Let’s, for a second, assume that you are really awesome at investing, kinda like I am. Every call you make is the right one, like when I bought Research In Motion back a few months ago. Your returns have surpassed the market’s for years now, causing your investments to grow almost as big as your ego. When discussing your investing results with the ladies, they get a little moist in the pants. Why would you want to deprive the world of your investing awesomeness?

Because of your abilities, you want to take your investing career to the next level. Sure, you could go work for a bank or insurance company or something, but that’s for chumps. (Or, if you prefer, chumpettes. See, I’m totally not sexist.) The big bucks are made by hedge funds, especially since managers typically take 2% of the fund’s assets as an annual management fee, PLUS 20% of all profits. It’s a compensation model that’s supposed to encourage positive returns at all costs, hence protecting investors’ capital.

There are other advantages of running a hedge fund over a mutual fund. Hedge funds are under far less scrutiny than mutual funds, since they’re limited to so-called “sophisticated investors.” (Investors with a $1M net worth or $250k annual income) Hedge funds also have the ability to attempt strategies that mutual funds can’t, like taking huge positions in one security or actively betting on the market to go down.

Hedge funds are as varied as the condom aisle of your local drug store. Some try to find undervalued stocks, patiently holding them for a return to glory. Others use leverage to turbocharge small trading profits, over and over again. Some will invest solely in commodities or currencies, while some funds just try to make a profit from the spread between the known price of an acquisition target and that target’s market price – which is commonly referred to as arbitrage. Hell, as I wrote about before, there’s a hedge fund manager who bought 20 million nickels because he figured out the metal content is actually worth 6.8 cents per nickel.

First of all, the reality. The type of people who tend to want to set up a fund like this typically have a similar skill-set. They’re good at analyzing investments, reading balance sheets and trading. People who have those skills are usually pretty bad at something that’s really important for the success of the fund – sales. You constantly need to be searching for your next investor, your next customer. You’ll either need to suck it up and get better at sales or hire someone to do it.

But what about the logistics? What are the actual steps to setting up a hedge fund?

First off, you need to register the fund with your provincial securities regulator, since Canada doesn’t have a national one unlike EVERY OTHER COUNTRY. (Thanks, Quebec) The good news is the rules are pretty much the same for all provinces, excepting the weird French one.

There are two types of hedge funds – they either get sold with a prospectus or without one. A prospectus, for those of you too stupid unaware, is a document that outlines the fund’s investment strategy, the potential risks, etc. If there’s no prospectus, the fund manager gets much more flexibility, since he’s not held back. Most hedge funds in Canada are sold without a prospectus, meaning investment is limited to:

  • investors with either a $1M net worth or $250k income.
  • investors who invest at least $150k in the fund.
  • investors in BC, New Brunswick, Nova Scotia, Newfoundland and Labrador who sign a mandated form and acknowledge the risk they’re taking. They have 2 days to back out of the investment.
That’s not saying investors don’t get any information about the fund before they invest. Of course they do. But the information they get isn’t an actual prospectus approved by the regulator. It’s just something the company prepared.

Next, any portfolio managers of the fund must be registered as advisers, or depend on getting an exemption from the securities regulator. If someone is registered as an adviser, there are certain regulations they must keep up, including record keeping, proficiency, minimum capital requirements, and kissing some serious regulator ass.

Also, and I cannot stress this enough, do NOT send a bribe in with your registration. That’s kind of a no-no.

You have two options for the structure of the fund. It can either be a corporation or a general partnership. (which is also essentially a trust) Both structures will need certain contracts, things like a contract between the fund and it’s principal trader and a contract between the manager of the fund and the fund itself.

A hedge fund also will need to continually submit certain information to regulators, including who invests in their fund, descriptions of what the fund holds, the fund’s financials, etc. You’ll also need to get your books audited by a professional at least once a year. Don’t worry about all this stuff – it’s just the regulator making sure you’re not Bernie Madoffing everybody.

You’ll also need to make sure the broker doing all your trades is a registered dealer as well, but that’s probably the easiest part of this whole deal. I’d imagine every small hedge fund would just use one of the cheap online brokers.

Finally, just how much education must you have to manage the fund? You’ll want to get either a Chartered Investment Manager (CIM) or Chartered Financial Analyst (CFA) certifications. Just about every mutual fund street manager has one of those designations, so it’s a good place to start. I couldn’t find any actual minimum education requirements, so it may certainly be possible for someone to start a fund with less education.

For a super detailed look at the steps needed to set up a hedge fund in Canada, check out AIMA Canada’s guide. It’s massively awesome, and not the least bit boring, assuming you’re into that kind of thing.

That’s about it. Setting one up isn’t the easiest thing in the world, but it certainly isn’t impossible. Finding investors on the other hand? Good luck with that one.

Tell everyone, yo!