The Hedge Fund Structure Is Dead
- Posted by Leigh Drogen
- on November 1st, 2010
This post is for those looking to start their own firms and manage money for others. The hedge fund structure is still necessary for those who trade complex strategies using derivatives or illiquid assets. But for most of us, the stock, forex, and futures traders who go long and short the underlying, the hedge fund structure is obsolete and I’m declaring its death for all but the largest firms above $5B in AUM (there aren’t as many as you think).
Advances in technology, which in hindsight really weren’t that difficult, allow investment managers to trade multiple separate accounts across the same strategy at the same exact time. The main draw of the hedge fund structure previously was the ability for the manager to trade one account from one screen. The limited partnership legal structure sucks, plain and simple, it’s expensive to set up, requires many headaches along the way when adding and subtracting clients, and adversely effects the other partners when someone pulls money out or puts money in. Whoever thought that commingling funds was a good idea in the first place needs to be (fill in ruthless torture scenario here). It has caused a great deal of pain for many investors who’ve had their funds outright stolen by the general partner, had gates thrown down on the removal of their assets from the partnership, and everything bad in between. As I said above, the limited partnership structure serves a purpose when dealing with illiquid assets that are hard to buy and keep track of across different accounts, save for that, it serves zero purpose these days.
Back in 2006, before I founded Surfview Capital, and then Estimize, I was an analyst for a hedge fund here in NYC named Geller Capital Management. We used two different structures, a fund and separate accounts. The fund was an archaic vehicle held over from a previous firm my boss ran. The strategy had changed, but the structure was still there and it was useful to some extent. But the majority of the money we managed was in separate accounts. We ran accounts as small as $500,000 and as large as $12,000,000. They were all treated the same way. But at the time, the technology did not allow us to trade those accounts as easily as I can today. Staff was needed to allocate the correct amount of shares across the accounts. Portfolio tracking software (Advent) was needed to determine if those shares had been allocated correctly, it was time consuming and expensive.
At the end of the day the allocating shares system works, it just doesn’t work well if you run a one or two man shop. So if you were trying to start your own firm this just isn’t the way to go, it was hedge fund structure or nothing.
But not anymore. Now, the following may sound like an advertisement for Interactive Brokers, but I can assure you, I am in no way shape or form affiliated with that company. In fact, I have plenty of gripes with them, they are without a doubt the worst institutional and retail brokerage in terms of customer service, they really just couldn’t give a crap. That’s ok, it’s their business model, they have decided to put their money towards technology and not service, opposite of Schwab.
I would not have been able to set up my firm a few years ago if it were not for the technology on the IB Trader Workstation platform. Because of them, I don’t need a back office, and I sure as hell don’t need a hedge fund structure. If you are looking to set up your own firm, here is a very simple way to do it that will save you a ton of hassle, a ton of money, and a ton of time, and you lose absolutely nothing.
Surfview Capital is an LLC, very simple. It cost me a couple hundred dollars to set up and a few weeks. I didn’t need an expensive lawyer to draw up partnership documents, and I sure as hell don’t need one going forward.
I set up an institutional account at Interactive Brokers under my LLC, very simple. They ask you a minimal amount of questions and don’t require much in the way of forms, and you have an institutional account open.
The next step is not necessary, but I feel that it is a good show of faith in yourself to your clients or prospective clients. When you set up your institutional master account, Interactive Brokers will ask you if you would like to open up a sub trading account for your LLC. Do it, and run the money in there the exact same way you are running money for your clients. This shows that you are willing to put your firm’s own money on the line along side you client’s in the same strategy, what’s good for them is not only now good for you in terms of fees, it is directly going to impact your firm in terms of P&L on your own account. This goes a long way to showing that you truly believe in yourself, even beyond past performance.
Next, you need an investment management agreement for your firm. This document takes some time to put together and needs to be done by a lawyer. The document itself is pretty simple and many investment managers use the same one with a few little tweaks. My advice if you want to be cheap about it, find one online from another firm that trades the same assets as you, and modify it. Then take it to the lawyer and have them look it over to make sure its kosher. Otherwise, have the lawyer just write it up, you’re going to pay for it, but getting this right is important. This is the agreement between you and the client that lays out everything that isn’t said in the Interactive Brokers managed account sign up process. The truth is that you don’t need this document, legally. But to be safe and cover yourself in case of a dispute, in reality you need it. I would share mine here, but something tells me that’s just not the right thing to do, and it could be illegal, I don’t know.
Bringing clients into your firm is not a difficult process when you set up the structure the way I have. Here’s how it works. Someone contacts me, either through the web site, the blog, Twitter, a friend of a friend, a friend of a client, or however else they might find Surfview Capital. We have a few conversations, I ask them an extensive list of questions, they ask me any questions they have, and if we both feel like there’s a mutual fit, I send them the investment management agreement. We review it together, they sign it and send it back to me. I then go into my Interactive Brokers platform and send them an invitation to open a brokerage account. This account is their own, it is not under your LLC, you don’t have any access to the funds in the account, you can not move money in and out, you have no power of attorney over the account, it is theirs, just as it would be had they signed up without you. The invitation to open the brokerage account comes with another electronic sheet (this is all electronic by the way, there is no actual paper required, it’s amazing), the second set of forms gives you the permission to trade the account, and it lays out how you will bill the client. You can choose from several different ways, I won’t cover that here, you will figure it out when you get in there and look around, but basically it’s all automated and that’s awesome.
The client fills out the forms online and opens the account. Their account is now under your master account, you have access to trade it, and the fees are automatically taken out, there is no billing or invoicing, no back office, no computing stuff, it’s all done automatically, amazing. You need to take the time to do a back of the napkin review at the end of each quarter to make sure that something huge didn’t go wrong, some form wasn’t incorrectly filled out and wayyyy too much or too little was charged, but I haven’t run into an issue yet. Just be diligent and look for obvious errors.
The client then funds the account, and that’s about it for the signup process. You never touch a dollar of theirs, ever. The only paperwork you handle is sending them the investment management agreement. And that’s it for the rest of the term of your relationship with them. You trade their account within your master account on your Trader Workstation in IB, and IB bills them automatically and puts the money in your master account. You can then withdraw those fees from your master account at any time, or leave them in there, or transfer them to your LLC’s trading account. One nice aspect for hedge fund managers with the partnership structure is that when the manager takes his fees, he takes it in the form of an increased ownership in the partnership. We also call this carried interest. The manager now has a larger stake in the partnership, and he benefits from the fund doing well just as the clients do. So in a sense, you can create this by just moving your fees from the master account to the trading account, and believe me, your clients will respect you for it. The downside is that the IRS treats this as income, not carried interest, which means you do have to pay taxes on your fees now.
Now here’s where we get down to the real reason this all works. Remember before I said that at Geller Capital we had to allocate shares to each account, a tiresome process that needed many checks, and checks, and rechecks. There is none of that. The Trader Workstation platform allows you to trade all of your client sub accounts at the same exact time, without allocating shares. Here’s how it works. Interactive Brokers allows you to group accounts together and trade them all at once using the Portfolio Rebalance tool. This page allows you to say, I want to buy 5% of each account’s net liquidation value in Apple. The screen that you are looking at is the aggregate of all of the accounts in that group, it’s almost like you are looking at the group as a fund. When you buy a 5% position, it automatically calculates the amount of shares needed to buy a 5% position in each account with a different net liquidation value. You don’t see any of this or have to deal with any allocations. You trade off of one screen. If you want to sell half that position late, you go back to the rebalance screen and enter 2.5% where the 5% was previously. Hit create orders and it will create all the orders for all the accounts. Hit transmit and you trade for each account at the same time.
The great part here is that I can trade 500 accounts with the same effort it takes to trade 1. That is the beauty and the reason that the hedge fund structure is dead. You couldn’t do this before. Each of my clients has his or her own account and it doesn’t cost me anything in terms of effort to trade.
As I said, this only works for certain strategies that aren’t too complicated. Once you start getting into derivatives and illiquid securities it gets a little more difficult. Also, if you are dealing with thin securities or derivatives, you have to makes sure that all accounts got filled on the trade. It’s not fair that one client gets filled at one price and another client another price, this is very bad.
In terms of reporting and tax stuff, there is no need to do anything for either. All of the tax forms are prepared automatically by Interactive Brokers for your clients and reports are generated automatically each day. They can have it sent straight to their email if they like, or you can just review it once a quarter with them at the end. They can also see what’s in their account at any time by logging in. Yea what a novel concept, a client being able to see what’s in their account. I do not let my clients trade inside the account, but the platform does allow this too, it’s their account. The whole thing just makes a lot of sense.
If you are looking to manage money for other’s and are looking for a structure, I feel this is the best way to go for the client and the manager. I hope this helps some of you out there looking to do so. The partnership structure has lead to a lot of heartache for many people, most notably clients of Bernie Madoff. There is no need to custody your assets with your investment manager, absolutely none. And if they ask for that privilege, walk the other way and say thanks but no thanks.
The hedge fund structure is dead.
Note: you must comply with all state and or SEC regulations as well, which includes being a registered investment advisor. There is a maximum threshold for the number of accounts and aggregate capital you can manage before having to register, this goes state by state, do your homework, you can get started without it but need to register eventually.
After running Surfview Capital for 2+ years with excellent returns (30%+ each year with max 6% drawdown), in 2011 I returned money to investors in order to found a financial technology startup called Estimize, a web platform which enables buy side and independent analysts to crowdsource fundamental estimates. It’s free and you may be interested to get involved or just access the data which is more accurate than sell side estimate data sets 70% of the time. I’m always glad to answer any questions about Surfview Capital, the strategies we ran, my background, Estimize, etc.. I do not consult on how to set up asset management firms or how to raise capital from investors. If you’re interested in chatting you can reach me at leigh at estimize dot com.
Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see the Disclaimer page for a full disclaimer.
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Leigh Drogen is the founder and chief investment officer of Surfview Capital, LLC, a New York based investment management firm employing an intermediate term long/short momentum strategy. More »
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