Since the launch of Darwinex Reloaded, the investors in our platform are receiving a daily bonus in the form of return of execution commission: the new diversification rebates.
So why have we decided to introduce this new incentive for investors? Many will think that we have gone mad, others that it is a dream come true… we hope that with this post you will convince yourselves, as we have, of the advantages that this bonus will have for our trader movement. Below we will present the principal reasons behind the creation of the diversification rebates for the investors.
The trader´s compensation system actually disincentivises the investor to diversify their portfolio. We remember that the performance fees are individually charged above the obtained yield in each DARWIN on an individual basis. This causes situations such as:
If a user has a portfolio with two DARWINS and in a period one DARWIN gains 2,000 € and the other loses 2,000€, the result would have been a net zero. Nevertheless, at the end of the period the investor would pay 400€ in performance fees (= 20% x 2,000€) to the DARWIN that gained 2,000€, despite his portfolio not generating any aggregated gains.
However, from the investor’s point of view, there must be diversification incentives, because this is the only way to protect themselves from unexpected events in the markets (like, for example the “flash-crash” in cable on the 7th October last year, or the huge movement of the Kiwi dollar on 24th August 2016).
Given that the risk manager cannot protect himself from these sudden movements, the diversification of the DARWINS is the only way to moderate the losses in their accounts during unexpected events, making the diversification rebates a form of incentive for the investors to diversify .
The old structure of execution costs was, in a certain way, “unfair” for investors that wanted to diversify their accounts. It was difficult to appreciate, but it was the case that adding DARWINS to the account, the commissions remained but the potential benefit (= account risk) would be reduced.
As an example, we are going to compare two investors that do not have diversification rebates.
Investor 1 : Invests 10,000€ in DARWIN NTI
Investor 2 : Invests 5,000€ in DARWIN NTI and 5,000€ en DARWIN PLF
We have chosen these DARWINS because they rotate their capital more or less the same every month (same commissions). We assume that both generate 0.5% of commissions each month.
The second investor pays 50€ in commissions every month , but his potential returns are less. If we consider that NTI and PLF don´t have correlations between them, the risk of each investment is 7.07% instead of the 10% that investor one has. The second investor , would have had to receive ideally a compensation of 14.65€ for his ratio between commissions and potential return to be the same as the first investor.
Calculation of the rebates:
Our net margin above the investor commission is approximately 40%, so that any potential rebate paid must be less than 40% ( we are not mad). So, well how can they be shared out?
We have found a manner that is transparent, easy and, in time, has a correlation to the diversification that exists in the account.
If we assume the the correlation between the Darwins in the portfolio is zero, the diversification factor is:
Diversification factor = √(∑invi)/∑invi
Being invi the amount invested in each DARWIN
Making the supposition that all the DARWINS generate the same commission , and therefore, that they are dependant on the volume invested in them, we can use the last diversification .
Thus , with a maximum diversification factor of 40%, the rebate would be equal to
Rebate = 0.4*(∑ci-√(∑ci)
Being C¡ the daily commission charged in each DARWIN portfolio.
To mention the efficiency of the diversification rebates we have done a backtest of the rebates that would have been paid to the investors in the past, and we have compared the performance fees charged at source
Rebates / performance fees=74.01%
That is to say, the rebates, without compensating all the performance fees, they do solve a vast majority of the problems that are generated with diversifying the accounts.
Please note this is an average value, the % of each user will vary depending on the skill of the investor when they select the DARWINS in their portfolio.
Related article: Diversification rebates for DARWIN investors