Setup a Hedge Fund

Setup a Hedge Fund | Tips from Sykes

Below is an article being added to our Hedge Fund Startup Tools page. This piece is from Tim Sykes, a colorful wall street personality with a large online following and experience in running a small hedge fund and then writing a book on the experience, which I have reviewed here. I do not agree with everything noted below but I believe it is valuable as it is rare to read articles by those who have managed a hedge fund about the struggles of running a small hedge fund.
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I brought an outline of my strategy and performance to a friend of a family friend, who supposedly had access to many hedge fund and rich clients - he was impressed, but wanted to know the details of my strategy but wouldn’t give me any assurances he simply wouldn't use it for himself. In addition, he wanted my returns audited and only then would he consider helping me raise capital in exchange for a "slight" fee. I couldn’t trust this guy and I didn't want to tell him my secrets so I passed. This encounter made me realize that audited returns would be necessary because my success was rather unbelievable. I figured this expense would be crucial to my fund raising, so I found a local accountant familiar with stock trading and spent a college semester’s tuition to have my tens of thousands of trades audited.

After a few weeks of patiently reviewing all my trades with this accountant, the audit was finally finished and the numbers looked good. In fact, the numbers looked too good. Yes, my ridiculous returns might be a problem.

Lesson #1:

If you consistently beat the market, you will face endless questions about whether or not you are a fraud.

No matter, I decided to form my own fund and take my chances raising capital. Since I was still in college and had focused solely on trading for the past few years, I had very few business connections and most of my friends and family were not wealthy enough to invest considering the all knowing industry regulations stated my investors would need a net worth of $1 million or more to be worthy of such a “risky investment”. Only my continued performance could attract new money, but, being my cocky self, that was the one part of the equation I wasn’t worried about.

Mutual funds could accept less wealthy investors, but had severe investment limitations. No, I did not want to start a mutual fund because most of them had to be invested at all times and they couldn’t even short sell! Hedge funds were considered the hot new investment vehicle, so I researched the industry nonstop for a few weeks and liked what I saw. I discovered the startup costs to be surprisingly modest and I loved the legal flexibility that would basically allow me to invest in any manner I saw fit.

Before the emergence of discount hedge fund startup shops over the past few years, I found the template for offering documents and lawyer fees could exceed $75,000. Since then, hedge fund boutiques had appeared, offering their administrative and startup services so startup costs did not exceed $10,000. That was some reduction!

I chose the second least expensive boutique I could find (probably something ingrained in me ever since my dad advised to always purchase the second cheapest bottle of wine from a restaurant’s wine list). Still, I was surprised there were so many forms to fill out and small fees to be paid, but I went along with whatever my fund administrator said because he had set up dozens of firms over the past few years. This was the real world so it would take patience, something never required of me in the trading world.

Lesson #2:
Everything takes much more time in the real business world compared to the trading world.

The ink on my letters of incorporation was barely dry when it hit me. I had been distracted by my quest for finding outside investors and creating all my companies that my trading had suffered as a result. Successful trading is all about focus, discipline and concentration and these lessons had been consumed by my ambition and greed. I had taken some rather stupid losses and now, with my fund inception just days away, I would no longer have that magic whole number in front of the millions of dollar under management. No, I would have to put a dreaded decimal point and some other numbers before the word million, hurting my credibility from the start.

Lesson #3:
Focus on trading first; never schedule investor meetings during market hours.

Meanwhile my fund administrator convinced me to switch brokers because my trusty online discount brokerages were simply not used in the hedge fund world. I quickly agreed, but I was in for a rather big surprise. This newly recommended brokerage did not have any electronic trading platform (I was told it would be ready within weeks) and the traders executing my orders gave me some of the worst executions I had ever seen. I called to complain, but they brushed me off. They placated me by saying their new online software was only days away from completion. Almost twenty months later, the software is still almost ready. I switched to yet another recommended brokerage that had online trading software and I became friends with one trader who expertly executed my larger orders.

Still, the commissions I paid were much higher than my previous setup so I asked for and received several price reductions, based on how much trading I did. It quickly became clear which broker I wanted to stay with when the broker without electronic access incredibly upped their commission on a trade without telling me. When I called to complain, the broker told me he knew I was paying more at the other broker and therefore he was entitled to the same rate. He was mistaken on top of the fact that he just had taken matters into his own hands without consulting me. The difference in price on that one trade was only a few dollars, but I lost my temper based on the principle of the situation.

Luckily, I had started chatting regularly with a popular industry commentator and he referred to me another broker that was perfect for short selling. This new broker’s online software, cost, and short-selling list blew away the competition so, I dropped my other brokers and focused on this new guy.

Lesson #4:

Do not feel bad about changing brokers if they are ripping you and your clients off. They are not girlfriends; there is always somebody cheaper and better out there.

The CEO of the brokerage I dropped called me to see what they had done wrong and ask why I had closed my account. I could not understand why it was so important my small fund stayed with their firm that supposedly had billions of dollars in accounts. My commissions with them barely touched into the thousands. As ridiculous as this conversation was, I respected this man for his dedication to providing customer service. Too bad their brokerage services weren’t up to par.

Every fund manager should price as many prime brokers as possible that fit the fund’s strategy. There are many brokers who may trade for themselves, but mainly exist and make money by taking their share out of our online trading commissions. They make their money from trading commissions—that’s the bottom line. There should be no reason to have to pay an individual representative of a major brokerage when we simply use their online software, but that’s the way it is. I am very skeptical when dealing with these people, and I do not feel bad about getting into arguments with them. In fact, I’ve grown to enjoy these fights.

Within a few months with my quality broker, my performance moved back to the range of my previous years, crushing the overall market and my investors were very happy. Yes, my parents and a few of their friends were elated. After months of solid performance that consistently beat the market, I still had yet to raise much outside capital. I realize now that it will take a lot longer than I originally anticipated, but I have made so much money in the past and I am confident in my skill as a trader and that is what gives me the faith to go forward. It doesn’t hurt that I make up a large portion of my fund so I can probably go on forever, however unhappily, even without many outside investors.

Lesson #5:

The larger the ‘nest egg’ stake the manager has, with the initial startup--the better.

When I first started my fund, I moved to New York City because I figured it was the epicenter of the hedge fund industry so I should be able to make thousands of investor contacts. I had met many potential investors and many in this industry, but no matter how many times people said they were interested, no checks were written nor wires sent.

One interesting meeting was with a senior manager of a major mutual fund company who had heard about my performance. I met him at his luxurious house in Florida and we proceeded to discuss my situation. After a few hours of listening to my story, he told me I was very smart and that I should focus on raising capital by changing my strategy around to suit potential investors. He told me in his years of experience, investors would be skeptical of such high returns and would want very low volatility. I told him in my years of outperforming the market I could care less if people accepted my strategy as I believed people will respond to performance. He’s probably right, but I take a certain pride in being a true rebel, a modern-day financial speculator.

Lesson #6:

Focus on what works for you and do not change to accommodate others.

Next, I attended a few alternative investment conferences and handed out plenty of business cards. I was even part of a panel discussion thanks to my fund administrator’s connections, but my speech sounded naïve and unpolished compared to the more experienced managers and veteran marketers in attendance. In fact, I was mesmerized by one particular fund marketer who had grown his fund exponentially over six months. I do not think he said one useful fact during his presentation, but he delivered an eloquent speech and several people, including me, approached him afterwards. Ah, the power of marketing skill. We discussed marketing my fund, but he charged some ridiculous fees without guaranteeing results whatsoever. I was just a startup fund; no matter how great he sounded, I wasn’t going to blow upwards of $10,000 all based on his incredibly polished speech. So, I decided to send out my marketing materials to all potential investors. I contacted just about everyone I knew, but the rate of follow-through was ridiculously minimal.

Lesson #7:

Raising money does not come easily for a startup hedge fund manager.

There are very few reasons for individuals to take a chance on a new operation unless they have known you for years or if your performance warrants the added risk of being invested in a startup. People in large firms will not want to take a chance on your fund because of the minimal track record, lack of transparency of positions, and the volatility of returns. Their job is on the line with any investments they make, and if they mess up—they are fired. For the most part, they would rather underperform than risk losing big. This is what Warren Buffett once called the “institutional imperative.” It is a herd mentality, where these “institutional lemmings” move together, not necessarily doing what is best or smartest for their clients, but what is best and smartest for themselves. The decision to go with a high performing emerging manager is a risky bet, due to the outside chance of looking like a fool. No fund-of-fund manager will make that decision, because they will be fired or scolded if these risky investments don’t go exactly according to plan. Similarly, these emerging managers’ careers are to be ended if they do not make positive yearly performance each year.

My wonderful broker, who I was almost completely satisfied with after months of moving down commissions, recently baited me by saying one of his fund-of-fund clients might be interested in my fund since he was comfortable with my strategy and my performance had been above average. I had heard this many times before, from brokers trying to lure me to changing to their brokerage services to potential investors whose checks always seemed to get lost in the mail. Simple common sense dictates that when a fund-of-fund hears about me--if they are serious, they will contact me, not through my broker.

Full of doubt, I still met my broker and the fund-of-fund manager for lunch so we could discuss a possible investment. Initially, I grew rather excited because the conversation was surprisingly detailed as this manager actually did know about my fund! In fact, his talk of a possible investment sounded rather concrete and the proposed addition would increase my fund assets by 25-50%. We decided to meet again a few weeks later, so I spent hours creating a new presentation tailored to this fund-of-fund’s style. I never got to meet the fund-of-fund manager again, but my broker said he showed him my presentation and he supposedly loved it. The other day, my broker told me the great news. The manager had agreed to invest in my company without even needing to meet me again. Wow! Awesome! Of course, there was a catch. My broker felt horrible telling me (as he claimed), but he could only transfer the funds to me if the commissions on trades for this new investment were quintuple my normal rate! I felt my heart sink. I anticipated compensating my broker for this capital introduction, but quintuple fees with no hope for a reduction over time over the lifetime of the investment seemed somewhat ridiculous. I said no.

Lesson #8:

With capital introduction, there’s always a catch.

My fund is listed on many hedge fund databases, but Hedgeco.net and Hedgefund.net have led to the most information requests by far. After a year of listing my fund, I have had over a thousand hits on my fund’s web pages. In fact, many third party marketers have contacted me through these websites. I have a premium listing on Hedgefund.net that costs the equivalent of a semester of college.

Some third party marketing firms have also contacted me. One marketer said he was showing my PowerPoint presentation to potential investors the day after I emailed him and he would get back to me. Three months later, he has yet to get back to me. Another marketer said he would work for my fund, but wanted 50% of the incentive fee I’d receive on any profits on the investment. Another wanted 30% of the incentive fee. With those kinds of figures, it would take me too long to make it worth my effort even if my returns continued to trample the market. I wanted to pay an upfront finders’ fee to them, but they knew that was not where the big money was. I understood their dilemma; why should they risk their entire reputation on a startup fund with only the chance for a small payoff?

But there was an individual that said he had the connections and was willing to take a job full time with me without taking more than 10% of the incentive fee. I just wanted him to introduce my fund to his connections because I have just a handful of family and friend connections that were wealthy enough to be potential investors. He demanded an exorbitant yearly pay for his services, and would not guarantee he could raise the millions he promised, but he was optimistic after reading my presentation and looking at my returns. I was happy yet skeptical that he did not want to know more about my strategies. It took weeks for him to “write out some contracts” and he insisted I only use his lawyer. Nevertheless, I was optimistic after having talked to him several times. But when I looked at the contracts, I was dismayed.

He wanted to focus on completely overhauling my marketing by creating new expensive presentations. He also tried to sell me on using his buddy as a graphics designer, supposedly the guy who designed the Oakley logo, to design an incredible logo for me that would surely attract investors! I am no marketing genius, but somehow I felt a new logo was not the problem and the Oakley guy was more than a little out of my price range. He also wanted to do a traveling road show to his contacts to present my fund so I could stay put and focus on my trading. Somehow paying for him to jet around the country without me was not my idea of a good investment. I told him no and I designed a simple logo on Microsoft Paint. I still receive many compliments on my simple yet modern logo each week.

Lesson #9:

This industry is full of frauds and con artists.

Are you seeing the pattern here yet? This industry is tough for the little guy because there are many promises and very little follow through. Not being able to advertise is very difficult and you must rely on contacts and networking for capital introductions. You have to be willing to give up your strategy and any chance at tiny yet consistent profits for a shot at the big time. I chose the other path; focus on what I do best and be content to make some decent money while waiting for more opportunities. I figure there will always be people who want to raise money for me and they will only multiply with time, especially if I keep outperforming the market. I do not want to compromise my trading and investing style and I accept the fact that it might take years for investors to come. Only performance and patience will create the path of success—a journey I am willing to take.

Lesson #10:

Results are much slower in the real world compared to the trading world.

Timothy Sykes is a hedge fund manager, star of the reality show Wall Street Warriors, and author of the upcoming book, "An American Hedge Fund" He can be reached at timothysykes.com

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