This is the second in a series of posts written by Frank Smietana, an expert guest contributor to QuantStart. In this detailed post Frank takes a look at the different ways in which an algorithmic trading business can be established—and why you might want to consider it.
- Mike.

Setting up an algorithmic trading business can provide the requisite credibility and legal structure to manage institutional funds or cater to high net worth investors. The cost and effort to establish a business can be significant, depending on how the organization is structured and what the objectives are. In this article, we provide an overview of various trading business structures, their benefits and drawbacks.

Managed accounts

Before incurring the significant legal and administrative fees required to set up a business, it's useful for traders to determine whether they have the temperament and attention to detail required to run a business. Managed accounts provide an ideal way to make this determination, and offer several advantages, centered on simplicity and low operating costs.

One way to get started is with the Interactive Brokers (IB) family and friends program, enabling a trader to manage up to 15 accounts without having to register as an investment advisor. This is not meant as an endorsement or infomercial for IB, any similar broker-sponsored program should work equally well. With the IB program, data costs are waived so long as a pre-defined number of monthly trades are executed across accounts. Commissions are quite low, even for a discount broker. Orders can easily be allocated across accounts based on specified ratios, and the IB trade blotter is adequate for managing up to 15 accounts. IB handles the back office accounting, generating daily account statements, notifications and annual tax forms. If the trader charges management or performance fees, IB handles account billing without any administrative overhead. Investor safeguards prohibit traders from depositing or withdrawing funds from client accounts.

Some drawbacks to managed accounts exist. Individual accounts are subject to margin calls, so risk must be managed on a per-account basis by the trader. Partial fills on limit orders can occur, so some accounts may not receive a trade allocation. It falls on the trader to explain allocation-based account performance differences to their investors.

A family and friends program is an ideal way to build a track record without incurring huge startup costs. With the broker handling back office functions at minimal cost, traders can focus on risk control and refining their systems. Once a trader has outgrown the 15 account limitation, managed accounts are still a very viable option, but will involve establishing a corporate entity and registration with regulatory authorities.

CTA

If your strategies utilize futures, futures options, off-exchange FX, or swaps, then establishing a Commodity Trading Advisory (CTA) is a relatively simple and low cost way to establish a quant fund. In the U.S., the National Futures Association (NFA) is the self-regulatory organization that oversees CTAs, Commodity Pool Operators and several other trader/dealer entities.

If you plan to establish a CTA, then an NFA membership is mandatory. Establishing a futures-based CTA will cost roughly $1000 in NFA registration and membership fees, and requires passing the Series 3 exam and completing various registration forms and background checks. Establishing a CTA Forex Firm requires a $2500 membership fee.

The NFA website provides a detailed overview of registration requirements, forms, compliance policies, and publications to help establish a CTA.

Prop Fund

Traders at prop funds trade the firm's capital, rather than money from retail and institutional investors. Typically, the firm has been funded by a sophisticated individual investor, perhaps a successful retired trader, or spun out of an existing investment firm or bank. Proprietary trading departments within large banks have largely disappeared due to the Volcker Rule, part of the Dodd-Frank Act that prohibits banks from proprietary trading in an attempt to lower systemic risk after the collapse of Lehman Brothers and Bear Stearns.

Prop firms are asset class agnostic, but typically trade in the most liquid markets intraday, including equities, ETFs, futures and FX. Since prop firms are not beholden to outside investors, they aren't threatened by account redemptions during periods of lackluster performance. Unlike hedge funds and other institutional investment managers, prop funds retain 100% of their trading profits.

For a well-capitalized individual, setting up a prop fund is relatively straightforward. A corporate structure must be agreed in consultation with legal counsel, and compensation policies must be drawn up if the fund intends to employ traders, analysts and operations staff. Since no money is managed on behalf of outside investors, prop funds have little in the way of regulatory obligations.

Hedge Fund

Collectively, hedge funds deploy a broad range of systematic, discretionary, and hybrid approaches to alpha generation, making it difficult to speak of a “typical” hedge fund. In general, hedge funds tend to engage in investing, rather than intraday trading like prop funds. In a hedge fund context, investing entails the development of a macro or micro economic outlook or thesis, identifying the markets and instruments to implement that outlook, establishing a position, and then holding and managing that position for some period of time, typically days to months.

Hedge funds invest on behalf of high net worth individuals and institutions, including pensions, insurers, and sovereign wealth funds. Unlike prop funds, hedge funds are quite exposed to the whims of impatient investors. The well-publicized underperformance of the hedge fund sector over the last three years has led to a significant decrease in AUM, and the shuttering of many funds. Hedge funds charge a management fee, and most still get a small share of profits in the form of a performance fee during periods of outperformance.

The largest hedge funds such as Bridgewater Associates and Renaissance Technologies are increasingly indistinguishable from traditional institutional asset managers such as BlackRock and PIMCO. Both invest largely on behalf of institutions, deploying conservative strategies over long term time horizons with sophisticated risk management.

Starting a hedge fund is difficult, time consuming, and expensive. Assuming a trader has established a reasonable track record, scaling that strategy to handle significantly larger AUM introduces an entirely new set of challenges unrelated to the strategy itself. These challenges include compliance with regulatory reporting obligations, liquidity constraints, and licensing enterprise level trading, risk and portfolio management solutions.

Setting up a tax-advantaged structure introduces still more complexity, and depends not only on the fund's geographic location but also that of the investors eligible to invest in the fund. Hedge funds also require hiring an administrator and auditor, additional overhead not necessary for a prop or managed account business, in addition to compliance expertise, which is typically outsourced in the startup phase, but a significant cost nonetheless.

For traders needing to establish a marketable track record, creating an incubator hedge fund is a low cost approach. While the incubator can be converted into a fully operational hedge fund once the trader's track record convinces initial investors to commit funds, only personal capital can be traded in an incubator fund.

Several firms specialize in helping traders launch hedge funds, see here and here. A preliminary consultation is well advised.

Family Office

The rise of the family office underscores the difficulty of successfully managing a hedge fund in a highly regulated global environment. Legendary investor George Soros has converted Soros Fund Management from a hedge fund into a family office. Steven Cohen, founder of consistently profitable S.A.C. Capital Advisors shuttered the firm following a bruising insider trading investigation, then reemerged in 2014 as Point72 Asset Management, also structured as a family office.

A family office is a combination of prop firm and hedge fund, in that it trades only proprietary capital and is largely exempt from regulatory oversight, while deploying mostly long term strategies like a hedge fund. Though a family office can certainly be a great place for a trader, developer or analyst to work, with opportunities for mentorship and advancement, it's not a structure utilized by a startup trading firm with limited capital. Rather, it can be a source of allocations for a fledgling hedge fund with a promising track record and an ability to market that record to a family office.

WHY do you want to do this?

Hopefully this article has proven more cautionary than encouraging. Making the leap from individual to professional trader is not only costly and time consuming, it forces a trader to deal with arduous legal and administrative details that have little to do with developing and deploying algorithmic trading strategies. Traders really need to examine and understand their motivation for making the leap. The obvious reward is the possibility of earning far greater profits than could be achieved managing only personal funds. For traders with the appropriate skills, temperament and work ethic, running a successful hedge fund can become a reality.