In this segment of Motley Fool Answers, Alison Southwick, Robert Brokamp, and former hedge fund manager Ron Gross -- who has in fact started one -- discuss what it takes to launch a new hedge fund, and also talk about the fees such funds charge, and the tax implications around those payments.
A full transcript follows the video.
This podcast was recorded on Aug. 30, 2016.
Alison Southwick: So if we wanted to start our own little hedge fund, Bro and I are like...
Ron Gross: OK. I've done that.
Southwick: Yeah, yeah, So, and actually, it's not going to be a small little hedge fund. It's going to be a massive, popular, successful hedge fund. And Bro and I have a ton of money, and we want you to manage it.
Southwick: Do we basically all go in together and we're like, "Here, Ron. You manage our money." And you're like, "OK, I'm going to manage it." And that's it? And then we all live happily ever after?
Gross: Kind of. It's certainly easier to start a hedge fund than it is to start a mutual fund, because hedge funds are very lightly regulated. You need to really only file a form or two with the SEC. If you want to do it right, you write up a private placement memorandum to tell your potential investors what you're going to be investing in and what your strategy is. If your investors think that's interesting, they will write you a check, and you'll deposit it into your brokerage account along with all the other checks. Then the hedge fund manager will start to manage that money on behalf of the partners, taking a nice fee along the way.
Southwick: Yes. Let's talk about the fees, shall we?
Gross: Sure. So hedge funds are notorious for high fees, and theoretically, the performance you'll get is worth those fees, although in reality, it certainly, lately, appears that's not the case. There's two typical fees associated with hedge funds. The first is an annual fee based on assets under management, and that, historically, has been a 2% fee. My first fund was 2%. My second fund was 1%. It's really up to the fund manager what they want to do, and it's up to the investor whether they want to accept that or not. But that's an annual fee.
The more controversial fee is the hedge fund manager gets to take a percent of the annual profits they make for the investors, and that historically has been 20%. Sometimes nowadays you'll see 10. Sometimes you'll see 40 if the person is so good...
Gross: ...that they can command that type of a fee. But that fee is a little bit controversial from a tax perspective, and during election season, you'll hear lots of talk about it, because the fund manager gets favorable tax treatment on that reallocation of gains. You're just taking 20% of your investors' gains, so that's taxed as a capital gain. It's not taxed as ordinary income, so you benefit from that.
People say, "No, no, no, you hedge fund guys. You're making enough money. You should pay taxes the normal way like everybody else." That's constantly a battle. Eventually this will probably be changed, but then the hedge fund guys are smart enough. They'll figure out some other way to kind of skirt around that. But that's the controversial part of the fee.
Southwick: So 20% of the profits. So your hedge fund manager could not even be beating the market.
Southwick: Like if the market is on a tear, and he's not even beating the market, he could still be getting...
Southwick: Twenty percent of...wow.
Gross: Now remember, it's all about what that manager writes into his memorandum to say, "This is how we're going to operate," and you can take it or leave it. Very often, especially in the olden days, you would have a hurdle rate, where the fund manager would say, "I'm not going to take anything until I get 6%," or whatever number he chooses. "After that 6%, I'm going to take 20% of the profits." So sometimes you'll see that. The hurdle rate started to go away kind of in the late, like, around the 2000 area, I feel, early to late 2000s, but you start to see it creep back in, especially as hedge fund performance gets weaker and weaker, and people start saying, "Hey, wait a minute. What am I paying for here?"
Southwick: Yeah, because it sounds like it's very hard for an investor in a hedge fund to make a lot of money, but in theory, you're supposed to make a lot of money. Like, these are supposed to be the smartest guys in...
Gross: And they often are. Performance lately, as I said, wouldn't show you that. But another thing we should mention is that you have to be what's called a sophisticated investor to be able to invest in hedge funds.
Southwick: Is that an official...
Gross: And the technical term for that is "accredited investor," which means you have a net worth of $1 million excluding the value of your home, or you make $200,000 in income. You've done that over the last two years, and you expect that that will continue into the future. So the idea is that these are relatively wealthy people who should be somewhat sophisticated, which is not necessarily the case...
Southwick: Not necessarily true, yeah.
Gross: And should be able to understand what they're getting into. When they read this sometimes very intricate private placement memorandum, they'll be able to understand the strategy, understand what they're getting themselves into, and hopefully that's the case.