Fund Structure Arbitrage
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.