On scalability

Thoughts on the walk home from the City this morning:

A lot of trading & asset management, in particular the areas with which I’ve been involved, rely on the concept of scalability or capacity.  That is, how many $$ can we put to work in a given strategy?

  1. The main concern in an institutional context is the limited scalability of many types of strategies.  Any strategy with ‘arbitrage’ in the title fits in this context, as do many ‘convergence’ (i.e. purchasing/selling under/overvalued, related assets) strategies.  For example, funds targeting convertible, capital structure, or merger arbitrage have a limited universe of securities to access.  This limits fund size.
  2. The shorter the holding period for strategies, generally the lower the capacity.  This is both due to explicit trading costs and available market liquidity.  For example, latency arbitrage (a common high frequency trading strategy) has very limited capacity from an institutional perspective: one can put $millions to work, but not $billions.
  3. My experience is there’s a negative correlation between capacity and risk-adjusted returns.  While Sharpe ratios of unlimited capacity strategies – such as long-only equities – tend to average around 0.5 (e.g. 7.5% return for 15% annual standard deviation), arbitrage strategies commonly have ratios of 2.0 or above.  Several HFT strategies have Sharpe ratios so high the ratios lose meaning (is a ratio of 25 really that much worse than a ratio of 50?)

From a personal account perspective, scalability takes on a different importance.  In particular:

  1. Many strategies and asset classes are too large for individual investors to access.  For example, a diversified trend-following strategy should really have positions in 20+ futures markets to ensure adequate diversification; otherwise the strategy hinges on too large a proportion of the portfolio trending at the same time.  The lot size for futures markets is such that a reasonable trend-following programme is likely impossible with fewer than $1 million AUM.  Are you deep enough for this to be only a minority of your overall portfolio?  I’m not…
  2. The fixed costs of implementing many strategies is simply too large for small investors to access.  HFT is the most extreme example of this, in my opinion: data feeds, tech expenses, and co-location fees can run into the $millions/year.  That’s a big nut to cover before turning a profit.

What are the lessons?

  1. Hire others to do strategies you can’t.  If you can find HFT groups taking money (they’re basically non-existent), or can invest in trend-following funds (now freely available as mutual/UCITS funds), that’s probably the best/only way to access some diversifying strategies.
  2. Don’t pay others for strategies you can do.  Long-only investing seems to fit here.  Cheap ETFs, please!
  3. Take advantage of lower-capacity strategies which big funds have problems accessing.  I put many options-related strategies here, as market depth & costs are reasonable for an individual investor, but prohibitive for most funds.

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