4 reasons to not accept other peoples money
OPM – Other People’s Money. A big discussion among strategy developers. There are many out there that are unserious and when you look for “rent a strategy” on the internet, many programmers are willing to sell you very badly programmed strategies. Still, there are many developers out there that are selling valid strategies. The question is – why should a developer rent out of sell a profitable strategies? In this blog post we will have a look from the counter-argument. We will list reasons why a developer should not make a profitable strategy available.
We will ignore in what form other people’s money get involved. Arrangements here vary – from selling signals to trading other people’s accounts to opening a fund of sort. This blog post is about the fundamental disadvantages of accepting other people’s money.
Trading Other People’s Money is less profitable
Quite obviously – trading own funds is best. Whatever the cost of the signal, it will be less than the profit. Whatever the profit share, it will be less than the profit. A developer that accepts external funds of any sort is always giving up part of the profit. General profit splits vary. A good strategy may get 50% of profits, with 50% going to whoever is fronting the money. I have seen developers offering lower percentages, rarely higher. Management fees are not the norm. But as good as 50% sounds – it is still only 50% and a strategy cannot trade an unlimited amount. At one point it will start to move the market. Yes, one can make strategies that scale more – but most developers do not and then at one point relatively early – you end up losing short term trading and have to move to longer time frames. If you trade forex, then you can easily get a tick that is valid for 50 Million USD – but once you must trade a larger volume, you need to do that in multiple order and… start moving the market. Especially when you need to get out fast.
It is one thing to trade your own money. It is another thing to be responsible for possible millions of other people’s money. This is additional pressure that one must be able to handle. Have a bad day? Not only do you stand in front of the mirror wondering what happened – you also have to deal with calls from investors. A dropdown can not only take your account down, you may also have to stand the additional loss of investor funds and all the psychological pressure of that. I know of one fund manager that had to close his small caps US equity fund after a trade stop on a single stock forced in a 30% loss in one day – as his investors withdrew the money. Yes, a drop of 30% like that is bad, but a trader trading his own money may take a week vacation, then return and climb back up. Getting back investor trust is harder. I know one (undercapitalized) trader that collected money from people on an internet forum which started to trust his trading – and then lost most of it by ignoring his risk rules. Why did he do that? Because of the psychological pressure of having to fulfill other people’s expectations. He had accepted other people’s money and did not want to disappoint them. Yes, this was not automated – but even an automated strategy developer may feel the pressure to change risk parameters.
Legal and Compliance Cost and Risk
If you accept other people’s money you are taking on investors. This has a legal risk – and in finance it comes with potentially a lot of paperwork and compliance rules. It comes with a contract. It comes with responsibilities to be able to justify every single trade, or possibly be liable for the losses incurred. While the investor possibly keeps the profits from profitable trades. This is not only psychological pressure – it is a clear legal obligation. Trading own money, trader or strategy developer can do what he wants, without any obligation. Changing a strategy that an investor trades (and that then makes a loss) may require proof of quality control, at least some justification. A paper trail that tells the change had a reason. Risk management that is up on the paperwork. Yes, all this can be automated to a certain degree. But it is a lot of paperwork. Seeking investors? Besides possibly legal approval and validation of every document sent out, there are little items like audits that may have to happen, of contracts that lawyers have to draw up. This means costs, it means less flexibility. A trader accepting other people’s money may at times think he is not free to do what needs to be done.
Taking Other People’s money, finding investors. That is an activity. It means preparing documents. It means talking to people. It means grooming contacts that can then bring in investors. And the day has only 24 hours. And even a strategy developer needs to sleep sometimes. This means that the hours spend hunting other people’s money are taken from trading and development. A proprietary trader cannot trade while he is out meeting investors. A strategy developer has a better setup, because strategies can trade 24/7 without having his full attention, and system administration can be contracted out more easily than discretionary trading. This may mean that trading other people’s money is hurting trading - it is a different business. Yes, a good trader may hire someone to do part of this work – but at what cost? And it goes back to our first point: reducing his net income from the trading capital.
In the end…
Accepting other people’s money comes with a lot of negative side effects. Not all of them are directly related to trading profits, but it is also one major item that a trader accepting investors will give up a part of his profits. At the end, every trader or strategy developer has to decide whether or not it is worth it. While this article has focused on the negative parts, apart 2 and part 3 of this series will focus on the positive aspects and the conclusion we have drawn for ourselves on this topic. This article has shown 4 good reasons not to accept other people’s money.