Beginning the transition to mechanical system trading can be a daunting task. Many beginners feel as if there is no possible way they can match the tremendous results of seasoned hedge fund that have been doing this for decades. Those funds have so much size moving in their favor…….or do they?
Mike at QuantStart takes the exact opposite opinion in his post on this topic:
The capital and regulatory constraints imposed on funds lead to certain predictable behaviours, which are able to be exploited by a retail trader. “Big money” moves the markets, and as such one can dream up many strategies to take advantage of such movements. We will discuss some of these strategies in future articles. At this stage I would like to highlight the comparative advantages enjoyed by the algorithmic trader over many larger funds.
One of the biggest advantages Mike says that retail traders possess is capacity:
- Capacity – A retail trader has greater freedom to play in smaller markets. They can generate significant returns in these spaces, even while institutional funds can’t.
Market impact goes hand-in-hand with capacity:
- Market impact – When playing in highly liquid, non-OTC markets, the low capital base of retail accounts reduces market impact substantially.
Another advantage of retail traders is their risk management:
Crucially, there is no risk management budget imposed on the trader beyond that which they impose themselves, nor is there a compliance or risk management department enforcing oversight. This allows the retail trader to deploy custom or preferred risk modelling methodologies, without the need to follow “industry standards” (an implicit investor requirement).
Mike goes on to list a number of other advantages:
- Compensation structure – In the retail environment the trader is concerned only with absolute return. There are no high-water marks to be met and no capital deployment rules to follow. Retail traders are also able to suffer more volatile equity curves since nobody is watching their performance who might be capable of redeeming capital from their fund.
- Regulations and reporting – Beyond taxation there is little in the way of regulatory reporting constraints for the retail trader. Further, there is no need to provide monthly performance reports or “dress up” a portfolio prior to a client newsletter being sent. This is a big time-saver.
- Benchmark comparison – Funds are not only compared with their peers, but also “industry benchmarks”. For a long-only US equities fund, investors will want to see returns in excess of the S&P500, for example. Retail traders are not enforced in the same way to compare their strategies to a benchmark.
- Performance fees – The downside to running your own portfolio as a retail trader are the lack of management and performance fees enjoyed by the successful quant funds. There is no “2 and 20” to be had at the retail level!
The conclusion that Mike eventually arrives at is probably what you expected. There are tremendous advantages that retail algorithmic traders hold over their larger fund counterparts. It is important that we keep this in mind when we are actually in the trenches building and trading our systems.