Monday, 16 November 2015

David Versus Goliath

Just a quick post today. As most of you know until a couple of years ago I worked for a large systematic hedge fund. Now I manage my own money. I'm doing similar things (systematically trading futures, with a holding period averaging a few weeks, and a variety of trading rules with a trend following bias).

An interesting question, which I'm often asked, is can a little guy like me compete with a giant behemoth of a fund? Should we little guys just give up? After all surely a huge fund has a number of advantages over a one person "business" like mine. Or does it? Let's weigh up the pros and cons of size.

That's me on the right. In a manner of speaking. (

Advantages of big over small

Here are what I see as the key advantages that a large fund has over a small trader (or a small fund for that matter). I've listed them in order of importance - most important first.

Wider set of markets traded

A larger fund can trade a much wider set of instruments; 100 - 300 versus the 40 or so futures markets that I trade. Diversification is the only free lunch in finance, and diversification across instruments rather than trading strategies is much more powerful since the correlations are lower.

I estimate that I should be able to get a sharpe ratio around 30% higher if I could trade 300 instruments rather than 40.

Why can large funds trade more markets? I can think of three reasons:

Higher FUM

The main reason why large funds can invest in more markets is because they are ... large (this is the level of deep intellectual analysis you have come to expect from this blog). If you are a tiny investor with just a few thousand dollars in capital then in the futures trading world at least you're going to trade even a low risk market like the German Shatz future. To trade something like the japanese government bond future, which has a nominal size over a million bucks, you need to have a pretty substantial account size (assuming you don't want it to be a huge chunk of your portfolio risk allocation). 

(I talk about this problem in chapter twelve of my book)

Access to OTC markets

Institutions can trade over the counter markets, whilst retail investors are mostly limited to exchange traded (excluding the wild west of retail FX trading of course). Large funds can afford to employ large numbers of people in back and middle offices who can worry about painful things like ISDA agreements.

Dave's office after he mentioned in passing that he might want to trade Credit Derivatives some day. (gettyimages)

Also they can employ execution traders who understand how to trade the markets, and who can ring brokers and banks and say "Hi I'm calling from NAME OF LARGE FUND and I'd like to trade credit derivatives". Within minutes a team of salespeople will be round your fund salivating at the prospect of being your business partner. If I called brokers and banks I might get lucky and find someone I used to work with to buy me lunch, but I won't get a trading agreement set up any time soon.

Manpower for data cleaning

Even running a systematic, fully automated, fund requires some work. I spend a few minutes each month for every instrument I trade dealing with bad prices and deciding when to roll. If I were to trade a couple of hundred futures, then my workload would be enormous - perhaps a week a month.

With a technical futures system however this workload is still within the scope of an individual trader (as long as they aren't as lazy as I am). However if you were trading long-short equities, with a larger universe of instruments than in futures, and more types of fundamental data, then having more a few more people would be good.

Better execution

For a given size of trade larger funds should get better execution - lower slippage between the mid price and the fill price.

* Clearly large funds will do larger trades - I'll talk about this later in the post.

Large funds can invest in researching smart execution algos, much more sophisticated than the simpler stuff I do. However more importantly they can employ experienced execution traders to execute trades manually. In certain markets these guys will do much better than an algo (of course in certain OTC markets an algo won't be any good anyway, since there are no automated trading mechanisms).

I could execute my own trades manually if I wasn't so idle (and there's no way I'd get up early enough to trade Korea...), but I wouldn't do as good a job as a good execution guy would.

Note that the benefits of smarter execution are more powerful once you are doing larger trades; so all this category does is allow large funds to partially overcome one of their main disadvantages.

Lower commissions

Institutional investors pay lower commissions than retail investors do. This is pure market pricing power being exercised. If I'm trading billions of futures contracts a year I'm going to get a better deal than if I'm trading thousands.

I expect to pay around 30bp of my fund value in commissions; I'd expect to be able to halve that or better if I was a large fund. Adding 15bp to performance isn't going to change the world, but every little helps.

Economics of scale and specialisation

Having more people means you can have specialists. I'm an okay programmer, not a bad trader, I know a bit of economics, and I'm vaguely okay at statistical analysis. I've managed to teach myself the bare minimum of accounting to properly analyse my p&l. The point is I have to do all this stuff myself. I'm not even playing to my strengths; if I had a full time programmer working for me I'd be able to focus on developing better trading rules.

(I'm not moaning by the way, I enjoy dabbling in programming and having full control of the whole process).

However a large fund can hire people to do each of these functions seperately. They can afford to hire top notch programmers, excellent execution traders, super statisticians and brilliant economists; as well as all the other people you need to run an institutional fund.

This will add something to performance, but not a vast amount (except in specialist areas like high frequency trading where the difference between profits and losses is having someone who knows how to build a low latency trading system). It's hard to quantify how much exactly.

Large team of researchers

Related to the previous point most people assume the main advantage of a large fund is that they have a huge team of really smart people refining and developing models. Personally I'm less confident this is the case. I believe that a suite of relatively simple, well known, trading models will get you 95% or more of the performance of a more sophisticated complex set of trading rules (at least at the trading frequency I usually occupy).

So I believe one relatively stupid person (myself) can do almost as well as a team of very smart people. But maybe I'm being stupid.

Advantages of small over big

What is David's sling in this story, or if you prefer what can a small trader do that a large fund can't? Again I've listed these in order of importance, key point first.

More diversified signals

Large funds have investors, often themselves large institutions like pension funds. Large institutional investors buy funds not just because they think they are going to do well, but because they have a certain style such as trend following. To an extent this is rational because it's very hard to predict performance; but putting together a series of funds which are diversified across styles is an excellent way of constructing a portfolio.

What this means in practice is that funds might not be able to make as much in absolute return as they could in theory. If investors want to buy a trend following fund, but the optimal allocation to trend following is only 40%, then the fund will under perform someone who can put 60% into other trading rules even if the set of rules they haven't isn't quite as good.

No fees

If you invest in a fund you have to pay fees. If you invest or trade your own money, they you don't. Depending on how you value the opportunity cost of your own time, and how much time you spend on trading, this may or may not make sense. But it's certainly true that you'll get a higher absolute return from not having to pay fees.

No institutional pressure

The biggest mistake when trading a systematic system is to meddle. As an individual trader it's not easy to avoid meddling, but I usually manage to do so as I can't face the work involved. However I do believe that institutional pressures lead to models changing and frequent overrides.

Lower execution slippage

Smaller traders do smaller trades (for a given average holding period and leverage). If your trading size is always less than what is available at the inside spread then the most you should have to pay is half the spread.

However as I noted above large funds can employ resources to reduce the size of this effect.


I would say that a large fund has the edge, but it's perhaps closer than you might think, and the advantages they have aren't necessarily those you'd expect to be the most important.

As it happens after my first year of trading I was being beaten by my former employer, AHL - a large fund,  with a Sharpe of 4.0 vs my paltry 2.8 (okay it was a good year all round - this is about 3 times the long average SR I'd expect to see!).

So far this year (where both the large funds and myself haven't been doing quite as well) has been closer - and just for fun I'll update this comparision in April 2016.


  1. Would in not make sense to trade at a higher frequency where large funds can't participate due to capacity constraints?

    1. It probably would... except I don't know how to do that. All the analysis I've done points to the fact it is really hard to overcome the transaction costs of trading faster. I don't see any point in trying. Of course there are people out there who seem to be able to do it, but it's not for me.

      Having said that I do trade a little quicker than a large fund, mainly because I trade the 40 more liquid (and hence cheaper) instruments out of the 300 or so of the large fund.

    2. What are the less liquid contracts that a large fund trades? Orange Juice, Lumber, Oats, Rough Rice, what else?

    3. There are a variety of reasons why I don't trade instruments, not just liquidity. Some instruments are too big (JGB). For some the data is too expensive. And of course I'm limited in the number I can trade.

      As it happens I'd trade OJ if I didn't have these constraints and could trade say 100 contracts, but Lumber, oats and rice I wouldn't bother with.

    4. Hi Rob,
      Firstly thankyou so much for your articles. Really informative and probaly some of the best practical information out there. Big fan here!!!
      I have a question, I was thinking of doing a thesis on the carry trade strategy (how to hedge it) and was wondering if you would possibly have the time to do an article on it.
      Many thanks and best,

    5. Hi Rob,
      Firstly thank you so much for your articles!
      They are so informative and practical.
      I was wondering if you could do an article on the carry trade/ co integration strategy (hedged strategy) as I am looking at writing a thesis on it.
      Many thanks and best,

    6. I could an article, but really there isn't much I could put that wouldn't be in the seminal papers like:

      Good luck with your thesis.