Manage peanuts, make peanuts
- 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
- 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.
- 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
Trade peanuts, make peanuts
- 0: USD 10,000
- 1: USD 12,000
- 2: USD 14,400
- 3: USD 17,280
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
- 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.
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!
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.
Manager & investor incentives
- A owns intellectual property that can generate 20% a year
- B has USD 10 MM (unlevered) sitting idle
- Each other, and..
- ..acceptable pay-out function
Which brings us to the “mutually acceptable pay-out function”.
The capital asymmetry
… because it’s important to reflect on WHY this changes A’s game.
- USD 2k on A’s own capital
- PLUS, and only plus whatever B agrees to pay him
- 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)
- 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
- 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.