Manage peanuts, make peanuts
If you’re not in asset management, MAMMs, EAs, PAMMs, Signals or Hedge Funds mean little to you… But if you are, they’re all derivatives of Archimedes / Galileo’s principle you should only ignore at your peril!
This lesson is a must, and why this post covers:
- The rules of the Asset Management game
- Trade peanuts, make peanuts
- Manager / investor incentives
- The capital asymmetry
- Manager / investor alignment>
- Payout Functions: EAs, PAMMs, Hedge Funds… and DARWINs>
The asset management game
What is it about? Who wins it?
Whoever maximises absolute return on capital, subject to the capital constraint.
- Take whatever starting capital you’ve got
- Maximise it structuring asymmetric payouts (= investment strategies) by entering trades where:
- The odds of winning are better than..
- ..the probability of losing.
In the long run, it’s about the long term probabilities.
At all times you must remember it’s risky. There WILL be bad streaks, so you need enough fat to survive the worst drawdown and this is where it gets difficult. While
- You can’t lose forever..
- ..the more you lose, the less capital levers your wins, the more pressure on you to quit or take on silly trades with excessive risk
So let’s look at an example…
Trade peanuts, make peanuts
Meet A.
A invests with a strategy (= has designed a payout function) that yields 20% on average a year with a maximum drawdown of 10%.
A’s capital progression with 20% annual return off USD 10,000 base is:
- 0: USD 10,000
- 1: USD 12,000
- 2: USD 14,400
- 3: USD 17,280
A makes 20% year after year, which is phenomenal. Yet he only makes USD 2000 in year 1, USD 2400 in year 2 and USD 2880 in year 3…
The reality is that the problem is not his returns are too low – as we said 20% annually is excellent – the problem is the USD 10,000 starting capital!
The moral of the story is that if you trade peanuts, you will only ever make peanuts! But how can A improve his pay-out?
Lever peanuts, LOSE peanuts
Surely A could borrow to lever his payout from 20%. Let’s say he gets 5:1 leverage
- So with his own USD 10k initial capital he is investing $50k.
- If he makes 20% return he’ll earn USD 10k or 100% of his initial capital.
Sounds great, right? But what about the drawdown? Well, if he gets off to a bad start and has a drawdown of 10% he’ll be substantially underwater having lost USD 5k or 50% of his own capital!
So let’s say instead of 5: 1, A goes for 20:1 leverage
- So now, with his own USD 10k initial capital he is investing USD 200k.
- If he makes 20% return he’ll earn USD 40k or 400% of his initial capital!
Fantastic right? Oh wait, the drawdown. Well, a drawdown of 10% at the wrong time and he loses around USD 20k. But he only had USD 10k to start with, so he is one more dead trader!
In summary, with increasing leverage, the pay-out function becomes:
- Either huge upside or..
- ..TOTAL LOSS of capital and importantly credibility!
Further, A is not a risk-neutral robot, so loss aversion will destroy his track-record even faster than leverage.
As you might have imagined, there’s others who’ve figured a way to harvest peanuts… more on brokernomics here.
But enough side-tracking. Is there really no better pay-out than trade peanuts, make peanuts?
Manager & investor incentives
Meet B!
B has USD 10 MM sitting in his bank account, earning a consistent 0% per year. Somehow, A and B meet, and hit upon their mutual win-win opportunity:
- A owns intellectual property that can generate 20% a year
- B has USD 10 MM (unlevered) sitting idle
A’s strategy could lever B’s 10 MM, generating USD 2 MM surplus profits every year.
For this to happen, A & B need,
- Each other, and..
- ..acceptable pay-out function
Which brings us to the “mutually acceptable pay-out function”.
However before we delve into that, let’s look for a minute at how A’s life has changed for the better.
The capital asymmetry
… because it’s important to reflect on WHY this changes A’s game.
B changes A’s game, because with a 20% return, A’s payout becomes:
- USD 2k on A’s own capital
- PLUS, and only plus whatever B agrees to pay him
Because it’s only positive (=asymmetric), PLUS makes ALL the difference. B is A’s asymmetric opportunity to generate EXTRA payout without downside. Think about it like this:
- If the coin comes up heads, A extends his payout through B
- And if it comes up tails, he only loses his own money (B loses money but A is not impacted by this loss)
Let’s compare this to the previous situation where A is levered 20:1 and has a drawdown of 10%:
- 20:1 leverage with drawdown of 10%, A has blown up his account
- A levering B’s capital, with a drawdown of 10% he has only lost $1k of his own money
Manager & investor alignment
Which brings us to the contract between A & B.
How should A structure the capital asymmetry he offers B (and C and D etc.)?
- A signal service
- An EA or Expert Advisor?
- A MAMM?
- A PAMM?
- A Hedge Fund?
Certainly there are some considerations he might want to take into account. After all, he:
- Might fall foul of asset management regulation if he picks the wrong one
- Could have to take out a lot of risk to legally manage B’s money
- Might undervalue himself in rush to pick the short-cut and churn dumb investors
Or he could simply list a DARWIN!
In case you missed it, we provide a detailed overview of A’s options in our “DARWINs vs MAMs, PAMMs, Signals, EAs & Hedge Funds” webinar.