I was reading parts of the previous thread regarding hedge fund startups. I would just like to raise a question, most specifically targeted at Mr. Bright, regarding his position on people starting hedge funds vs joining prop shops. What's the difference exactly between starting a 40M fund (minimal) with 20% fees, and being given 10M in capital to trade on by a prop shop with 80% profits? Bright seems to say it is never of any use to start hedge funds. Yet, it seems to me that his business model is even more questionnable. On one side, you have hedge funds with usually trusted managers with specific strategies and low agency risk, hence the high capital concentration and the low incentive for extreme performance. On the other side, you have prop shops which provide leverage to untrusted traders with no specific strategies and high agency risk, hence the high diversification and high incentive for a few highly performing traders. In this case, what is the benefit for someone with a reputation and tangible strategies to go in a prop shop? And finally, if someone has no strategies nor reputation, but the potential to make lots of money, why not go for a bank?
Here are a few disadvantages that immediately come to mind, of being with a prop firm as opposed to running a hf, as described in the hypothetical examples given above. - In a prop firm your money is in an llc (which you become a member of). There is always risk involved with this (some here are aware of what happened to the 600 or so Worldco traders when that firm went belly-up, as well as Lyons Group, Harbour, and many more). It is a fact that you can lose some or all of your money in an llc account through no fault of your own. Some firms impose minimum holding periods of your capital, depending on the llc agreement and the capitalization of the firm. - In a prop firm, you must be a registered representative, subject to all that entails, as opposed to trading as a customer. - Depending on the firm, you may not be able to open accounts with the big houses in order to get "calls" in return for giving them business. - As a hedge fund your business is in an entity as opposed to being a sole proprietor (unless your firm admits entities). There are many tax advantages to the former. - Depending on the firm, you may not be happy with the "culture" of the firm or whatever restrictions or requirements in place.
I doubt bright or any prop firm will let you trade your own capital, i.e without 25-100k as a cushion. I have looked myself, and no door is open to trade your own strategy without some money behind you. The other problem is drawdown. There is no strategy without a drawdown, and the cushion needs to support the system through the drawdown, but also support the traders lifestyle. Therefore, you need 25k minimum in my opinion. If someone is willing to support traders with less than 10k u.s, and allows me to trade my strategy, I'll call them monday morning.
An assumption that I have regarding prop shops is that they offer capital funding for otherwise low margin trades. This is good for traders who have scalping strategies and with only 4:1 leverage can make a few cents per trade. However, with currencies - retail firms offer 200:1 leverage. How does trading through a prop shop add value? Does Bright actually give you money to manage and share the risk? Or do props usually just give you leverage and have you carry all the risk? Am I making sense at 2AM with this post? Cheers, Granville
Bright seems to say it is never of any use to start hedge funds. Yet, it seems to me that his business model is even more questionnable. On one side, you have hedge funds with usually trusted managers with specific strategies and low agency risk, hence the high capital concentration and the low incentive for extreme performance. On the other side, you have prop shops which provide leverage to untrusted traders with no specific strategies and high agency risk, hence the high diversification and high incentive for a few highly performing traders. ----------------- Not clear what you mean by agency risk. My understanding of agency risk is the risk borne, for example, by shareholders of a firm where the ceo is the agent. The risk is that the ceo's agenda is not to maximize shareholders' value but rather persue his/her own agenda. Enron is an example. Using the above definition then prop shops incurr little or no agency risk since traders' profit is directly tied to the prop shops' profit. Also traders' accounts are monitored constantly. Account holders of hedge funds have little control over the managers' agenda. Although account holders gets 80% of the profit, they incurr all losses. Thus managers have incentive to take high risk positions since they have only upside potential but not downside risk. LTCM is an example.
You got the definition right for agency risk. However, I do not agree with you on the points you made. IMHO, the likelihood that traders will risk it all is much higher in a prop shop than a conventional hedge fund. As fund managers, prop shoppers do not share (most of) the downside with the principal. However: - Getting into a prop shop requires much less of a reputation than raising capital, thus less to lose; - Prop shoppers, unlike hedge fund managers, do not have specific mandates except for trading a market and making money; - From my experience, account holders have a *lot* of control over the manager's agenda, and if money is lost outside of the manager's mandate, they can sue him. As an agent, the manager has a legal responsability. If the manager is an individual or a partnership, the individual or the partners can be held personnaly responsible; - LTCM is a very exceptionnal case of mass stupidity and blind trust (in the HF world, at least); All those facts, and the fact that it's much easier to join a prop shop than raise funds or join a bank, tell me that good traders will most likely prefer the latter than the former. Hence, prop shops in the long run get stuck with a high rotation of traders that suck. Who pays for that? Don Bright? I don't think so. Much more likely it's the good traders who make the money. It's their 20% on their 10M capital. If a good trader can make a good living with 80% of return on 10M, think of what he could do with 20% of return on 200M.
Well to me the 2% fee and the 20% of profits while risking others money is what the "business" of trading is all about. Please note Bright is a business as well. If you are a great trader pure and simple and you are so good you are not worried about draw down... Well then I guess the question is why split your profits. Just make sure you money is diversified accross multiple firms.
well if one is a great trader and has $100 million, he'd just trade his own capital. business of hedge funds and pro firms exist to extend leverage to those who need it. big difference is that traders at pro firms don't receive mgmt fees. so they had better get 100% without profit split. hf managers make 7 figures just on the mgmt fee, regardless of fund performance. mgr is then paid out % of performance on top of fee. also, for trader at pro firm to have equivalent buying power (and i don't mean daytrading) as decent sized hedge fund, he'd have to personally deposit millions at a pro firm. btw, pro firms are not prop. prop is another area, where leverage is extended out without a capital deposit from trader. payout at prop somewhere in between pro and hedge fund.
The most obvious reason is related to risk. Using the parameters you defined, the hedge fund manager can trade $40 million without using leverage. The prop trader would have to use 4-1 leverage to trade the equivalent of $40 million in capital. All things being equal, the prop trader incurs at least a 300% higher probability of sustaining a catastrophic loss at some point. Leverage = risk.