How to Build a Hedge Fund

The first hedge fund is usually credited to Alfred Winslow Jones, a Harvard graduate who launched his fund in 1949.

Jones ran it as a general partnership, which kept him clear of the rules that bound mutual funds. In 1952, he reorganized it as a limited partnership and began taking a fifth of the profits. He borrowed to buy some shares and sold others short to soften market swings. That long/short approach to hedging the risk is where the name comes from. It caught on after Carol Loomis profiled him in Fortune in 1966. By the end of the 1960s, others, including Michael Steinhardt and George Soros, had launched their own funds.

Today, there is still no statutory definition of a hedge fund. In practice, the term means a private, actively managed fund sold only to wealthy investors. Because it is sold privately, it skips most of the rules that limit retail funds. The following features stand out:

• Open-ended. Investors can usually subscribe and redeem on a set schedule, not a closed-end fund with a fixed term.
• Liquid instruments. Invests in liquid assets: listed securities, bonds, indices, commodities, and increasingly cryptocurrencies.
• Flexible and higher-risk. Far more flexible, and higher-risk, than mutual funds.
• Leverage. Often borrows money (leverage) to boost returns.
• Two-part fees. Charges a management fee (1–2%) and a performance fee (commonly 15–20%).
• Wealthy investors only. Offered only to wealthy investors; offshore vehicles typically require at least $100,000.
• Regulated on three fronts. Managing the assets, the fund vehicle itself, and offering interests to investors are each regulated, often separately across countries.

They also differ sharply from mutual, venture, and private-equity funds, not just in risk and return, but in how they are built, who can invest, and how investors get their money back.

Across all these vehicles, hedge funds have grown fast: the industry has roughly quadrupled since the 2008 crisis, passing $6 trillion in 2025.

For all the aura of mystique and complexity around hedge funds and the industry, every one is the same handful of parties, tied together by a few contracts and legal entities. Start with the plain-vanilla version below. Tap or hover over any box to see what it is and why it sits there.

There are two standard set-ups: with a separate general-partner entity, and without one (toggle above). In the combined version, a single management company is both the general partner, which puts up the GP commitment and takes the carried interest, and the investment manager, which runs the portfolio for the management fee. Splitting the general partner into its own entity ring-fences that liability and keeps the carry cleanly apart from the fee for tax purposes, which is why larger managers often prefer it.

The base structure above then branches into several more involved set-ups. What drives the choice is almost always tax: the tax status of the key limited partners, how the fund’s portfolio investments are taxed, and where each party is resident for tax (for example, whether the holdings are U.S. securities or foreign ones). Because a large share of the capital usually comes from U.S. investors, the structure a fund adopts is mostly driven by whether U.S. investors sit among its limited partners. That leads to the structures below.

Having mapped the key legal fund structures, let’s turn from how a fund is built to how it is regulated. Regulation falls into three layers: the manager, the fund itself, and the offering of its interests to investors. Each is the subject of one of the next three sections.

Managing a fund’s assets is a regulated activity. In most countries, the management company needs a license, or an exemption, in the jurisdiction where it is set up. Most managers set it up in the United States, and that dominance shows up on two different measures. By the number of the largest firms, the United States is home to 48 of the 66 managers running $10 billion or more, about 73%, according to the leading industry rankings. By share of assets, the U.S. lead is real but narrower; the chart below shows where the world’s hedge fund AUM is actually managed.

In the United States, investment advisers are regulated under the Investment Advisers Act of 1940. For decades, most hedge fund managers fell outside it. A long-standing exemption let an adviser with fewer than 15 clients avoid registration, and because each fund counted as a single client, a manager could run several funds and still qualify. After the 2008 crisis, the Dodd-Frank Act of 2010 repealed that exemption and brought most private fund managers within the Act’s reach, either as registered advisers or under one of a few narrower exemptions.

Today, a manager generally does one of two things. It can register as a Registered Investment Adviser (RIA), with the U.S. Securities and Exchange Commission (SEC) or with a state if it is smaller, and take on a full compliance program. Or it can rely on an exemption and file only a short report as an Exempt Reporting Adviser (ERA).

The key dividing line is $150 million in private fund assets under management: below it, a manager that advises only private funds can usually report as an ERA rather than register. Above it, SEC registration is required. A handful of advisers sit outside both boxes, among them foreign private advisers, family offices, and managers who don’t advise on securities at all.

So almost every U.S. hedge fund manager ends up in one of these two tiers: an ERA while it is small or VC-only, and a full RIA once it crosses $150 million. Registration adds a CCO, a written compliance program, custody, a marketing review, Form PF, and SEC examinations, and often $150,000 to $300,000 a year in cost. These two tiers are not the whole map, though. A manager whose fund trades futures or swaps may also have to register with the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) as a commodity pool operator, and smaller or non-U.S. managers can fit other narrow exemptions.

The management company usually sits close to home, where the principals are based and where the capital comes from. The fund entities are a different story: they are often more varied and can sit across several jurisdictions, chosen to fit the investors and the assets.

The previous section was about regulating the manager. A separate question is whether the fund vehicle itself is regulated as a product, and the answer depends on where the fund is set up, not on where the manager sits.

In the United States, the weight of hedge fund regulation falls on the manager, not the fund. A pooled fund would ordinarily be an “investment company” under the Investment Company Act of 1940 and have to register, but hedge funds are built to fall outside that Act by relying on one of two exclusions:

Fit one of these and the fund is not registered or supervised as a product. There is no U.S. fund regulator licensing the vehicle; what applies instead is the manager’s regulation, set out above, and the rules on offering interests, set out below. One practical footnote: a §3(c)(7) fund still keeps its holders below 2,000 to avoid triggering reporting under the Securities Exchange Act.

Offshore, the picture flips. Once a vehicle is set up in a center such as the Cayman Islands or the British Virgin Islands (BVI), that vehicle is regulated as a fund in its home jurisdiction. It must register with or be recognized by the local regulator, appoint local service providers such as an administrator, auditor, and custodian, and meet economic-substance requirements. That adds a recurring layer of registration and administration cost. It is the price of going offshore, and for a fund raising non-U.S. or U.S. tax-exempt capital it is usually one worth paying.

So the domicile choice is a real decision, made at the level of the fund vehicle and independently of where the manager is regulated. Five offshore centers host most funds, each offering a ladder of fund types from lightly regulated private vehicles to fully authorized retail funds. The Cayman Islands list is below; switch tabs for BVI, Gibraltar, Jersey, and Guernsey.

We have now covered two of the three layers of regulation: the manager and the fund itself. The third and final layer is the offering: how, and from whom, a fund may raise capital.

Bringing an investor into the fund means selling them an interest in it, and that interest is a security. Selling securities is its own regulated activity: almost every country sets rules on who may be offered, how, and with what disclosure.

In the United States, any sale of securities must be registered with the SEC or fit an exemption. Most hedge funds rely on Regulation D, the safe harbor adopted in 1982, which lays out three paths: Rule 504, Rule 506(b) and Rule 506(c). Rule 506(b) is the one most funds use.

In practice, almost every hedge fund offers under Rule 506 and sells only to accredited investors, so the real threshold question is who counts as accredited.

Source: Securities Act of 1933, Rule 501(a) (Regulation D).

The rules so far cover offers to U.S. investors. Most funds raise from abroad as well, and that side carries two separate questions: how the United States treats an offshore sale, and what the law of the investor’s own country requires.

On the U.S. side, the safe harbor is Regulation S. It places offers and sales made outside the United States beyond the reach of the Securities Act’s registration requirements. Two conditions carry it: the sale must be an offshore transaction, meaning no offer is made to a person in the United States and the buyer is outside the United States when it commits, and there must be no directed selling efforts inside the United States, meaning no marketing that conditions the U.S. market. Most funds run Regulation S alongside Regulation D, the onshore vehicle selling to U.S. accredited investors under Rule 506 and the offshore vehicle selling to non-U.S. investors under Regulation S. Interests sold under Regulation S stay restricted, with a compliance period before they can flow back to U.S. persons.

Regulation S only answers the U.S. question. It does not let a fund market wherever it likes. A fund interest is a security, and most developed countries regulate the offer of one under their own private-placement and fund-marketing rules. A fund that takes foreign capital has to clear the law of each jurisdiction where it actually offers, not U.S. law alone.

Europe is the clearest case. Marketing a fund to investors in the EU is governed by the Alternative Investment Fund Managers Directive (AIFMD). A non-EU fund cannot simply approach EU investors: to market actively it must register country by country under each member state’s national private placement regime, meet that regime’s transparency and reporting conditions, and even then usually reach only professional investors, not the retail public.

The usual way around that is reverse solicitation. Where an EU investor approaches the fund on its own initiative, with no prior solicitation from the manager, the contact is not treated as marketing, and neither the AIFMD nor the parallel MiFID II rules on cross-border services apply. It is a narrow, fact-sensitive route: the investor, not the manager, must start the conversation, regulators read it strictly, and the EU’s newer pre-marketing rules have tightened what qualifies. Many offshore funds take European capital this way, but only where the approach is genuinely investor-led, never as a cover for active selling.

Source: Securities Act of 1933, Regulation S (Rules 901–905); AIFM Directive 2011/61/EU; MiFID II.

The structure section shows the parties and the agreements that tie them together. Here are those agreements as actual documents: the core paperwork behind almost any fund, what each one is, and why it has to exist. A registered manager carries a few more than an exempt one, but the spine is the same.

A crypto fund adds a layer on top of this set: a digital-asset custody agreement, SAFT (simple agreement for future tokens) or token side letters, and extra PPM risk disclosures covering smart-contract, fork, slashing, oracle, and bridge risk.

A hedge fund manager makes its money from two fees: a management fee charged on the fund’s assets, and a performance fee charged on its profits.

The management fee covers the cost of running the firm: its people, premises, technology, and compliance. It is charged as a percentage of assets under management and paid throughout the year, whether the fund gains or loses. It sustains the business rather than enriching the manager.

The performance fee is the manager’s real upside: a share of the profits the fund earns, paid only on gains. It is also known as the carry, or carried interest. The name is far older than hedge funds: it is usually traced to medieval Genoese and Venetian merchants, and later ships’ captains, who took a fixed share, traditionally about a fifth, of the profit on the cargo they carried. A modern manager’s share of the profits is the direct descendant of that practice and still carries its name.

For decades, the convention was “two and twenty”: a 2% management fee and a 20% performance fee. It remains the reference point, but the industry has drifted below it. Most funds now charge less on both, and the averages have edged down year after year. The charts show where managers now cluster and how the averages are trending.

Fee compression is the norm, not an absolute. A fund that delivers exceptional returns can still command exceptional fees, and one sits far above the rest.

Two mechanics decide how much of a strong year the manager actually keeps, and both are built to protect investors.

The high-water mark means the performance fee is charged only on new profits. It is the highest value an investment has previously reached; the manager is paid only on gains above it. Consider an investment of $100 that falls to $80 and then recovers to $120. The fee applies to the $20 above the $100 mark, not to the full $40 recovery, so the investor does not pay twice for the same gains.

The hurdle rate is a minimum return the fund must clear before the manager shares in the profit at all; below it, all profit accrues to investors. Funds differ on how the hurdle is measured. Under the gross approach, the performance fee applies to the return above the hurdle before the management fee, so a 12% gross year over an 8% hurdle leaves four percentage points to charge on. Under the net approach, the management fee comes out first: a 12% gross year less a 2% management fee is a 10% net return, so only two points sit above the hurdle. The net approach is the more common, and the more favorable to investors. Only about a quarter of hedge funds use a hurdle at all.

The calculator below shows how a single year’s return is divided between investors and the manager. Adjust the fund’s terms and the annual gross return to see how the split responds, the hurdle included.

A cluster of defined terms governs how investors enter, how the performance fee is struck, and how and when money can leave. The 20 most common are grouped below by what they govern, with the typical market figure noted where there is one.

Every fund works with a handful of outside service providers and signs a separate agreement with each of them.

Reviewing those agreements is a real part of the legal work of launching a fund. The templates almost always come from the provider and are drafted to suit the provider, so each one repays a careful read before it is signed.

Across all of them the same few levers recur: the standard of care, a cap on liability, the indemnities each side gives, and how and when the agreement can be ended.

For most of the last decade, the regulatory line moved in one direction: toward tighter oversight of private funds. Over the past two years, it has reversed. The shift has come from two directions at once: the courts and a change of administration in Washington.

In mid-2024, the Supreme Court reset the ground under every federal regulator. In Loper Bright Enterprises v. Raimondo, it ended Chevron deference. A court no longer defers to an agency’s reading of an ambiguous statute and instead interprets it for itself. A day earlier, in SEC v. Jarkesy, it held that the SEC must bring securities-fraud penalty cases in a federal court before a jury, not before its own in-house judges. Together, the two decisions made the SEC’s rules easier to challenge and its enforcement slower to bring.

Hedge fund managers felt the change almost immediately. In June 2024, the Fifth Circuit vacated the SEC’s Private Fund Adviser Rules in full. That 2023 package would have required quarterly investor statements, an annual audit, and limits on preferential side letters; the court held that the agency had no authority to impose them. Five months later, a Texas court struck down the SEC’s expanded dealer rule, which had threatened to pull actively trading funds into broker-dealer registration. Both fell for the same reason: the SEC had exceeded the authority Congress gave it.

The change of administration pushed in the same direction. Paul Atkins became SEC chair in April 2025 on an openly deregulatory program. The Form PF overhaul, which would have demanded far more data from large hedge fund advisers, has been delayed more than once, now to October 2026. The Commission has said it intends to narrow what it collects. Atkins has also signaled an interest in widening retail access to private funds, revisiting the long-standing limits on who may invest.

Even the formation requirements eased. In March 2025, the Financial Crimes Enforcement Network (FinCEN) rewrote the Corporate Transparency Act’s beneficial-ownership rule to cover only foreign entities, dropping the filing entirely for funds and managers formed in the United States.

The near-term direction is more of the same: lighter federal oversight, fewer new filings, and pressure to open private funds to a broader base of investors. Several developments are worth watching: whether the SEC re-proposes any private-fund rules in a narrower form built to survive the new best-reading standard; whether a clearer framework emerges for crypto funds; and whether the accredited-investor and qualified-purchaser thresholds move. The one safe assumption is that the rules will keep moving. Confirm the current position from the primary sources before relying on it.

That brings the guide to a close. We have gone from what a hedge fund is and where the name began, through how one is structured, regulated, documented, offered, and run. The rules will keep shifting, as this last section shows, but the architecture underneath stays much the same. We hope it has been a useful guide to building a hedge fund.

Disclaimer

This guide is for informational purposes only and does not constitute legal advice. Fund structuring, offshore domicile rules, and the U.S. private-offering and adviser-registration regimes change with legislation and regulator practice; the figures, thresholds, and dates here are current as of the points noted and may shift. For advice on a particular fund, please contact Buzko Krasnov directly.