Introducing Long Tail investing

24 February 2015
Juan Colon

The most re-assuring lesson Darwinex founders have learnt is that traditional investment firms will never “steal” our concept.

Reading would have saved us anxiety: smart innovators actively encourage start-ups to disclose everything… if it’s really an innovation people think you’re nuts!

“Institutional” asset managers seem to agree: when they hear about DARWINs listing independent traders, two objections invariably come up:

  1. Retail traders are a bunch of losers
  2. Ok, even if “a few” win consistently, their strategies don’t scale

Darwinia and the DARWIN Leaderboard tell a story very different from 1.

How about the scalability objection? Does it hold?

Do winning “retail” strategies scale?

As a general rule, no. Most consistent DARWINs don’t scale beyond a couple of million assets under management.

Beyond low Assets under Management (AuM) thresholds, execution slippage eats into most profitable strategies, at speed.

BUT, is that really bad news?

Depends. It is if you’re Wall Street, but we think it’s the best evolution that skilled traders and investors ever dreamt of.

Here’s why.

Long tail, meet financial markets

Large prop traders are in the elephant hunting business. Even uber-traders struggle to come up with more than a handful of strategies, so they focus on those scalable enough to yield millions of absolute P&L. They better find them for trading floors are Darwinian eco-systems: you meet targets until someone else takes your chair.

(Actually, bulge bracket investment banks trade abusing information asymmetry… but for now let’s assume GS did trade on a level playing field with the rest of the market.)

Now, there’s not one but several large prop-trading books competing for large market inefficiencies and this limits their number and size… in a volatility boom, Wall Street employs more traders, who then come up with more strategies to milk more trading profits… until bonanza collapses and bonuses fade.

The Internet & technology rocks this boat. “All of a sudden” (in evolutionary terms), smaller and smaller fry (Tier 2 banks, boutique Hedge Funds,  even inferior “retail” traders!) joined the fray. With weapons ever approaching  the big guys’ (better, cheaper trading technology) they get by on smaller strategies structurally BELOW the Goldman Sachs radar: when trading from home, overheads are not a problem, so small becomes nimble.

Plenty of strategies below Wall Street's radar

Plenty of strategies below Wall Street’s radar

If the Long Tail hypothesis holds, small, non-scalable strategies might not be such a bad thing.

Could this be why more and more managers go independent, creating nimbler hedge funds? And if things really HAVE changed, is change over?

If not, what’s the new stable state? Time will tell. For our part, we’re convinced the Long Tail is whipping financial markets into shape!

The independent trader perspective

Let’s run some numbers.

Making 20% p.a. on 2 million AuM is a LOT easier than on 200 million. There’s plenty of small opportunities for every large one, and you’re competing in a much less congested space. Produce 3 such strategies (as the best DARWIN providers seem capable of), what’s better than getting paid 180.000 EUR a year (3 strategies * 2 MM / strategy * 20% return * 15% success fee) for trading from home?

Sure, 180 K a year is hardly the stuff Ferraris are made of,  but in a global village with 7 BN online brains, there’s plenty of smart ambitious engineers!

Further there’s compound, compound investor leverage. Returning 20% long enough, you eat investors out of your pie and 180.000 EUR become 1.200.000 EUR (3 strategies * 2 MM trader equity * 20% return), by which point it’s GS traders who wonder if non-scalable was really stupid after all!

The savvy investor perspective

Where are you more likely to make a consistent 20%, on an average year?

  1. With a share in a single fund with 5 BN AuM
  2. Co-investing with the managers of 500 consistent DARWINs returning on average 20% on 100 K each

This is where the law of big numbers kicks in. Plus the 500 DARWIN providers are competing for your attention every year, whereas the 5 BN star manager delegated in his management team long ago (how else would he sail the yacht your 2% management fee bought him?).

Who looks vulnerable now?

Small size is a structural advantage in the long tail economy: Wall Street economics can’t engineer profitable strategies at nano-scale.

Who's the better dancer?

Who’s the better dancer?

Any thoughts? Is this really so crazy?