How to Make Money in The Market: Providing Liquidity

Since you brought it up - what is your edge?

I am really a liquidity provider of last resort, with occasional forays into macro.

Certainly lots of people can or are willing to provide liquidity in your world, no?

So let me start by saying that I believe that there are only two ways of making money in the mkt. They are:

**A) accurately predicting the future; and B) providing liquidity.**

In the famous words often attributed to Mark Twain, "it's difficult to make predictions, especially about the future". Moreover, it's even harder to make such predictions in the mkt, where you have to not only be right about the future, but also about when this future will be realized. On top of that, you have to make sure that you survive all the mkt fluctuations in the interim. So method a), which is what most people refer to when they talk about "old-school" macro, is really really hard, especially in this day and age. On the other hand, b) is kinda hard, but it's not really that hard.

So, based on the above, my edge is using distortions in the rates mkts (created by large, somewhat price-insensitive flows) to put on trades, which allow me to make bets on the future with favorable risk/reward characteristics. If you're careful and diligent and have some experience in these things, you could construct a "neutral" portfolio that should perform in a majority of future scenarios and, most importantly, will be relatively timing-insensitive. This, I guess, is sorta similar to the basic premise behind a typical long-short equity book. It's the "relative value" element, if you will. Furthermore, if you do feel the urge to actually bet on a particular future outcome and you have a selection of trades to play with, you can also adjust the relative weightings in your portfolio to "skew" it in your preferred direction.

Obviously, this process has certain costs and disadvantages. Specifically, the resulting portfolio is likely to be quite leveraged. It also won't be anywhere as liquid as "old-school" macro, although I personally don't think it's such a big deal.

So this is it, in a nutshell. Hope it helps.

Mod Note (Andy): Top comments - this comment was originally posted in the Q&A "HF PM Q&A"

 

Two questions:

1) Isn't there still some future prediction involved in your "liquidity provider" approach? I'm assuming you're not hedged against every possible market move, so you'd need to decide what your portfolio structure is implicitly tilting towards based on your view of the future

2) I'm assuming your "liquidity provider" strategy involves high transaction costs. How do you manage that and optimize?

 

1) Absolutely and it's a fine balance, undoubtedly. As you say, hedging against every possible outcome is impossible. Furthermore, it becomes impractical to hedge too much well before you cover even a handful of scenarios. So, undoubtedly, you have to take risk. Obviously, as you get more senior and experienced, you become more comfortable with risk and you get to run more of it.

2) Well, transaction costs are undoubtedly a concern, although "high" is a very relative term. Transaction costs are undoubtedly higher than if you were punting extremely liquid instruments. On the other hand, there's a lot more edge. So, again, there's a fine balance that needs to be negotiated and that's a skill that one has to hone over the years.

P.S.: I've just realized how prone I am to using the same word in a paragraph over and over again. It's, undoubtedly, not great.

 

Do they? I mean do they make money? In a risk-adjusted sense?

If I (very briefly) look at the data, I can observe, at best, that systematic strategies broadly produce similar performance to "relative value", but with a lot more volatility (based on arnd 30y of performance history). More recently, looking at the performance of the various systematic strategies post-crisis, the overwhelming majority of them produce a Sharpe ratio of well below 1. The big, famous and (maybe) good ones are able to produce 1 or slightly better. Furthermore, their max drawdown characteristics don't make them look a lot better than the others and that, at least post-crisis, was a big selling point.

So, to put it gently, I just not 100% convinced. Two caveats apply to what I've written above: 1) I am not sure how to look at "trend followers" specifically, so I used data for a broad set of systematic strategies/CTAs. 2) To be fair, the 2008 experience is a meaningful one and argues very strongly in favor of systematic. Every investor should weigh this consideration vs what I've mentioned above and make their judgement.

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