What is the 12 20 80 rule? A practical guide for new managers

What the 12-20-80 rule means when you are learning how to start a hedge fund

A plain-language definition

The 12-20-80 rule is commonly described in practitioner writing as a simple way to split a portfolio into a liquidity buffer, a set of higher-conviction positions, and a broader diversified core. It is usually offered as a starting template, not as a formal or regulatory standard. For background on common position sizing approaches that practitioners adapt into simple heuristics, see Investopedia on position sizing: Investopedia position sizing

Different managers mean different things when they say 12, 20 and 80. Those numbers can refer to percent of net asset value, percent of gross exposure, or percent of a defined risk budget. The choice changes how the figures translate to real dollar limits and trade sizing. A clear definition is the first operational step for anyone figuring out how to start a hedge fund.

Why practitioners use simple numeric heuristics

Practitioners favor short numeric rules because they help communicate allocations to colleagues and investors. A short rule gives a visible starting point for governance discussions and for initial sizing decisions. Documents that collect practitioner guidance show this tendency to use concise templates for discussion rather than fixed policies. For a view of industry reporting and practitioner templates, see the Preqin industry overview: Preqin global hedge fund report and Cambridge Associates insight

When you consider how to start a hedge fund, use simple heuristics as conversation starters. Translate them into documented limits, stress tests and governance steps before they guide live trading. The provenance of the 12-20-80 label appears to be practitioner discourse rather than peer-reviewed literature, so treat the numbers as a draft to be validated.

Why industry guidance does not treat 12-20-80 as a formal standard

What trade bodies and industry reports emphasize instead

Trade bodies and research reports tend to emphasise formal risk budgets, documented concentration limits and liquidity management rather than a single numeric split. These frameworks encourage explicit limits per position and per sector, and require governance for exceptions. AIMA sets out best practices focused on portfolio construction, liquidity and documented policy rather than on a single rule: AIMA best practices

Industry reports also show wide variation in how managers implement simple heuristics. That variation is one reason a single numeric label rarely appears in formal guidance. If you are planning how to start a hedge fund, expect to find diverse implementations and be prepared to explain your own definitions to investors and service providers. See the Preqin report for examples of differing implementations across managers: Preqin global hedge fund report

Regulatory and reporting focus points

Regulators and reporting frameworks look for clear disclosure about liquidity, leverage and concentration. For private funds, Form PF and related guidance emphasise liquidity management and reporting expectations that intersect with any cash buffer policy a manager might adopt. When you document a liquidity target you should be able to show how it supports redemption management and margin requirements. See the SEC guidance on Form PF topics: SEC Form PF guidance and see Deloitte on hedge accounting: Deloitte hedge accounting

Regulatory expectations mean a neat heuristic cannot replace documented policy. Managers should map any simple split to compliance steps, recordkeeping, and reporting templates. That mapping reduces the risk that a heuristic will be misread as a rule for investors or regulators.

The three-part framework behind a 12-20-80 style split

Component 1: liquidity or cash reserve

One common reading of a 12-20-80 split places the first number into a liquidity buffer. This cash or highly liquid instruments bucket is meant to meet redemptions, margin calls or tactical opportunities. Industry guidance recommends explicit liquidity targets and testable assumptions when funds set aside cash or equivalents. AIMA guidance highlights liquidity management as a core component of portfolio construction: AIMA best practices

When you set a liquidity target, be explicit about the instruments allowed, holding period assumptions, and how the buffer interacts with leverage. That clarity matters because a percent of NAV in cash differs mechanically from the same percent of gross exposure. State your holding rules and rebalancing triggers in your policy documents.

Component 2: conviction or tranche positions

The second element often groups higher-conviction ideas into a tranche with larger per-position caps. In a 12-20-80 framing this might be where a manager allows bigger individual position sizes for concentrated bets, while still limiting absolute exposure. Position sizing literature explains how managers trade off concentration and diversification when they decide per-position caps. For accessible background on position sizing, see Investopedia on position sizing: Investopedia position sizing

If you use a conviction tranche, document the criteria that convert an idea into a tranche holding. Typical criteria include signal strength, liquidity of the underlying market, expected holding period and worst-case loss assumptions. These operational rules help governance teams assess overrides and exceptions.

Component 3: diversified core exposure or risk budget

The largest bucket in the simple split is usually a diversified core or broad risk budget. The core holds positions intended to reduce idiosyncratic risk and create a stable exposure profile. Industry practice prefers small per-position limits within this core to manage concentration risk. CFA Institute discussion of risk budgets and concentration suggests measured per-position caps and a formal risk budget approach: CFA Institute portfolio construction

Define whether your percentages apply to NAV, gross exposure, or to a risk budget expressed in volatility or VaR terms. That definitional choice changes trade sizing and reporting. Include scenario testing to show how the core behaves under stressed market moves and how much of the overall risk budget the core consumes.

Position sizing theory and risk budgeting: what the academic and practitioner literature say

Kelly criterion and optimal bet sizing as background

The Kelly criterion and related research provide a theoretical backdrop for thinking about optimal bet sizes and long-run growth trade offs. Kelly-style analysis helps managers understand how expected edge, win probability and volatility interact to determine a mathematically optimal stake, but it does not produce a universal 12-20-80 split to apply across managers. For a technical reference, see the Journal of Portfolio Management article on Kelly and position sizing: Journal of Portfolio Management on Kelly (see advanced ETF trading strategies for a related practical guide on ETFs)

Kelly-based insights are useful when calibrating risk budgets, especially for systematic strategies with measurable edge. Many practitioners prefer conservative fractions of Kelly or alternative utility-based allocations depending on investor preferences, leverage limits and drawdown tolerance.

How position sizing advice differs from a fixed-percentage heuristic

Academic work tends to derive sizing from model assumptions and outcome objectives. Heuristics like 12-20-80 are simpler and designed for communication and quick decision making. Use theory to test and refine any heuristic, rather than to adopt a heuristic as a rule. Investopedia-style position sizing pages give practical rules that managers adapt into simpler templates: Investopedia position sizing. See AnalystPrep on heuristics and asset allocation.

When you are deciding how to start a hedge fund, use theoretical insights as inputs into scenario tests. That will show whether a heuristic is defensible under different market conditions and parameter assumptions.

How to operationalize a 12-20-80 style approach when you start a hedge fund

Practical checklist for governance and documentation

Turn any heuristic into policy by writing clear definitions, limits and approval processes. Your checklist should begin by defining the denominator that the percentages apply to. That definition affects trade sizing, reporting and investor disclosure. AIMA guidance on portfolio construction recommends documented policies and governance for limits: AIMA best practices

Key checklist items include define NAV or gross exposure, set maximum per-position and per-sector caps, list permitted cash instruments, set rolling holding-period assumptions, and specify who can approve overrides. Add required recordkeeping fields and reporting cadence. Consider including training options for staff and governance teams (see short-term certification courses in finance).

Sample internal controls and stress-test steps

Run scenario P&L tests that apply shock moves to the conviction tranche and to the core separately. Show sample outputs to the governance board and keep snapshots in committee minutes. CFA Institute material on risk budgets and concentration provides practical framing for board-level review: CFA Institute portfolio construction

Document override procedures so exceptions are rare and recorded. Include attendee lists for approvals and require pre-specified rebalancing actions after a material override. These steps help ensure that a simple heuristic does not become an undocumented practice that increases concentration or liquidity risk.

Regulatory, reporting and liquidity considerations to document

How liquidity buffers interact with reporting expectations

Regulatory reporting and Form PF expectations focus on how funds manage liquidity and leverage. A stated liquidity buffer should be defensible in terms of how it supports redemption horizons and margin calls. The SEC guidance on Form PF highlights liquidity and leverage considerations that are directly relevant to a cash reserve policy: SEC Form PF guidance

Leverage, transparency and investor protection points

Leverage changes the economics of any split because gross exposures can exceed NAV. Document how leverage amplifies concentration and how margin obligations will be met without breaching your liquidity plan. Industry best practice encourages clear disclosure and conservative interim limits when a strategy is new. See AIMA for recommended governance and documentation practices: AIMA best practices

Clear disclosure of concentration policies and liquidity plans helps align investor expectations and reduces the chance of later disputes. Include concise policy language in offering documents and in regular investor reporting.

Common mistakes and pitfalls to avoid with a 12-20-80 approach

Frequent definitional errors and governance gaps

A common mistake is an unclear denominator, for example saying percentages without saying whether they are of NAV or gross exposure. That gap can produce unintended concentration. Preqin analysis of manager practices shows variation and the need for clear definitions when presenting allocation templates: Preqin global hedge fund report

Another frequent error is treating the numbers as hard limits without guardrails or governance for overrides. Without written procedures, an exception can become a new normal and increase risk. CFA Institute materials stress formal risk budgets and governance for concentration decisions: CFA Institute portfolio construction

Behavioural traps and operational blind spots

Managers can fall into behavioural traps like anchoring to the original heuristic even when market conditions change. Operational blind spots include execution timing that turns intended limits into higher realized exposure and underestimating liquidity of assets. AIMA guidance on portfolio construction and liquidity management highlights the importance of scenario testing and conservative assumptions: AIMA best practices

Mitigate these risks by documenting assumptions, running reverse stress tests and setting conservative interim limits until you have a track record that supports change. Regular reviews reduce the chance that a convenience heuristic becomes a dangerous shortcut.

Practical examples, a short worked approach and final checklist before launch

How to run a simple scenario P&L for a proposed split

Run a few simple scenarios that shock prices and liquidity for your conviction tranche separately from shocks to the core. Use conservative liquidity assumptions for the conviction tranche and model redemption or margin events against the liquidity buffer. AIMA best practices discuss stress testing and scenario analysis as part of portfolio construction: AIMA best practices

Keep the exercise non-prescriptive: the goal is to see whether your draft split produces plausible outcomes under stress and whether governance steps are sufficient to respond to breaches. Record results, decision rationales and required governance signoffs.

Final pre-launch checklist

Final checklist items before launch should include defining the denominator, publishing per-position and per-sector caps, listing permitted cash instruments, running documented stress tests, setting override governance and including concise policy language in investor documents. CFA Institute work on risk budgets and concentration provides a useful structure for board or investor review: CFA Institute portfolio construction

Before you accept capital, validate that your operations, prime brokers and administrators can report on the definitions you will use and that your investors understand the concentration and liquidity policies. Use the checklist to align internal teams and to create clear investor disclosures. See options for setting up accounts before launch: best business bank accounts.

Use the checklist, keep your assumptions transparent, and treat the 12 20 80 framing as a starting point to be validated by risk models and board review.

References

• https://www.investopedia.com/terms/p/position-sizing.asp
• https://www.preqin.com/insights/research/reports/global-hedge-fund-report-2024
• https://www.aima.org/education/research/best-practices-hedge-fund-portfolio-construction-2025.html
• https://www.sec.gov/files/form-pf-guidance-2024.pdf
• https://www.cfainstitute.org/en/research/foundation/2024/hedge-fund-portfolio-construction
• https://jpm.pm-research.com/content/45/6/78
• https://financepolice.com/advanced-etf-trading-strategies/
• https://analystprep.com/study-notes/cfa-level-iii/heuristic-and-other-approaches-to-asset-allocation/
• https://financepolice.com/short-term-certification-courses-in-finance/
• https://financepolice.com/advertise/
• https://dart.deloitte.com/USDART/home/codification/broad-transactions/asc815-10/hedge-accounting/chapter-2-hedge-accounting-requirements/2-5-hedge-effectiveness
• https://www.cambridgeassociates.com/insight/hedge-fund-ing-the-pension-deficit/
• https://financepolice.com/best-business-bank-accounts/