regulate hedge funds, and it considers accredited investors to be suitable to handle the potential risks of investing in a hedge fund.

Hedge funds use the leverage

They use borrowed money to increase their returns and allow them to take short positions. However, leverage can wipe out hedge funds along with other big parts of the economy.

Hedge fund managers have a wide latitude

A hedge fund can invest in anything including real estate, land, stocks, currencies, and derivatives. On the contrary, mutual funds stick to stocks or bonds and invest for the long term.

How to start a hedge fund

Here are the basics of starting a hedge fund.

Choose your hedge fund type

You will need to identify the type of business you want to launch before anything else. Choose whether you want it to be an equity, macro, event-driven, or relative-value hedge fund.

Name your hedge fund

Choose an appropriate name for your hedge fund so people can consider it a respected and well-known brand, and you can attract investors. The name you choose should describe your strategy and investment style. Usually, the most popular option is LLP (limited liability partnership), although you can also set yourself up as a trust or LLC. LLC formation rules vary from state to state. Read more about how to get an LLC in California in this Marketwatch article.

Write a hedge fund business plan

A business plan for your hedge fund should outline your goals, strategies, and operations of your business. You can use it to secure funding from lenders or investors and guide the daily operations of your hedge fund business. It should include information about the company including products or services, financial projections, market analysis, and management team.

Initial costs

Hedge funds are expensive ventures because they have burdensome start-up costs. Note that a standard equity hedge fund can run approximately $1 million in the first year. However, most hedge fund managers will spend the majority of their money in the first year on costs related to salaries and fees for third-party services such as consultants and lawyers.

Apply for permits and licenses

Don’t forget to apply for the necessary licenses and permits you’ll need to obtain before you launch your hedge fund. Whether you plan to operate as an investment adviser and register with SEC, or you’ll solicit funds from the public, in which case you’ll need to comply with state and federal securities laws. Make sure you register your business as a legal entity with the state where you plan to do business.

Final thoughts

Starting a hedge fund is not easy and it can pose a high risk to your investment. However, understating what it is and how it works can help you start a hedge fund that you can operate without worry. Just make sure you follow the key elements and market your hedge fund to potential clients by creating a website where you can explain your investment strategies and experience.