If you've come up with a market-beating strategy and have a good track record of outperforming the market, you may be thinking about starting a hedge fund. Hedge fund managers receive considerable compensation for their performance, and the tax benefits are great for high earners.

But a short track record of outperforming the market in your personal trading account isn't enough to start a hedge fund. You'll also need to assemble a team to make sure that you establish and operate legally and register with all the necessary parties. You'll need to market your fund and raise money to invest. And you'll need to run a business on top of managing the hedge fund's investments.

If you think you're up for the challenge, here's how to start a hedge fund.

An investor at the computer.
Image source: Getty Images.

What is a hedge fund?

A hedge fund is an investment company that pools together funds from investors. It works similarly to a mutual fund, but there are a few key differences.

Properly structuring an investment company as a hedge fund exempts it from certain registration requirements under the Securities Act of 1933 and the Investment Company Act of 1940. As such, hedge funds are able to use all sorts of investment strategies in order to earn outsized returns for their investors. In order to maintain that status, however, hedge funds can only accept investments from accredited investors -- defined as individuals with a liquid net worth exceeding $1 million, or $200,000 in annual income.

High Net-Worth Individual (HNWI)

People who have amassed investable (or liquid) assets of $1 million or more.

Why would someone start a hedge fund?

Managing a hedge fund has the potential to be extremely lucrative. The standard fee structure of 2 and 20 provides a 2% management fee for all assets under management and a performance fee of 20% of the profits each year. If there are no profits, the company still collects the 2% management fee. When we're talking about hundreds of millions of dollars, the money adds up fast.

Of course, in order to get to $100 million-plus of assets in your control, you'll need a network of high-net-worth individuals. You'll need to prove to them that you're a better steward of their money than they are. You'll also need to be marketing the new fund in order to expand the business, and don't forget you'll need to invest all your investors' money, too.

If that sounds like a job you're capable of pulling off, then maybe you should start a hedge fund.

How to legally start a hedge fund

1. Define your strategy

1. Define your strategy

The first thing you need to do is define your investment strategy as clearly as possible. Make sure the strategy is replicable and scalable. It can't rely on certain policies or economic environments to succeed. Hedge fund investors want to see consistent gains. The strategy you used to grow your personal account over the past decade may not work over the next decade and with an account with tens of millions of dollars.

If you have a strategy that's repeatable in any market, that you can scale by investing more time into research, and that's easily understood by investors, then you have something you can work with. Common hedge fund strategies include: long/short equity positions on undervalued/overvalued stocks, merger arbitrage where markets misprice securities slated for mergers, buying distressed companies, and algorithm-driven quantitative approaches.

Once you have a viable strategy for your hedge fund, you're ready to actually start a business.

2. Incorporate

2. Incorporate

Hedge funds are typically set up as a limited partnership where the hedge fund manager is a general partner and all the investors are limited partners. You could also set up an LLC or use some other structure. It's best to consult a professional on the right structure for your hedge fund.

Once you determine the proper business structure, you need to register with the secretary of state in the state you wish to incorporate and file your articles of incorporation with the state. Additionally, file for an employer identification number (EIN) with the IRS, which you'll use for further registrations and taxes.

As a hedge fund manager, you'll likely want to protect yourself by forming an LLC. An LLC will protect your personal assets if the hedge fund declares bankruptcy  or gets sued (although you'd still be personally liable if you committed wrongdoing on behalf of the company).

3. Complete the proper registrations

3. Complete the proper registrations

Once incorporated, you need to register the new company with the Securities and Exchange Commission (SEC) and the regulatory bodies of the state where you incorporated. You'll also need to register the company as an investment advisor.

Additionally, you need to register as an investment advisor, and any other representatives of the hedge fund manager will as well. That requires you to pass the Series 65 exam administered by the Financial Industry Regulatory Authority (FINRA)

Finally, you'll need to register the hedge fund offering with the SEC using Form D. You need to do this for every state where you'll be offering the fund. Form D is specifically for exempt securities such as hedge funds.

A good lawyer will ensure that you cross your t's and dot your i's when it comes to filing all the registrations necessary to set up your hedge fund.

4. Write your investment agreement

4. Write your investment agreement

Before you go out and market your new hedge fund, you'll need a clear investment agreement to show prospective investors. The investment agreement will include details such as:

  • Your fee structure: What's the expense ratio? Do you have a performance fee? The industry standard is a 2% management fee and 20% performance fee, but there's been pressure on lowering fees over the past decade.
  • Minimum commitment: Is there a minimum amount of time or money an investor must commit? Many hedge funds require at least $1 million and a one-year commitment, sometimes more.
  • Distributions: Will you have set periods where investors can request distributions, or will they be able to take distributions by providing notice 30, 60, or 90 days ahead?

Again, a good lawyer will be invaluable in making sure your investment agreement covers everything you need.

5. Get your team together

5. Get your team together

Beyond the aforementioned lawyer, you'll also want to assemble a team of key service providers.

  • A broker offering prime brokerage service:  Being able to make trades or borrow cash and securities are essential to running a hedge fund. A broker can help facilitate the core activity of a hedge fund. Hedge funds need prime brokerage services for lending securities from other institutional investors and facilitating margin loans from commercial banks.
  • Auditor: Hedge funds need their results audited if they want their track record to hold any weight when marketing to potential investors.
  • Administrator: As a hedge fund manager, you want to focus on trading. An administrator can handle the day-to-day tasks of making everything else in the business run smoothly.

6. Market yourself

6. Market yourself

Before you can actually manage people's money, you need to sell them on why your fund will be a better fit than managing their money themselves or allowing someone besides you to do it. 

As a hedge fund, you're only able to accept investments from accredited investors. An accredited investor holds $1 million in liquid assets or has an income of $200,000 per year (or $300,000 per year with a spouse). If you have a network of friends and family who fit that description, start with them. If not, you'd better be a really good networker and salesperson. 

Be sure you comply with all laws and regulations when marketing. Consult your lawyer.

Show your prospective investors your (audited) track record from using the same strategy you'll use for the hedge fund. Explain why the strategy will continue to work in the future. Then ask for their money.

7. Launch

7. Launch

Once you have enough investors, you can launch your fund. Link up the brokerage account and start trading.

Even after launching, the hard work probably isn't done. In fact, it could be more difficult. Now you have to manage the fund, continue to market it, and attract new investors in order to expand the business.

Related investing topics

Is it worth it?

Starting a hedge fund is a lot of work. It'll take a lot of your own time and money just to get things set up, and then you have to do the real work of getting others to invest with you and investing their money. The payoff could be substantial, but you could also end up wasting a lot of time and money.

The Motley Fool has a disclosure policy.