The most important and difficult step to starting a hedge fund is attracting investors.
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Who will you market your hedge fund to? There are many categories of hedge fund investors and their needs vary greatly both between and within categories.
As a hedge fund manager, it is essential to understand your clients' needs and attitudes toward their investments. This article introduces three large categories of hedge fund investors: individuals, endowments & foundations, and pension funds.
This is the largest category of hedge fund investors by far. Security laws limit which individuals could invest in hedge funds. In most cases, individual hedge fund investors tend to have high net worth and/or high income. Small investors, however, are not barred from investing in hedge funds but most hedge funds turn them away for two main reasons: 1) limitations on the number of investors in a hedge fund and 2) compliance and reporting issues.
High net worth individuals tend to be more receptive to newer hedge funds and take more risk. Unlike institutions, wealthy individuals are only responsible for their own money so nobody will sue them when risk taking does not pay off. In general, individuals are attracted by absolute returns, no market correlation, and high returns.
Family offices, which is a group of close associates or family members who choose to invest their money together, might legally register as individuals but behave more like institutions. Offshore individual investors also tend to invest in groups through a foreign bank. Like family offices, offshore individuals tend to have professional guidance when choosing which hedge funds to invest in.
Endowments & Foundations
University endowments are some of the early participants in hedge funds. Endowments tend to invest in hedge funds in order to increase diversification and decrease market correlation instead of seeking excess returns. Endowments tend to have very long investment horizons and tend to favor funds with moderate to low volatility and leverage. Although endowments are not as concerned with short term performance, they are very weary of large, unexpected losses. Endowments enjoy tax benefits that individuals and most institutions do not, making hedge fund investments much more attractive.
Foundations are very much like endowments with a few minor differences. Foundations have long-term investment horizons but slightly shorter than endowments. Foundations are also more concerned with short term performance since investment performance tends to affect a foundation's ability to attract donations.
Pension funds are manages a large pool of capital but are slow to commit to hedge funds. Pension fund managers tend to be risk averse since there is not much upside for a manager who is able to generate excess returns but risk being sued or fired for large losses.
State pension funds tend to allocate a larger percentage of their assets than private pension funds. State pension funds are more likely to invest in fund of funds to increase diversification.