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The Hedge Fund Structure Is Dead

Posted by Leigh Drogen
on November 1st, 2010
This post is for those of you out there looking to start your 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most of us, the stock, forex, and futures traders who go long and short the underlying, the hedge fund structure is
obsolete and Im declaring its death.
Advances in technology, which in hindsight really werent 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, its 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 whove 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.
Only a few years ago when I was a trader/analyst for an investment management firm up in White Plains, NY
named Geller Capital Management, we used two different structures. There was a fund and there were 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 $100,000 and as big 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 doesnt work well if you run a one or two man
shop. So if you were trying to start your own firm this just isnt 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
couldnt give a crap. Thats ok, its 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 dont need a back office, and I sure as hell dont 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
didnt need an expensive lawyer to draw up partnership documents, and I sure as hell dont 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 dont 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 firms own money on the line along
side you clients in the same strategy, whats 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, youre 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 isnt said in
the Interactive Brokers managed account sign up process. The truth is that you dont 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 thats just not the right thing to do, and it could be illegal, I dont know.
Bringing clients into your firm is not a difficult process when you set up the structure the way I have. Heres 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 theres 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 dont 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, its 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 wont cover that here, you will figure it out when you get in there and look around, but basically
its all automated and thats 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, its 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 didnt go wrong, some form wasnt
incorrectly filled out and wayyyy too much or too little was charged, but I havent run into an issue yet. Just be
diligent and look for obvious errors.
The client then funds the account, and thats 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 thats 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
LLCs 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 heres 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. Heres 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 accounts net liquidation value in Apple. The screen that you are looking at is
the aggregate of all of the accounts in that group, its 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 dont 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 couldnt do this before. Each of my clients has his or
her own account and it doesnt cost me anything in terms of effort to trade.
As I said, this only works for certain strategies that arent 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. Its 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 whats in their account at any time by logging in. Yea what a novel concept, a client being able to
see whats in their account. I do not let my clients trade inside the account, but the platform does allow this too,
its their account. The whole thing just makes a lot of sense.
If you are looking to manage money for others 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. Im 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 youre 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.

3 comments

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Rob

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11 months ago

What is the theoretical minimum amount a client would have to fund a new account with?
1
z

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2 months ago

What about commision?

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Joe Harris

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11 months ago

How would you charge an incentive fee with this approach?

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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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