Starting a fund / raising capital

[bryce910]

Also noting to the above that as you do not have outside investors or less then 35 you pertain to the exception allowing you to start an incubator hedge fun without registering and being a licensed adviser.

 

[Epic]

Thanks for the comments, EPIC.

I have been managing some friends and family money under a managed account structure now for a bit less than 2 years. I am also in the process of registering as a RIA with 2 states and going through the formal entity set up process to begin accepting clients under a SMA structure.

My impression is that the SMA structure has the following advantages:
1. Minimal costs due to avoidance of administrator and audit costs.
2. Clients potentially like the transparency.
3. Simple to manage.

While pooled structure has the following advantages:
1. No need to register with the state until you reach a certain size, also avoiding annual regulatory burdens, which I'm told aren't that bad.
2. Protect your position information and trade secrets, prevent clients from potentially shadowing your trades.
3. Benefit from carried interest tax treatment.
4. Lower fiduciary responsibilities to clients, as they are treated as your investors, rather than clients. Under a SMA structure you must determine whether your strategy is suitable for their situation and risk tolerance.
5. Can charge performance fees (I think) to everyone whereas your clients need to have a net worth of 2mm under the SMA structure before you can charge a performance fee.

I was also sold by the lawyers on the incubator fund. While I am skeptical of its benefits, they only charged me about 1k more for its formation, I think. I am told that you can include the incubator fund performance or your personal account performance (I believe) as part of your presentation materials if you note that it is proprietary performance. Also, the lawyers told me that having the 'fund' lets you put your 'track record' in certain hedge fund performance databases.

I should clarify that you seem to be talking about SEC regs whereas I'm talking about NFA and CFTC. There are certainly enough differences to make sure that we acknowledge them.

This is all just as it's been described to me, so a competent lawyer would probably know best. Anyway, one issue is whether a manager is trading "securities". Futures are not securities, and so a CTA is not regulated by the SEC. I've contacted the NFA and spoken directly with senior management in regulation and compliance, and they have indicated that they are not aware of any CFTC regulation restricting the charging of performance fees for separately managed futures accounts. Even so far that when I mentioned the term "qualified client" I was stopped mid sentence and told that "it sounds like I'm referring to a rule on the securities side". Also, a CTA is not considered a fiduciary like an RIA is. So the difference between futures and securities is pretty large there. CTAs aren't required to register with the states either, because you aren't offering securities. Every state that I ever contacted asked if I was registered with the NFA, and when I said "yes", they didn't require any state registration.

That said, any pooled investment vehicle, even if only trading futures, is considered a security. As such they will have to be registered with each state they are offered in. The issue is whether they qualify as an "investment company" under the 1940 Act. Almost every CPO maintains an 1940 act exemption, sut I'm still unaware of any qualified client performance fee restriction for a CPO, whereas I know that one exists for a securities fund. I did find several law firms claiming that the qualified client restriction applies to CTA/CPO as well, but contact with the NFA denied it.

I can say that on the futures side, SMA is significantly less burdensome than any pooled vehicle.

 

[R1234]

I am currently wrestling with whether or not to form a fund.

In my personal accounts I've been trading a portfolio of short term systematic stock strategies since last December and so far real time results have been in line with my backtests producing a competitive return and Sharpe ratio (long term expected Sharpe ~4).

In my RIA business I currently only do SMA. But I am hesitant to offer this new strategy in SMA format because the edge involved is significant and I am concerned about a few of my sophisticated clients trying to reverse engineer and/or piggybacking on my trades. Therefore I want to offer it as a fund.

From my Accredited Investors client base I believe I could raise $5 million for this new strategy without too much effort by showing them my CPA prepared, unaudited prop performance.

But my question is about AUM growth potential. $5m is fine to start but given the headaches and operating costs of running a fund structure I would want to grow that to around $20m.

What are some avenues to raising that kind of AUM? I've worked at a FoF in my past and know that I would never pass muster with those types of allocators as I am a one man shop working out my basement office.
Are there stock brokers that would market my fund in exchange for clearing business?

 

[Epic]

I am currently wrestling with whether or not to form a fund.

In my personal accounts I've been trading a portfolio of short term systematic stock strategies since last December and so far real time results have been in line with my backtests producing a competitive return and Sharpe ratio (long term expected Sharpe ~4).

In my RIA business I currently only do SMA. But I am hesitant to offer this new strategy in SMA format because the edge involved is significant and I am concerned about a few of my sophisticated clients trying to reverse engineer and/or piggybacking on my trades. Therefore I want to offer it as a fund.

From my Accredited Investors client base I believe I could raise $5 million for this new strategy without too much effort by showing them my CPA prepared, unaudited prop performance.

But my question is about AUM growth potential. $5m is fine to start but given the headaches and operating costs of running a fund structure I would want to grow that to around $20m.

What are some avenues to raising that kind of AUM? I've worked at a FoF in my past and know that I would never pass muster with those types of allocators as I am a one man shop working out my basement office.
Are there stock brokers that would market my fund in exchange for clearing business?

My experience is similar to what Heech was sharing earlier in this thread. Try not to force things early on. Lots of wheel spinning while circumstances become more favorable.

I can tell you exactly what difficulties you'll have. $5MM AUM will probably keep the lights on if you don't try to represent yourself as something you're not. Don't go hiring top tier services trying to look legit, cause they just bury you in expenses. You gotta try to get yourself above $20MM as quickly as possible after launch. Otherwise you're asking small difficulties to become big operating problems.

Those who know you, are going to trust their previous experience with you, but many still won't commit heavily until things mature. They might test things with $100-200K for a year or so, unless you really start killing it, which will bump them up quicker. Keep in mind that as the RIA you must act as a fiduciary and make sure they don't over-allocate to your new fund. Also, as their current fiduciary, you are potentially taking on much more risk if things go bad than you would be if you were unaffiliated. I personally don't know a single traditional RIA willing to try both simultaneously. If you wanna charge performance fees as an RIA, they gotta be qualified. How many clients with a $2MM+ portfolio (home excluded) do you currently have on your book? If they don't have that, you can't charge 2/20, in which case there is no real incentive getting them to switch from your adviser to your fund. If you "think" you can raise $5MM quickly, count on $2MM quickly and then another $2-3MM trickling in over the next 6-12 months.

But the bigger issues come outside of your current network. Sounds like all you have is 8 months composite prop performance. Prop is hard to use anyway. That prop is gonna have a hard time holding up if it wasn't a dedicated account for that system. Going back and creating a composite of various personal accounts won't hold up to scrutiny. Backtesting looks nice on paper, but rarely helps enough to close any type of sophisticated client unless it has at least a bit of real-time with it. Something like 24+ months of dedicated real-time that closely resembles the backtest results and maybe you start to get a few more nibbles in the HNW and FO space. Another difficulty is gonna be the fact that you're trading equities. Every retired Joe I know, trading his own Fidelity account, has done 25%+ annualized over the last two years, with a 4 sharpe. Every sophisticated allocator knows that is about to end. Even if you had 2 years track record, you're gonna have a hard time standing out in the equity space right now. Almost everyone I talk to is shifting away from anything long equity right now, and toward non-correlated alternatives; CTA, CPO, fixed income arb, and private equity.

You're correct in that almost no institution will give you a look. They usually wanna allocate $5MM+ initially, and they can't constitute more than 10%-20% of the fund AUM. They also want at minimum 36 months audited discretionary. Preferably 48-60 months. Don't count on getting any interest from these guys, and don't waste your time pursuing them.

Some FO's are early adopters of certain startup managers. They are difficult to find and you gotta be careful about pursuing a cold calling fundraising strategy. You might fall under the new advertising regs which means you'll have to take steps to verify the net worth of every new investor. Clients don't really like it when you start asking for tax returns and pay stubs. Of course, your RIA might already put you in that situation. Better check with the SEC.

Introducing brokers are pretty common in the commodity space, but not in securities. In the securities space it would be other RIAs allocating to your fund, but most outsource their due diligence and you'll never get through that at this point. PB are common for securities, but none will really work with you until at least $20MM AUM. 3PM is common, but expensive. I can tell you right now, they would have a very hard time selling your fund, regardless of the performance. For that reason, they will either not take you as a client, or they'll want a large retainer to make it worth the wasted time.

Sorry to sound negative, but imo you are about 2 years away from where you need to be if you want a legit shot at success. You'd be amazed at how much easier it gets with 4+ years of audited performance vs where you're at now.

 

[R1234]

Epic - thanks your insights.
I plan to see how the strategy does in a bear market before I show it to my clients. One part of it is long/short trading and another part is market neutral/beta neutral pairs trading so I think it should look value more added during a bear than it does right now.

What are the ongoing administrative burdens on me if I did a fund - monthly, quarterly, annually?
What would be the operating costs? I've called around various places and I've heard around $25k per year in admin + legal fees per year to keep a domestic fund going. Have you seen anything cheaper?

 

[markettimer]

DoubleT, this is a very interesting thread, I just read the whole thing. I now find myself in a similar situation as you were two years ago (a few years of solid returns, ~$600K equity), and can only hope to have a similar experience over the next two years as you have had. A few questions came up as I was reading. I guess one of the most important is, what is the endgame for you? In other words, are you just trying to maximize wealth in a sort of detached way like in a video game? Or do you have a lifestyle in mind that you hope your wealth will allow you to attain?

I'm also a bit curious on your strategy. On post 43 (page 5), you listed some names you were long and short a couple years ago. It seems you focus mostly on internet names. Is your account still concentrated in this sector? What fraction of your returns can be explained by an internet sector fund?

 

[Blackdollars]

I'm not really that familiar with the prop firm landscape, but my impression is that most of them are trash. Also, my strategy has become almost entirely investing based as opposed to trading oriented, and I don't imagine that makes sense with the majority of prop firms out there. Also I am managing 3mm of my own money now, and with IB's portfolio margin, that's a enough buying power for me.

You know, I understand why you don't want to trade for a Prop Firm; for god's sake you have $3mil of your own money that you trade. What I don't understand, why do you want the hassle of trading for others, when the trading income from $3mil is huge based on your returns stated earlier in this thread.

So, please explain, why????

 

[1245]

Why not do both.

 

[Blackdollars]

Why not do both.

From my understanding really good traders make at least 20% per year on the lower end. This select group usually do not trade for others although they do teach how to trade (read "Millionaire Traders"---interviews with "real traders").
From reading this thread, if you live in the US it doesn't seem to be worth it to trade for others, unless you have low returns, so you do need alot of money under management to make decent money in fees and commission.

 

[Blackdollars]

What do you all think of the following statement
"Real Traders" trade for themselves, fake traders need other people money to loose.

What my associate is saying (in private conversations) a good trader need, $10,000 in order to get rich, people who don't know how to trade "needs" other people's money.

How accurate or inaccurate is this statement in your opinion?