This is the second article in a series where Frank examines the various ways an algorithmic trading business may be founded—and the reasons you might want to explore it.
Creating an algorithmic trading company might give you the legal framework and reputation you need to manage institutional capital or serve high net worth clients. Depending on how the organisation is set up and its goals, starting a business can be expensive and time-consuming. In this post, we give a general review of several trading business structures, along with the advantages and disadvantages of each.
It’s helpful for merchants to assess their temperament and level of attention to detail before shelling out the hefty legal and administrative costs necessary to set up a firm. The best approach to decide on this is through managed accounts, which offer a number of benefits centred on simplicity and minimal running costs.
With the Interactive Brokers (IB) family and friends programme, a trader can get started by managing up to 15 accounts without becoming registered as an investment advisor. This isn’t meant to be a promotion for IB or an infomercial; any programme offered by a broker that is comparable should function just as well.
The IB programme covers data costs as long as a certain number of trades are conducted across accounts each month. Even for a budget broker, commissions are rather minimal. Based on predetermined ratios, orders can be simply distributed around accounts, and the IB trading blotter is sufficient for handling up to 15 accounts. IB manages the accounting in the back office, producing daily account statements, alerts, and annual tax filings. If the trader levies management or performance fees, account billing is handled by IB without the need for additional administrative work. Investor protections forbid traders from adding to or taking money out of customer accounts.
There are certain drawbacks to managed accounts. Margin calls might affect specific accounts, thus the trader must manage risk on an account-by-account basis.
Due to the possibility of partial fills on limit orders, some accounts may not receive a trade allocation. It is the trader’s responsibility to communicate allocation-based account performance disparities to their investors.
A family and friends programme is an excellent approach to establish a reputation without spending significant initial fees. With the broker managing back office activities at a low cost, traders may concentrate on risk management and system refinement. Once a trader has exceeded the 15-account limit, managed accounts remain a feasible alternative, but will necessitate the formation of a business company and registration with regulatory authorities.
If your strategies involve futures, futures options, off-exchange FX, or swaps, forming a Commodity Trading Advisory (CTA) is a reasonably simple and low-cost approach to launch a quant fund. The National Futures Association (NFA) is the self-regulatory organisation in the United States that monitors CTAs, Commodity Pool Operators, and other trader/dealer firms.
If you want to start a CTA, you must be a member of the NFA. Setting up a futures-based CTA will cost around $1000 in NFA registration and membership fees, as well as passing the Series 3 exam and filling out various registration documents and background checks. A $2500 membership fee is required to establish a CTA Forex Firm.
The NFA website provides a comprehensive overview of CTA registration requirements, paperwork, compliance regulations, and publications.
Rather than money from individual and institutional investors, prop fund traders trade the firm’s capital. Typically, the firm is sponsored by a smart individual investor, such as a wealthy retired trader, or it is spun out of a larger investment firm or bank. Proprietary trading units within large banks have mostly vanished as a result of the Volcker Rule, a provision of the Dodd-Frank Act that prevents banks from engaging in proprietary trading in an effort to reduce systemic risk following the failures of Lehman Brothers and Bear Stearns.
Prop firms are asset class agnostic, but typically trade intraday in the most liquid markets, such as equities, ETFs, futures, and foreign exchange. Because prop businesses are not accountable to outside investors, account redemptions during periods of poor performance are not a danger. Prop funds, unlike hedge funds and other institutional investment managers, keep all of their trading earnings.
Setting up a prop fund is pretty simple for a well-capitalized individual. If the fund intends to hire traders, analysts, and operational employees, a corporate structure must be decided upon in collaboration with legal counsel, and compensation policies must be developed. Prop funds have less regulatory duties because no money is managed on behalf of outside investors.
The Hedge Fund
Hedge funds use a diverse set of systematic, discretionary, and hybrid techniques to alpha production, making it impossible to define a “typical” hedge fund. In general, hedge funds, unlike prop funds, prefer to invest rather than trade intraday. Investing in a hedge fund requires developing a macro or microeconomic view or thesis, choosing markets and instruments to implement that outlook, building a position, and then maintaining and managing that position for a period of time, generally days to months.
Hedge funds invest on behalf of wealthy individuals and institutions such as pension funds, insurance companies, and sovereign wealth funds. In contrast to prop funds, hedge funds are more vulnerable to the whims of impatient investors. The hedge fund sector’s well-publicized underperformance over the last three years has resulted in a large fall in AUM and the closure of numerous funds. Hedge funds charge a management fee, and most still receive a tiny portion of profits as a performance fee during periods of outperformance.
Bridgewater Associates and Renaissance Technologies, for example, are becoming increasingly similar to classic institutional asset managers like BlackRock and PIMCO.
Both invest primarily on behalf of institutions, employing conservative strategies with sophisticated risk management over extended time horizons.
Starting a hedge fund is a difficult, time-consuming, and costly endeavour. Scaling a trader’s approach to manage considerably greater AUM involves an altogether new set of issues unrelated to the method itself, assuming the trader has developed a decent track record. Compliance with regulatory reporting duties, liquidity limits, and licencing enterprise level trading, risk, and portfolio management systems are among the issues.
Setting up a tax-advantaged structure adds another layer of complexity, as it is dependent not only on the fund’s geographic location, but also on the investors who are qualified to invest in the fund. Hedge funds also necessitate the appointment of an administrator and auditor, which is not required for a prop or managed account business, in addition to compliance expertise, which is often outsourced during the launch phase but is still a major expenditure.
Creating an incubator hedge fund is a low-cost way for traders to create a marketable track record. While the incubator fund can be converted into a fully operating hedge fund once the trader’s track record convinces early investors to commit funds, an incubator fund can only trade personal capital.
Several firms specialise in assisting traders in the formation of hedge funds; see here and here. A preparatory consultation is highly recommended.
The Family Office
The growth of the family office emphasises the challenge of running a hedge fund successfully in a highly regulated global context. George Soros, the legendary investor, has changed Soros Fund Management from a hedge fund to a family office. Steven Cohen, the creator of the dependably profitable S.A.C. Capital Advisors, shut down the firm after a brutal insider trading probe, then reemerged in 2014 as Point72 Asset Management, another family office structure.
A family office is a hybrid of a prop business and a hedge fund in that it trades only proprietary capital and is essentially immune from regulatory monitoring, while employing primarily long-term tactics. Though a family office can be a terrific place to work for a trader, developer, or analyst, with prospects for mentorship and growth, it is not a structure that a beginning trading firm with minimal money would choose. Rather, it can be a source of capital for a young hedge fund with a solid track record and the potential to sell that record to a family office.
WHAT MAKES YOU WANT TO DO THIS?
Hopefully, this post has served as a warning rather than an encouragement. Making the transition from individual to professional trader is not only costly and time consuming, but it also requires a trader to deal with time-consuming legal and administrative matters that have little to do with designing and applying algorithmic trading methods. Traders must thoroughly investigate and comprehend their motivation for making the leap. The obvious benefit is the potential for significantly bigger returns than could be obtained by managing simply personal finances. Running a successful hedge fund is a possibility for traders with the necessary talents, temperament, and work ethic.