CHAPTER 8
Conclusion: Can Independent Traders Succeed?

Quantitative trading gained notoriety in the summer of 2007 when some enormous hedge funds run by some of the most reputable money managers rung up losses measured in billions in just a few days (though some had recovered by the end of the month). It is déjà vu all over again in January 2021. They brought back bad memories of other notorious hedge fund debacles such as that of Long-Term Capital Management and Amaranth Advisors (both referenced in Chapter 6), except that this time it was not just one trader or one firm, but losses at multiple funds over a short period of time.

And yet, ever since I began my career in the institutional quantitative trading business, I have spoken to many small, independent traders, working in shabby offices or their spare bedrooms, who gain small but steady and growing profits year-in and year-out, quite unlike the stereotypical reckless day traders of the popular imagination. In fact, many independent traders that I know of have not only survived the periods when big funds lost billions, but actually thrived in those times. This has been the central mystery of trading to me for many years: how does an independent trader with insignificant equity and minimal infrastructure trade with a high Sharpe ratio while firms with all-star teams fail spectacularly?

At the beginning of 2006, I left the institutional money management business and struck out on my own to experience this firsthand. I figured that if I could not trade profitably when I was free of all institutional constraints and politics, then either trading is a hoax or I am just not cut out to be a trader. Either way, I promised myself that in such an event I would quit trading forever. Fortunately, I survived. Along the way, I also found the key to that central mystery to which I alluded earlier.

The key, it turns out, is capacity, a concept I introduced at the end of Chapter 2. (To recap: Capacity is the amount of equity a strategy can generate good returns on.) It is far, far easier to generate a high Sharpe ratio trading a $100,000 account than a $100 million account. There are many simple and profitable strategies that can work at the low-capacity end that would be totally unsuitable to hedge funds. This is the niche for independent traders like us.

Let me elaborate on this capacity issue. Most profitable strategies that have low capacities are acting as market makers: providing short-term liquidity when it is needed and taking quick profits when the liquidity need disappears. If, however, you have billions of dollars to manage, you now become the party in need of liquidity, and you have to pay for it. To minimize the cost of this liquidity demand, you necessarily have to hold your positions over long periods of time. When you hold for long periods, your portfolio will be subject to macroeconomic changes (i.e., regime shifts) that can cause great damage to your portfolio. Though you may still be profitable in the long run if your models are sound, you cannot avoid the occasional sharp drawdowns that attract newspaper headlines.

Other disadvantages beset large-capacity strategies favored by large institutions. The intense competition among hedge funds means the strategies become less profitable. The lowered returns, in turn, pressure the fund manager to overleverage. To beat out the competition, traders need to resort to more and more complicated models, which in turn invite data-snooping bias. But despite the increasing complexity of the models, the fundamental market inefficiency that they are trying to exploit may remain the same, and thus their portfolios may still end up holding very similar positions. We discussed this phenomenon in Chapter 6. When market environment changes, a stampede out of similar losing positions can (and did) cause a complete meltdown of the market.

Another reason that independent traders can often succeed when large funds fail is the myriad constraints imposed by management in an institutional setting. For example, as a trader in a quantitative fund, you may be prohibited from trading a long-only strategy, but long-only strategies are often easier to find, simpler, more profitable, and if traded in small sizes, no more risky than market-neutral strategies. Or you may be prohibited from trading futures. You may be required to be not only market neutral but also sector neutral. You may be asked to find a momentum strategy when you know that a mean-reverting strategy would work. And on and on. Many of these constraints are imposed for risk management reasons, but many others may be just whims, quirks, and prejudices of the management. As every student of mathematical optimization knows, any constraint imposed on an optimization problem decreases the optimal objective value. Similarly, every institutional constraint imposed on a trading strategy tends to decrease its returns, if not its Sharpe ratio as well. Finally, some senior managers who oversee frontline portfolio managers of quantitative funds are actually not well versed in quantitative techniques, and they tend to make decisions based on anything but quantitative theories.

When your strategy shows initial profits, these managers may impose enormous pressure for you to scale up quickly, and when your strategy starts to lose, they may force you to liquidate the portfolios and abandon the strategy immediately. None of these interferences in the quantitative investment process is mathematically optimal.

Besides, such managers often have a mercurial temper, which seldom mixes well with quantitative investment management. When loss of money occurs, rationality is often the first victim.

As an independent trader, you are free from such constraints and interferences, and as long as you are emotionally capable of adhering to the discipline of quantitative trading, your trading environment may actually be closer to the optimal than that of a large fund.

Actually, there is one more reason why it is easier for hedge funds to blow up than for individual traders trading their own accounts to do so. When one is trading other people's money, one's upside is almost unlimited, while the downside is simply to get fired. Hence, despite the pro forma adherence to stringent institutional risk management procedures and constraints, one is fundamentally driven to trade strategies that are more risky in an institutional setting, as long as you can sneak past the risk manager. But Mr. Jérôme Kerviel at Société Générale has shown us that this is not at all difficult!

L'Affaire Société Générale cost the bank $7.1 billion and may have indirectly led to an emergency Fed rate cut in the United States. The bank's internal controls failed to discover the rogue trades for three years because Mr. Kerviel has worked in the back office and has gained great familiarity with ways to evade the control procedures (Clark, 2008).

In fact, Mr. Kerviel's deceptive technique is by no means original. When I was working at a large investment bank, there was a pair of proprietary traders who traded quantitatively. They were enclosed in a glass bubble at a corner of the vast trading floor, either because they could not be bothered by the hustle and bustle of the nonquantitative traders or they had to keep their trade secrets, well, secret. As far as I could tell, neither of them ever talked to anyone. Nor, it seemed, did they ever speak to each other.

One day, one of the traders disappeared, never to return. Shortly thereafter, hordes of auditors were searching through his files and computers. It turned out that, just like Mr. Kerviel, this trader had worked in the information technology (IT) department and was quite computer savvy. He managed to manufacture many millions of false profits without anyone's questioning him until, one day, a computer crash somehow stopped his rogue program in its track and exposed his activities. Rumor had it that he disappeared to India and has been enjoying the high life ever since.

So there you have it. I hope I have made a convincing case that independent traders can gain an edge over institutional traders, if trading is conducted with discipline and care. Of course, the side benefits of being independent are numerous, and they begin with freedom. Personally, I am much happier with my work now than I have ever been in my career, despite the inevitable gut-wrenching drawdowns from time to time.

NEXT STEPS

So let's say you have found a few good, simple strategies and are happily trading in your spare bedroom. Where do you go from here? How do you grow?

Actually, I discussed growth in Chapter 6, but in a limited sense. Using the Kelly formula, you can indeed achieve exponential growth of your equity, but only up to the total capacity of your strategies. After that, the source of growth has to come from increasing the number of strategies. You can, for example, look for strategies that trade at higher frequencies than the ones you currently have. To do that, you have to invest and upgrade your technological infrastructure, and purchase expensive high-frequency historical data. Or, conversely, you can look for strategies that hold for longer periods. Despite their typically lower Sharpe ratios, they do enormously improve your capacity. For many of these strategies, you probably have to invest in expensive historical fundamental data for your backtest. If you are an equity trader, you can branch out into futures or currencies. If you run out of ideas or lack expertise in a new market that you want to enter, you can form collaborations with other like-minded traders, or you can hire consultants to help with the research. If you are running too many strategies to manage manually on your own, you can push your automation further so that there is no need for you to manually intervene in the daily trading unless exceptions or problems occur. Of course, you can also hire a trader to monitor all these strategies for you. Finally, if you don't think you have a monopoly of all trading ideas in the universe, and would like to diversify and benefit from trading talent all around the world, hire a subadvisor from the many websites that offer them (e.g., iasg.com, rcmalternatives.com).

These investments in data, infrastructure, and personnel are all part of reinvesting some of your earnings to further the growth of your trading business, not unlike growing any other type of business. When you have reached a point where your capacity is higher than what the Kelly formula suggests you can prudently utilize, it may be time for you to start taking on investors, who will at the very least defray the costs of your infrastructure, if not provide an incentive fee. Alternatively, you might want to take your strategy (and, more importantly, your track record) to one of the larger hedge funds or proprietary trading firms and ask for a profit-sharing contract. In the last couple of years, our own fund at QTS has taken on an increasing number of subadvisors, and overall it has greatly improved the consistency of our returns.

After the major losses at quantitative hedge funds in 2007 and again in 2020 Q1, many people have started to wonder if quantitative trading is viable in the long term. Though the talk of the demise of quantitative strategies appears to be premature at this point, it is still an important question from the perspective of an independent trader. Once you have automated everything and your equity is growing exponentially, can you just sit back, relax, and enjoy your wealth? Unfortunately, experience tells us that strategies do lose their potency over time as more traders catch on to them. It takes ongoing research to supply you with new strategies to overcome this dreaded alpha decay.

Upheavals and major regime changes may occur once every decade or so, and these might cause sudden deaths to certain strategies. As with any commercial endeavor, a period of rapid growth will inevitably be followed by the steady if unspectacular returns of a mature business. As long as financial markets demand instant liquidity, however, there will always be a profitable niche for quantitative trading.

REFERENCES

  1. Clark, Nicola. 2008. “French Bank Says Its Controls Failed for 2 Years.” New York Times, February 21. http://www.nytimes.com/2008/02/21/business/worldbusiness/21bank.html?ex=1361336400&en=cf84f3776a877eac&ei=5124&partner=permalink&exprod=permalink.
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