Drawdown Limits at MMs
Why do MMs care so much about hedging drawdowns? What would happen if they had looser risk limits? What tends to be the standard risk limit for MMs like Citadel / MLP / Baly?
Why do MMs care so much about hedging drawdowns? What would happen if they had looser risk limits? What tends to be the standard risk limit for MMs like Citadel / MLP / Baly?
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Because people are terrible at risk management. So they do the risk management for you
Because the capital allocated to PMs is already levered. If a fund has 10x leverage, a 2% drawdown is 20% loss on capital.
As others have pointed out, leverage. They also aren’t asking you to make 10%, they are looking to combine a bunch of low risk (low drawdowns, vol, etc) strategies with leverage to make a decent return at the overall fund level.
It's about the optionality and the incentives for the PM, which become warped when they are down meaningfully.
Let's say you're a PM, and you have lost money and are down meaningfully. Consider your thoughts:
- This year, your outcome if nothing changes is close to the worst case: a 0 bonus and probably getting fired. Losing more money may moderately increase the odds of getting fired, but you're probably losing your job regardless.
-Thus your risk reward is massively skewed toward trying to take more risk, however you do it. The worst case outcome is already largely locked in, unless you can dig yourself of the hole, so your incentive is to maximize your volatility
So from the risk control perspective:
-No risk control system is really able to monitor every subtle risk a PM might bet on--even a very robust risk control system implicitly relies on PMs not behaving like maniacs and trying to find aggressive bets that aren't caught by a traditional factor/correlation model
-Thus, the right move for the platform is to dial down the available risk budget of the PM to offset their likely-crazier behavior once they're down.
To add to this: It's definitely *not* because of the leverage inherent in a platform structure. Any one PM losing money does not create significant financial risks for the platform. It's a category error to think about any platform PM as having burned up some percentage of their equity.
The problem with this argument (and claiming it isn’t leverage) is that this argument is also true at a 3% loss limit.
If you are down 2% you are going to get 0 bonus, you need to dig yourself out, your standard vol won’t work as you need to take on additional risk for your strategy to get you positive (as you run a low vol strategy with the risk controls) so you take on additional risk (even if equity is cut), worst case you get fired. Firms will cut capital to help mitigate this risk as you call out, but that doesn’t necessarily stop someone from taking large risk. It all has to do with firm survival.
The reason why people say it is leverage is because you cannot do the above if you give people 10% risk limits at 10-1 leverage. You’ll blow out the fund. If you had 3-1 leverage you would probably have different drawdown limits.
You're conflating platform-level leverage with individual PM-level risk limits. The platform is robust to any individual PM losing money in an uncorrelated fashion. If the platform as a whole loses significantly then yes, it has to bring down its exposures to maintain its leverage levels. But that's not going on with the rules around individual PM drawdowns.
Cutting off a given PM because of losses only makes sense if you believe their expected future alpha/return profile has changed because of their losses.
Again, individual PMs don't have a separate pool of equity they can blow through, and individually their potential losses, at any level of leverage, does not challenge the fund's economics.
Remove all drawdown limits and does it really take skills for a PM to make money? Can the MM survive this way? I would say it's a hard "no" to both questions.
Question: why would any L/S equity PM work at Citadel over a Millennium when they have virtually the same drawdown limits (around 5% from my understanding), but Citadel has a vastly more restrictive risk model (at Citadel you have max 15% factor exposure vs. Millennium gives way more flexibility and doesn't have a hard-and-fast rule)? Add the fact that Millennium provides higher pay-outs and lower netting, and I don't see why you'd choose Citadel. I mean I guess is that why you see much more instances of Citadel Analyst/PM going to Millennium than vice versa? For what it's worth I've worked at Citadel and before you mention it, no, MLP is not more "cut-throat" than Citadel and I've seen insanely high turnover at Citadel with PMs/Analysts being let go even before they've worked there for a year (this forum has some flawed notion that Citadel gives more leeway to Analysts/PMs than other platforms).
EDIT - specifying this for L/S fundamental equity where I believe at least at Citadel, 99% of equity teams are on the exact same risk model (DD limit may vary but think its largely the same). Citadel has one,if not the most restrictive risk model - there were times we couldn't even get an idea into the book because it'd push the portfolio above the "15% factor exposure" threshold which is insanely low to begin with.
What are the sets of factors that their risk model looked at, if you don't mind commenting?
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