Why some trading strategies only work with smaller capital

Mathematician James Simons founded Renaissance Technologies LLC. Their flagship fund is the Medallion Fund.

Renaissance is atrocious when it comes to charging fees.

As I always say, your cost has a profound impact on your fund's performance. Your compounded returns are variable, but your costs are always incurred before you get your return.

Medallion charges a base fee of 5 per cent a year and their performance fee is 40 per cent.

Over a 30 year period, from 1988 to 2018, these atrocious fees reduced investor's return from 66 per cent a year to a measly 39 per cent a year.

$1,000 in 1988 could have grown to $4 billion. Instead, it only grew to $19.5 million.

That is why I say beware of active fund that charges high fees. Even worse, this fund makes short term bets instead of taking a long view on the markets. They do not buy and hold.

You would not be able to detect what is wrong with my commentary above if you do not have a good baseline on some financial matters. I believe most readers would not be misled because you would recognise that whether the returns are 66 per cent a year, 39 per cent a year or even 20 per cent a year, they were crazily good returns.

WHAT IF SOME STRATEGIES CANNOT WORK IF CAPITAL GETS TOO BIG? 

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There are other things that I picked up on the recent commentary on the book The Man Who Solved the Market. This is a book on James Simons and Renaissance Technologies LLC.

At this point, the Medallion fund is mostly run for its own fund employees. The fund size has been kept at $10 billion. They have been giving back capital to their investors.

Of course, the investors are disgruntled because if you have a fund that performed this well, would you want to exit?

There is also another data point in that at one point the fund was doing very well in the commodities and futures space. But Simons was not satisfied just being successful there.

If they could not find a formula that works in the equity markets, they cannot scale up. And they nearly could not, save for some good fortune, among other things, the discovery of a bug in the system. Had they not discover the bug, how differently might history turned out.

Probably, they could only operate in the commodities trading realm at that size. If they had become bigger, they would have affected the prices themselves.

Medallion fund was deliberately kept to this size because if they were bigger, the model would not work, or not work as well.

Medallion are not the only ones giving back money. Value fund managers like Seth Klarman also gave back investors money. However, in those cases, it is likely due to the lack of investment opportunities that fit their criteria.

There are some strategies that might not be able to scale.

ILLIQUID, SMALL COMPANIES 

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For example, if you are a fundamental investor, you could prospect small companies and find companies that are worth more than their currently traded price.

Large funds could not get into them because they are so illiquid. If they get in, there is not enough liquidity that they will not move the stocks share price themselves.

But if your capital is $20,000 only, you could do it.

FOREX AND FUTURES TRADING 

In a conversation, I was privileged to listen to in the past, I manage to learn a bit of the inner struggles of some traders, trading for a long time, trying to do it consistently.

My friend and his acquaintance came to the conclusion that for a lot of strategies, there is a certain size which your strategy could still be valid.

If your trade size gets too big, somehow, your trade would "disturb" the markets.

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So usually, what they would do is that they will start from a certain trade size, build a process and do it consistently. They will scale up the trade size up to a certain limit.

Once they build up their capital to a certain size, say, $300,000, they would take the money off the table and start off again with a small initial capital.

Rinse and repeat.

In trading your returns can be really impressive, but it is a matter of money management and risk management. The strategy entails enough unsuccessful trades that you lose but in controlled amounts.

It would seem that you cannot compound your money in the way we know it.

The strategies are meant for individual traders with their own small capital size. If they are good and they start a fund to help third party manage their wealth, and trade for them, they might realise their existing strategy do not work.

THIS IS WHERE PROPERTY AND BONDS COME IN 

In the past, I have always wonder why if a strategy is so robust, why won't the trader or investor put 100 per cent of their allocation into it?

Surely if your strategy gives you 20 per cent a year return as what you have touted, you should just concentrate your capital in one strategy.

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Unless that strategy has certain flaws that are seldom discussed, unwilling to be discussed. These flaws are large enough that even expert traders need to diversify across strategies.

It would seem that the popular one are individual bonds and investment property.

The total return from these 2 asset classes is comparatively very low compared to these trader's strategy.

So why are they the favourite amongst traders?

They are seeking a barbell approach to investment management. Due to the high risk, they take with their trading strategies, the majority of their wealth are in lower returns, but much lower volatile, predictable, seemingly safe assets

Perhaps this ceiling of trading strategies means it would be more lucrative to teach folks how to do it, then they did it themselves.

Some wealth-building strategies may have a ceiling. Sounds good on paper but given different circumstances (read a high net worth investor with $10 million in investable assets), their mileage may vary.

This article was first published in Investment Moats. All content is displayed for general information purposes only and does not constitute professional financial advice.