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Fund Structure Arbitrage

August 28, 2011

An amusing old Nuclear Phynance thread comparing money management styles of Kelly and Soros reminds Quantivity of the perverse incentives which plague the financial services industry—retail investors have nobody with whom their incentives are perfectly aligned; instead, everyone takes a piece. Yet, rather than bemoan this state of affairs, more interesting is to pose the following comparative advantage question:

What advantages do sophisticated tech-savvy quantitative traders, managing their own money (whether retail or prop), have over funds?

Understanding this question naturally leads to the concept of fund structure arbitrage, which refers to potential profit earned by exploiting idiosyncrasies arising from the organizational and regulatory constraints imposed on institutional funds. This concept is important, as many novice traders make the mistake of dreaming up strategies in a vacuum, forgetting that what moves markets is big institutional money—much of which behaves with fairly predictable behavioral and statistical biases. For those who enjoy biological analogies, this is the study of pilot fish.

The following are potential comparative advantages which sophisticated quantitative, tech-savvy traders may possess over many funds (not all, but many), due to these exogenous constraints:

  • Small markets: traders operate on a small capital base, and thus can generate strong percentage returns even in markets which are too small for trading institutional size
  • No herding: traders can generate alpha which is not necessarily correlated with the small handful of “secret” alpha sources which are pervasively deployed by big funds
  • No risk budgets: traders can choose how to measure risk and diversify across strategies, rather than having a budgeting approach imposed on them
  • Minimal market impact: traders can turnover their entire portfolios daily with no appreciable price impact, provided they are in liquid exchange-traded securities
  • Anonymity: traders do not need a big bank counterparty for order flow and credit, and thus can fly under the radar quite effectively
  • Drawdown tolerance: traders are not compensated based upon high watermark or deployed capital, thus have greater flexibility to tolerate more lumpy P&L
  • Factor independence: traders need not rely upon “industry standard” portfolio and risk factor models (e.g. Barra) nor adhere strictly to composition methodologies (e.g. Black-Litterman)
  • No window dressing: traders need not periodically dress their portfolios for client reporting of either monthly performance or portfolio composition
  • Cross-instrument: traders can easily build strategies which cross instruments and markets, as opposed to funds whose organizational silos tend to reinforce pure plays
  • No benchmark: traders need not worry about performance relative to a benchmark, instead can truly focus on generating optimal absolute return
  • Wealth, not portfolio: traders are concerned with asset allocation and money management for their entire wealth, rather than just fitting into a pie slice for FoF portfolio allocation
  • No reporting: traders have little to no regulatory reporting requirements, beyond taxes
  • No legacy: traders can rapidly build and deploy the best technology, not having to be compatible with legacy systems or comply with firm IT policies

Comments on additional comparative advantages are welcome.

Depending on reader interest, subsequent posts may discuss some alpha strategies derived from these advantages.

13 Comments leave one →
  1. Scott Locklin permalink
    August 28, 2011 10:49 pm

    You left out the NP link!
    The numerous low capacity opportunities which are too small to support a prop trading operation is the big one. Freedom to use the right tools is another biggie. Tax arb using IRA legs is another.
    Downside: building your own infrastructure.

  2. August 29, 2011 6:44 am

    That NP thread rings a bell, but I couldn’t find it. I’d definitely be interested in further posts on this topic.

  3. August 29, 2011 7:54 am

    It seems to me like there are at least as many advantages going the other way. Traders inside big banks or funds get access to a lot of expensive tools, a network of knowledgeable people to talk to and discuss ideas with, access to information from client flows, access to bank research, etc.

    A more interesting question would be “which fund structure offers the best mix of advantages and disadvantages?”

    Obviously this would depend on the type of strategy. I find it hard to believe anyone can do high frequency trading inside a retail account, for example. A certain amount of scale is actually necessary for some strategies. Likewise there may also be certain strategies that invest in, say, futures, for which the minimum contract size impinges upon the precise implementation of the strategy in a small account.

    • quantivity permalink*
      August 29, 2011 10:03 pm

      @sheegaon: absolutely agreed–client order flow is the indisputable comparative advantage which banks will always possess (far superior to funds). Certainly the post was not intended to argue traders have superior advantages over funds; on the contrary. That said, traders now possess many more advantages than they did, say, a decade ago–which is worth noting and articulating specifics.

  4. Jon permalink
    August 30, 2011 3:02 pm

    Interesting post. Definitely interested to read more from you about fund structure arbitrage strategies.

  5. August 31, 2011 6:00 pm

    Great post!

    IMO, fund size (and resulting capacity constraints) is probably the most important. You include “small markets”, but I would add “low-capacity strategies” to this (possibly related to market impact, but a little more specific). There are a large number of strategies that don’t make sense to include in a large fund because they have such a small capacity. High-frequency trading is typically done with prop money for this reason. It may be possible to earn very high returns j(e.g. you hear about sharpe ratio’s on the order to 10 or above) on small amounts of capital, but it typically doesn’t make sense to run these kinds of strategies if you manage client money because they will amount to such a small amount of the overall risk.

    Managing money for clients entails certain other incentives that don’t exist in a prop setting. For instance, there is usually pressure to perform well when similar funds perform well (a possible reason that the Tiger funds and Soros got involved in the internet bubble). Also, people are very concerned about downside risk; managing your own money allows you to take more risk there without worrying about redemptions, which can allow for other opportunities.

    • quantivity permalink*
      August 31, 2011 9:51 pm

      @Shane: agreed; thanks for comment, and complement.

  6. September 3, 2011 9:15 am

    Interesting post! can you provide the link to the NP thread?

  7. human mathematics permalink
    September 3, 2011 7:56 pm

    OK, but how do you stay confident in your putatively “lumpy” strategy when it really just looks like you’ve lost a lot of money?

    • quantivity permalink*
      September 3, 2011 8:23 pm

      @human: your comment speaks to numerous fundamental issues. I will cover two briefly here.

      Foremost, drawdown tolerance and strategy robustness are orthogonal considerations, and the former should never motivate imprudence on the latter. For example, consider TIPP-based structured products: given strong drawdown guarantees, suitable strategies will need high kappa (relevance to funds being portfolio insurance via TIPP / CPPI + fund seems to be trendy again). Yet, this would seem to rule out the standard investing strategy practiced by the vast majority of the investing universe (i.e. buy and hold), as proven by numerous recent papers on portfolio insurance mathematical models.

      Second, careful consideration is required to define suitable strategy robustness, outlier detection, along with more qualitative portfolio notions of “confidence”.

      • human mathematics permalink
        September 3, 2011 10:44 pm

        I’d never heard of TIPP/CPPI, but this definition makes it sound like pure BS. I don’t get the kappa connection.

        Does the vast majority really buy and hold? I mean the biggest investors often hold a Product but that’s not the same as Stocks For The Long Run retail style in equities.

        I get what you’re saying otherwise though.


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