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So you want to run a hedge fund
By James Altucher 8/25/2005
As we see in the news every day, the hedge fund business is booming. Assets have gone from $100 billion to $1 trillion in the past 10 years, and the number of hedge funds has gone from 600 to 8,000.
In an eerie reminder of the late 1990s when downtown Manhattan was dubbed "Silicon Alley" because of all the dot-com start-ups clustered on Broadway, the area between 48th and 57th streets on Park Avenue is now called "Hedge Fund Alley" because of the hedge funds that can be found in every office building in between the two streets.
Additionally, industries have sprung up catering to the hedge fund world: software companies for analyzing hedge-fund returns, databases such as hedgefund.net and cogenthedge.com for checking up on your favorite hedge funds, and even magazines such as Absolute Return or the Trader's Monthly -- so you can see profiles and photos of your favorite hedge-fund managers making $600 million a year. This media buzz is tempting many traders to jump into the business.
But the reality is, this is a business and it is not a pleasant one. Like any business, nine out of 10 start-up funds are going to fail.
In fact, I wouldn't be surprised if more than nine out of 10 hedge funds fail; of the start-ups I see, most don't even think of themselves as businesses. They believe the success of their fund is determined by their trading strategy or their stock-picking skills, and fail to consider that a business requires many other disciplines in order to succeed.
Hedge fund warnings signs
But even assuming that the trading strategy is a decent one -- a big assumption because until the hedge fund starts, nobody really knows how the managers will perform under pressure and how they will react to their trading strategy during the first significant drawdown -- it's still not enough. I have seen each of the largely operational mistakes I outline below bring down entire hedge funds, even billion-dollar ones.
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Mistake No. 1: Offering monthly liquidity.
Many investors will want to bail the first time you have a drawdown, precisely at the point when they shouldn't. These redemptions could force liquidations that will cause further losses, and then further redemptions.
Recently, I saw a good $150 million hedge fund go out of business within three months when one of its seed investors had to redeem $50 million. Admittedly, when you are first raising money, you have to cater to the fact that initial investors are taking "seeding risk" by starting you up. They will want special conditions. But try not to cave on this one; you need "sticky" money, and the only way to guarantee that is contractual.
Mistake No. 2: Not charging a management fee.
You might have heard that Warren Buffett didn't charge a management fee, which is true. When Buffett started his partnership in 1957, he charged a 0% management fee and a 25% performance fee. But he also worked in his pajamas out of his living room for a few years.
And he's Buffett. Case dismissed.
Mistake No. 3: Having investor concentration.
Again, this is hard to avoid in the beginning. But the downfall of many hedge funds, or any business for that matter, is having that one investor who can pull out and cause your entire business to capsize.
Mistake No. 4: Not having expenses set aside.
Everybody starts off thinking his trading strategy is the best and that he will have great returns and no problem raising money. Listen. There are 8,000 funds out there, and one in eight (or 1,000 funds) have decent enough returns to keep growing their businesses. That's a lot of competition for the dollars.
Additionally, there are many other features that institutions look for when putting money to work: Does it fit their diversification plan? Do you have low volatility? Do they like you? Do you have an office? (Yes, this is an important box most institutions will need to check off.)
I know of one fund that had 36 up-months and couldn't get past the $10 million mark. Finally, after three years the manager made his way up to $40 million and can now pay his living expenses (and the living expenses of his four employees).
Mistake No. 5: Going for home runs.
There's a saying, "If you can return 1% a month, you'll raise $1 billion dollars." This statement is true. The largest allocators of money are institutions that have modest goals of 8%-10% a year with low volatility. Anybody returning 12% a year is a dream come true for these allocators. Targeting 50% a year can cause you to quickly go out of business if you miss, and even setting your goal at 50% could make you too volatile for an allocator.
Mistake No. 6: Starting a hedge fund in the first place.
To reiterate, this is a tough business with a lot of competition. One of the mistakes I've made in trying to survive in this business is starting off with no pedigree. I never worked at Goldman Sachs (GS, news, msgs), Morgan Stanley (MWD, news, msgs) or any of the big hedge funds.
Last week, Deutsche Bank Asset Management distributed a survey that discusses how pedigree is the most important characteristic (behind performance) for an allocator. It's the difference between launching with $300 million as opposed to $3 million. My background is that I had a software business in the 1990s, sold it, started another software business (which still exists), and then began trading, investing and writing about investing.
I didn't come up through the traditional ranks -- and every step of the way has been excruciatingly difficult.
In retrospect, I wish I had focused my efforts on somehow ending up at a bank or at a large hedge fund, even taking entry-level jobs just to learn the ins and outs and rise up through the ranks before going out on my own. For one thing, you avoid all the start-up costs and headaches. Second, you can focus on the investing rather than the business aspects.
And third, the payout might be greater. Guaranteed salary in most cases, plus a performance-based bonus that might be greater than what you would've made starting your own fund. Similarly, there are shops such as proprietary-trading firms that give up to a 90% performance bonus, rather than the 20% one would get (hopefully) starting one's own fund.
That said, I'm ultimately happy with my choices, even though regrets come and go daily in this business.
James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of "Trade Like a Hedge Fund," and "Trade Like Warren Buffett." At the time of publication, neither Altucher nor his fund had a position in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.
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