Long-Tail investment comes full circle

21 November 2017
The Market Owl

Long-Tail Investment comes full circle

Today is a happy day! THA is the first  long-tail investment to come full-circle: Finbou has paused THA to new investment.

Please note that THA‘s pause is:

  • To new investment – it will not be possible to buy THA, but existing investors remain in the DARWIN!
  • Temporary, until we measure marginal slippage with 3.5 MM AuM

THA is the first DARWIN to prove the asset class. Thank you finbou. And thank you investors!

The rest of this blog post outlines:

  • DARWIN divergence
  • Why pause new investment?
  • Average vs. Marginal slippage
  • THA & Long-tail investment strategies
  • Provider / investor alignment
  • The future

DARWIN Divergence

DARWINs replicate their provider strategy with a bit of latency. At the time of writing, the DARWIN replication sequence is:

  1. Provider’s account trades,
  2. Bridge auctions trader volume with LPs
  3. Bridge fills the trader and informs our risk engine
  4. Risk engine routes a block trade for all investors
  5. Execution engine breaks up the investor block in partial legs
  6. Allocation engine computes all legs’ volume weighted average price (VWAP), after the bridge confirms the last leg,
  7. Investors trade at the VWAP price

Which means, investors and traders don’t fill at the same price. Investor performance is:

  • Trader performance: THA’s 526 quote implies 426% performance since inception, at trader fill price
  • Plus/minus divergence

Divergence has two root causes:

  1. Latency: markets move in the time lapse between trader and last investor leg fill. Note that latency need not always penalise investors.
  2. Slippage: The better the DARWIN, the more investor trade size >>> trader size. Unlike latency, slippage always penalises investors.

We’ve explained the above in our youtube Channel – feel free to watch and ask any questions as comments to the video

Why pause new investment in THA?

(The screenshots below are available from THA’s Capacity (Cp) investable attribute assessment. Click the Cp badge on the right hand side of the interface, and scroll your way to the charts.)

The first plots THA 1 year investor performance for  hypothetical slippage scenarios.

Long-tail investment: THA divergence

Long-tail investment: notice average latency and slippage in the side columns

As you gather, the bigger the average investor slippage, the larger investor divergence. 

The full CP assessment estimates potential AuM for THA

The charts above plot:

  1. Max allowed divergence in pips: 0.06 pips yields 0.5% trader vs. investor monthly performance  divergence
  2. Average leverage per trade: THA trades 1.8 * 3.6 MM = 6.3 MM size when hitting the market
  3. Max estimated investment before hitting 0.5% negative monthly divergence

Further, note THA’s AuM grew from:

  • 0 to 1 Million in 226 days
  • 1 to 2 Million in 61 days
  • 2 to 3 Million in 16 days

Average vs. Marginal slippage

If you’re unfamiliar with the difference between average and marginal, google it, or watch this Khan academy video.

Let’s think through average vs. marginal slippage in the context of  THA‘s 3 investors:

  1. The first: For the first USD, slippage is negligible. What difference does it make for Finbou to trade e.g. USD 50.000 or USD 50.001? Initial divergence owes to latency only, and this is possibly random. It moves around the trader fill with amplitude depending on market volatility.
  2. The Average investor: experiences the volume weighted average slippage (VWAS) for all THA investors, starting from the first, ending with the last,
  3. The Marginal investor: experiences whatever slippage results from 3.600.000th USD depleting available market liquidity against him – and all other investors…

Keep adding marginal AuM, and average and marginal investors experience worsening slippage.

However, do average and marginal investor fills worsen at the same rate?

  • Average slippage decays “gradually
  • How does marginal slippage degrade for THA?

Long-tail investment strategies

Finbou described THA as follows:

The Thales core strategy is based on trading high-impact news events, in particular central bank monetary policy announcements. The strategy exploits mispricings in the currency markets, in relation to unexpected policy shifts, unexpected data, or any sort of perceived mispricing related to either one. The competitive edge lies in a unique pre-trade planning process. Every trade precedes a pre-trade plan, which contains in-depth scenario analyses on how the price action could unfold.

Over time, FinbouTHA have mastered high impact news events, where:

  • Volatility maxes out, which is the flip side of
  • Minimal (or very scarce) liquidity,

In such low liquidity environments, the price volume elasticity can approach infinity – and the cost to fill the marginal USD with it. Which is another way of saying that there’s times where there’s just no liquidity left, regardless of what price you pay.

Why does this matter? Because the marginal investor could exponentially slip the average investor into losing.

NB – in the current lead – replica set-up, – this can happen when the trader, and the DARWIN, quote at a profit. This is why “pause and observe the fills” is the prudent thing to do for now.

Provider / investor alignment

The more THA’s AuM grows, the closer it approaches dangerous territory – 10+ USD MM clips in a news event.

Let’s review incentive alignment in this situation:

  • Everyone wants a strategy that made 70% profit at 10% VaR this year – that’s why AuM grow
  • THA‘s existing investors dread marginal investment because their average price subsidises the marginal fill,
  • Darwinex wants the asset class to grow. But there’s a point where marginal dollars are better off in non saturated DARWINs (LVS, QUA, VTJ, anyone?)

How about Finbou? What does Finbou want? Surely more investors backing THA, regardless of price?

Think again.

Finbou‘s incentive is 20% of absolute investor profits. Finbou is better off as long as the marginal USD adds to the absolute profit pot.

BUT: a loss making marginal USD costs Finbou success fees. Finbou also wants THA paused!

So much for the beauty of incentive alignment. No-one wants anyone to lose.

The future

3 years ago, everyone laughed at the prospect at a bunch of “retail” traders beating the market. Most people still do. But you’ve now read this, you know the game has changed.

All that THA need to do to legally make 400k+ USD in 2018 is repeat 2017 performance. THA and others have worked their way out of the “trade pea-nuts, make pea-nuts” problem. The future is ONLY down to them, and this is HUGE progress for independent traders world-wide. 

Long-tail investment is one step closer – and tackling divergence has worked its way up our priority list. What to expect from us?

The core insight is to acknowledge that trading alongside – or close in time to – a consistent winner is a valuable privilege. An additional insight it that pausing a DARWIN for passive investment comes at the expense of active trading opportunities in THA. This temporary binary open/pause construct is inefficient for THA, Darwinex & traders.

That’s why we’re working on:

  • Refining the lead / replica concept, to better align provider, existing and prospective investors. Watch out for webinars on this 🙂
  • Empowering DARWIN
    • Managers with tools to optimise investor execution
    • Investors with information on marginal investment returns
    • Traders with suitable tools 🙂
  • and documenting everything we do better than to date

So, if you have any questions / suggestions, please make them in the comments section! If you don’t thanks for reading this far!

PS: In case you haven’t done yet, we encourage you to read our interview with THA before he was a rock star!