BUSINESS OF TRADING Forex hedge fund .BUSINESS OF TRADING Forex hedge fund management...

BUSINESS OF TRADING Forex hedge fund .BUSINESS OF TRADING Forex hedge fund management Thenumberofhedgefundsandhedgefu
BUSINESS OF TRADING Forex hedge fund .BUSINESS OF TRADING Forex hedge fund management Thenumberofhedgefundsandhedgefu
BUSINESS OF TRADING Forex hedge fund .BUSINESS OF TRADING Forex hedge fund management Thenumberofhedgefundsandhedgefu
BUSINESS OF TRADING Forex hedge fund .BUSINESS OF TRADING Forex hedge fund management Thenumberofhedgefundsandhedgefu
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  • BUSINESS OF TRADING

    Forex hedgefund management

    Thenumberofhedgefundsandhedgefundinvestorshassoared.Forextraderslookingtostarta

    fundneedtounderstandtherulesandregulationsbeforetheyquittheirdayjobs.

    BYHANNAHTERHUNEANDROGERLORENCE

    It's understandable why hedgefunds have become so popularin recent years - from a trad-er's perspective. A talented

    hedge-fund manager can accrue sub-stantial income, and while starting ahedge-fund obviously isn't for thenovice forex trader, it's not as compli-cated as it seems.

    Let's assume a trader has a modest

    $3 million under management and hisforex hedge fund has a I-percent man-agement fee and a 20-percent perform-ance allocation fee (Le., a share of theprofits). Assume the fund was startedon the first day of the year andreturned 15 percent.

    In this case, the trader would havegross income of $120,000,consisting ofa $30,000managementfee($3million*1% = $30,000)and a $90,000perform-ance allocation ($3 million * 15%return = $450,000 * 20% = $90,000).Using all the same assumptions, ahedge-fund manager with $10 millionunder management would make$400,000.

    Also, because prospective investorslike to see fund managers' risk theirpersonal capital, assume the fundmanager has a significant portion ofhis own money invested in the fund.Because there are no fees assessed (itwould just increase taxes), the traderearns an additional 30 percent on hisown investment in the fund.

    However, before a trader can poten-tially enjoy these rewards, he or shemust structure a proper business. Thegood news is forex traders are nowpositioned to quickly launch a forex

    52

    fund with minimal regulatory over-sight.

    Forex fund basics

    Regulation D, Rule 506, of theSecurities Act of 1933 defines a forexfund as an unregistered securityoffered as a private placement.Regulation D provides "safe harbor"provisions which, if complied with,exempt the private offering from com-pliance with the registration andprospectus delivery requirements offederal securities laws. However,Regulation D does not exempt theoffering from compliance with thefraud provisions of the federal andvarious state securities laws.

    forward contracts, and over-the-count-er options in currencies for which thereis also trading in regulatedfutures, allqualify as "Section 1256 contracts."Gains in these instruments are taxed ata maximum federal rate of 23 percent(60 percent of the gains and losses arelong-term and 40 percent is short-term). In addition, the fund usuallyqualifies as a "trader in commodities,"so the investors are able to deduct thefund's expenses more favorably thanexpenses in an investment partner-ship.

    Performance-based compensationfor fund advisers is usually structuredas an allocation of profits, but it issometimes structured as fees - in

    Mostforeigncurrencytradingiseligibleforfavorablefederalincometaxtreatment.

    Forex funds must supply allinvestors with comprehensive infor-mation about the offering in "disclo-sure documents." The purpose of thesedocuments is to limit the hedge fund'spotential risk by providing full disclo-sure to investors.

    A typical set of disclosure docu-ments includes a private placementmemorandum, an investor question-naire and subscription agreement, andan operating agreement for the fund.

    Most foreign currency trading is eli-gible for favorable federal income taxtreatment. Regulated futures contracts,regulated commodity option contracts,

    either event typically between 10 and20 percent of trading profits. In someinstances, the compensation agree-ment specifies that funds be only paidwhen the profits of the fund exceed aminimum rate, or "hurdle rate."

    Exempt lorex fundsTo be exempt from registration underthe Securities Act of 1933,a fund musthave no more than 100beneficial own-ers (also known as the "100 investortest") and must not publicly offer itsinterests.

    Under the Section 3(c)(7)exemption,a fund must offer its securities to

    March 2005 .CURRENCY TRADER

  • "qualified purchasers." There are nolimitations on the number of qualifiedpurchasers under the InvestmentCompany Act of 1940.

    However, when there are more than500 investors in the limited partner-ship, the entity my be subject to classi-fication as a "publicly traded entity."If that occurs, the entity could lose itsflow-through tax treatment (i.e., apartnership) which is one of the pri-mary benefits of the hedge fund'sstructure.

    Accredited vs. non-accreditedinvestorsGenerally, "accredited" investorsincludes persons whose net worth (orjoint net worth with spouse) exceeds$1,000,000,or whose income was inexcess of $200,000in both the two pre-ceding years (or, with a spouse, inexcess of $300,000in both the two pre-ceding years), and who reasonablyexpect to reach the same level ofincome in the current year.

    If you plan to have "non-accreditedinvestors" in your fund, you will notonly need a detailed set of disclosuredocuments, but also audited documen-tation of the source of initial capitalinvested in the fund. This initial auditis referred to as a "launch audit" or asa "seed-capital audit." Regulation Dlimits the number of non-accreditedinvestors to 35.

    Taking on non-accredited investorsis risky because if there are ever anyproblems with the fund's performanceand investors seek relief in the courts,a judge would probably take the sideof the non-accredited investor.

    Howdol~dinvestors?Rule 502(C) of Regulation D prohibitsany form of a general solicitation orgeneral advertising. Generally, inter-ests in your hedge fund may be soldby registered broker dealers, regis-tered investment advisors or officers

    of the fund's management to thosepersons with whom they have exist-ing relationships.

    Your marketing efforts must be per-continuedon p. 54

    CURRENCY TRADER. March 2005

    Steps to launch a lorex hedge fund

    1. If you need to register as a Commodity Pool Operator (CPO), start theprocess, which you will continue while executing the rest of these steps. Seewww.iard.com to get started.

    2. Determine what will make your hedge fund unique. Finalize the fund'sinvestment objective and investment strategies, prepare biographical data onyourself for the offering documents, and make decisions that will affect howoften you accept investors, how you will be compensated, what expensesyour fund (as opposed to the management company) will bear, how you willbe set up regarding trader tax status, etc. I

    3. If you are forming a commodity hedge fund, start the process of becominga member of the NFA. See this page: http://www.nfa.futures.orgJregistra-tion/nfa_membership.asp. You will need to register as a Commodity PoolOperator with the NFA. See http://www.nfa.futures.org/registration/cpo.asp.

    4. Obtain a first draft of your offering documents (Private PlacementI Memorandum, LLC Agreement, and Subscription Materials) from your

    provider(the firm advisingyou on settingup your hedgefund). Formyour Ibusiness entities, get tax ID numbers, make the appropriate IRS elections,and prepare resolutions so you can open bank and brokerage accounts.

    5. Your provider's attorney should be actively involved in the review of yourdocuments. This is an important part of the preparation of your fund.

    6. If you are registered as an Investment Adviser or registered with the NFAas a Commodity Pool Operator, make sure the regulators have approved anysuch applications.

    7. Your provider should give you the SEC Form D and the blue sky filings forI the initial states where you expect to distributeyour offeringdocuments.

    Make sure your provider gives you instructions on how and where to file theI various documents,and general instructionsregardingthe distributionof I

    your offering documents. You should now have a final set of offering docu-ments.

    8. Have your offering documents printed and bound. Consider the image you II wish your fund to project when choosing the printing materials and binding

    method. Remember that you can have no marketing materials other than II your offering documents.

    9. Mail your SEC Form D. You can check here to see that it was processedby the SEC: http://www.sec.gov/edgar/searchedgar/companysearch.html.IFile your blue sky filings within the appropriate time - either before distribu-

    I tion or within 15days of the first sale in that state,dependingon the state'srules.

    10. Start distributing your offering documents and attracting investors. Keep. a log of all individualsto whomyou distributeyourdocuments.Deposityour

    seed capital and start the initial trading of the fund.

    - - - -

    53

  • sonally directed toward investors whoare known to you. The SECviews non-personal communications as "generalsolicitations," even when the targetedrecipients of the communicationscould reasonably be expected to bequalified investors.

    However, it is possible to complywith the prohibitions against generalsolicitation or advertising by using asecure Web page for which access islimited to accredited investors.

    Blue skyWithin 15 days of the first sale of youroffering, you will have to me yourForm D (Notice of Sale) with the SECas well as comply with filing require-ments of the states in which each ofyour investors are located. Then youneed to be sure that your securities aresold with out violating the prohibitionon general advertising.

    NFA registrationIf your forex fund invests in currencyfutures contracts, currency futuresoptions, or forward contracts, it mustbe approved as a commodity pool bythe Commodity Futures TradingCommission (CFfC). In addition, youmust register with the National FuturesAssociation (NFA) and become aCommodity Pool Operator (CPO).

    This raises the differences betweenregistration as a CPO and a commodi-ty-trading advisor (CfA). A CfA man-ages indiv