Does My RIA Need Live-Trading Experience? (Part 2)

Today I will continue by tying together a couple other loose ends brought up in this blog mini-series.

In Part 8, I wrote:

> And yet–-the prospect of offering complete transparency
> bothers me somewhat because others may copy it. I will
> be the first to say there is nothing new or unique to
> my trading strategy. The only thing “proprietary” may
> be that I understand it so well. That understanding

Now I realize that my live-trading experience in and of itself is proprietary. A pittance of people worldwide can claim to have the live-trading experience I do and even within the industry, few financial professionals can claim to have it.

As concluded by my last post, however, while live-trading experience gives me an edge with the strategy I employ, live-trading experience in general does not necessarily make for higher performance in an investment adviser (IA). Most IAs are salespeople rather than traders but I have yet to see “live-trading experience” listed as something to look for when shopping for an IA. The claim sounds good and may be a marketing point but ultimately, I believe a lack of supporting evidence renders it less meaningful.

If I can’t sell my trading experience as a proprietary benefit then I’m left to sell the trading strategy. I suspect this is where the slippery slope comes in with regard to marketing. If my sales pitch divulges too many details to one of the few people on Earth with live-trading experience then it could be duplicated. Those qualified to copy my approach would either be financial professionals with extensive trading experience or retail traders with extensive trading experience. Of the latter, though, few seem to offer what I do so the risk of competition is probably small.

What remains as my strongest, marketable edge therefore seems to be the common sense, well-publicized, nonproprietary trading strategy that I apply.

Does any of that make sense?

I’m not sure it does to me.

Does My RIA Need Live-Trading Experience? (Part 1)

The question left on the table from my last post is whether live trading experience provides Edge for clients in the market for an investment adviser (IA).

I definitely see a disconnect in the financial industry because so many IAs (or investment adviser representatives–a legal term) do not actually trade: they just sell products. Whether or not this live trading experience provides superior returns remains an open question, though.

I Googled this and e-mailed one person purporting to be an IA with 15 years of trading experience. He responded:

> I’ve been an active day timeframe trader for more than 16
> years, but that is by no means all I do. In a nutshell, I
> manage everything from a long term investment portfolio,
> to positions running anywhere (in trade duration) from a
> few minutes, to a few days, weeks or even months.
>
> As far as an investment adviser trading for him/herself,
> and, I assume, for clients…that is a very tricky
> proposition. I know there are many readers that follow
> my work that DO in fact manage and trade money for
> outside clients, but I have no clue how their results
> measure. There is simply no way for me to know whether
> an investment adviser with an active style has any sort
> of edge over a typical adviser. Some probably do well,
> while many break-even or simply lose.

I this is an outstanding response. So many things in the financial industry cannot or are not measured. Without measurement, they are simply advertising claims. For what I would do, yes: live trading experience is absolutely necessary. For this reason, I could advertise Edge based on my live trading experience. Does this mean live trading experience in general provides an edge over most IAs who focus on sales?

That’s an answer I do not know and, in agnostic fashion, is an answer I’m not sure I ever can know.

Option Fanatic, RIA (Part 11)

Today I will tie together a couple loose ends from previous posts about the value-added benefit of my trading experience.

In Part 8 I wrote:

> …there is nothing new or unique to my trading strategy.
> The only thing “proprietary” may be that I understand
> it so well. That understanding comes from… my years of
> live trading experience… None of this should be a big
> deal to financial professionals who… do this full-time.

It’s not true that any full-time financial professional can get the live trading experience that I have. As I wrote in Part 5:

> Unlike most representatives of the financial industry
> who do little more than sell products, I actually
> trade. Trading experience gives me knowledge of how
> markets really work: details most “financial advisors”
> don’t [need to] know because they are generally
> specialized salespeople with a glorified title.

I am quite convinced that most financial professionals don’t know much about live trading. Here’s one article detailing potential jobs in the finance industry. If you look closely then you might see the word “trader.” Then again, you might not.

I view this as a significant disconnect in the financial industry. Most clients think they are dealing with the people who can make them money. In fact, they are dealing with salespeople who are limited in knowledge about the precise mechanics by which money is made. Put another way, the salesperson you’re working with may know many details about your personal history and financial needs. The trader who actually handles your money knows nothing about you. Who knew?

I still go back and forth about whether this matters.

I do know that what I would do as an RIA is all about the live trading. Details about working the bid/ask, watching volume and open interest, being cognizant of slippage, implementing limit vs. market orders, how to manage contingent orders, etc., are critical for success. If only for this reason alone, I will not be worried about transparency and the potential for clients to copy and adopt my trading strategy.

Option Fanatic, RIA (Part 10)

Today I continue discussion from the last few posts regarding trade transparency.

My original thought was that seeing option positions in the account was much more transparent than seeing a listing of funds. Mutual funds are not transparent because knowledge of their holdings is only available in retrospect. I therefore cannot replicate those on my own. Furthermore, some institutional funds (e.g. Dimensional Fund Advisers) may only be bought/sold by affiliated investment advisers. The typical client does not even have access to these.

What makes options so “opaque” is the typical ignorance that surrounds them. A typical client might see stocks in an account and be willing to go purchase or sell a stock. I believe the Average Joe/Jane may know a thing or two about stocks (but not enough to actually invest). I think most people know nothing about stock options and many have never even heard of them.

Besides knowing what they are, there is a great deal to know about how to physically trade these vehicles whether they be stocks or options. My concern suggests one could determine a pattern for what positions I get into and out of at different times. That’s just not true. With stocks and options there are criteria used to select which ones to trade (e.g. technical analysis, fundamental analysis). On top of that, much is to be known about what to look for and how to handle order entry to make sure reasonable prices are attained. Without this, any trader can get hosed by the middle man.

Did you know there was a middle man? I’m quite sure that many people do not.

Option Fanatic, RIA (Part 9)

In the last post I talked about my concern with investment transparency as a consequence of clients maintaining control of their funds in personal accounts. What if they figure out my trading and no longer need my services?

I suspect a lot of people hire investment advisers because they simply have no interest in doing it themselves. I think of it as analogous to installing new brakes. A mechanic friend could show me how to do that. I could get the parts from an auto supply store, jack up the wheels, remove the tires, and I’m off! I might get a little greasy but it could save me a few hundred bucks. The problem is I’m just not very mechanically inclined these days. Taking on this task would probably cause more pain, in the form of mental anguish, than money saved.

Besides the lack of interest, another reason clients might not try it themselves is because it’s flat-out dangerous. With the brakes, there’s the risk I might do it wrong. That could pose a danger to me or to others riding in the car. With option trading, mistakes will be made. A beginner needs to start small rather than trying to manage an entire account. If large sums of money hang in the balance then look out below!

For my concern to be realized a situation even worse than the brake installation would have to take place. In the analogy, the mechanic at least shows the other person how to install the brakes. If a client were to copy me then it would be without the “how-to” steps. My job as an investment adviser isn’t to teach people to trade. Lots of fine details go into trade design, trade entry, and trade execution. Whole classes could be done on these topics alone.

I’ll continue with more thoughts on trading transparency in the next post.

Option Fanatic, RIA (Part 8)

In the last post, I discussed some pros and cons to trading others’ accounts in a discretionary manner rather than having direct access to their funds to place in a tradable account that I manage.

I love the idea of not having direct access to clients’ funds. By maintaining control of their own accounts, clients would always be able to see how much money they have. I would not be running a Ponzi scheme or Madoff fraud where I take possession of funds leaving only my word to report investment performance. They would be able to see in real-time, online, how their accounts are doing. They would still get monthly statements from their brokerage–not from me or my company.

And yet–the prospect of offering complete transparency bothers me somewhat because others may copy it. I will be the first to say there is nothing new or unique to my trading strategy. The only thing “proprietary” may be that I understand it so well. That understanding comes from hundreds of hours spent backtesting and through my years of live trading experience. I also understand it through the thousands of hours I have spent to learn and understand options. None of this should be a big deal to financial professionals who also do this full-time.

Maybe I’m letting too much paranoia get to me. My trading strategy will suffer losses. If the losses occur sooner rather than later then clients probably will not be as eager to fire me and do it themselves (they may even choose to quit altogether and find another investment adviser). If the losses occur later rather than sooner then clients may think it simple enough and leave me to try it on their own. This may bite them hard in the rear, though, because when those losses happen they will have no experience with managing them. I strongly believe that in tough market conditions I’m going to do better than someone with little-to-no options trading experience.

I’ll talk a bit more about this transparency in the next post.

Option Fanatic, RIA (Part 7)

Comment [2] from my last post was particularly useful in bringing to light issues in need of legal review.

As mentioned, I love the idea of not having direct access to clients’ funds. Madoff-like frauds and Ponzi schemes succeed because clients give their money to a trustee. Good rapport with the nefarious trustee blocks any thought from investors’ minds about being swindled. Suspicion is held at bay through periodic financial statements from the trustee [or trustee’s business entity] with varying degrees of apparent authenticity.

Quite often when investors get duped, the money isn’t there but they think it is. If they could log into their own brokerage account and see real-time balances then this would never happen. The scary exceptions are brokerages that have gone bust. Those are supposed to be SIPC insured but I have no idea how long it would actually take to recover damages, how much I would end up recovering, etc.

As I’ve mentioned a few times before, remember the asterisk. Allowing clients to keep funds in their own personal accounts will separate me out from many investment advisers.

At the same time, though, I can see one potential problem with doing business this way. Would managing funds in this manner provide complete transparency with how I do my trading? If so then why could any client not watch what I do for a year or two and then fire me as an adviser in order to trade for themselves? Doesn’t any successful business need a moat of some sort to stave off competition? If there were nothing proprietary about a solid profit generator then others would rush in to start doing it themselves.

I’ll discuss this further in the next post.

Option Fanatic, RIA (Part 6)

Today I will continue responding to Internet posts about managing OPM.

       “There is a massive difference between setting up [a] business offering…
       trading services and doing it for a friend… tax and regulation are
       not matters that concern you if it is an informal agreement between you
       and your mate… it is a very simple process, you just need to trust your
       friend to pay up when/if you make him money.” [1]

I interpret this to suggest agreeing to trade money for a friend or family member in exchange for “under the table” payment.

One benefit to this would be forgoing the need to hire an attorney, to verify and maintain compliance, to get registered through FINRA, etc. I could save money in overhead, too.

I worry about liability, however. Emotions may turn sour if money is lost. People who are friends or family today can become vengeful enemies tomorrow. Nobody would think twice if I had official legal documents to sign as part of the investing process. I think they would even feel safer and more protected.

       “Your friend sets up a [brokerage] account. When activated he
       requests a power of attorney form… now [you]… have the power
       to place… trades… money can only go in and out from… [your
       friend’s] bank [account]… agree [on] a [payment plan] and make
       sure your mate understands that there are risks involved. [Your]
       friend can’t sue… as… both signed a legal… agreement for [you]
       to place trades on his behalf… the account holder can withdraw
       money [to pay your fees]… the key issue here is that they are
       friends. They don’t need to set up a hedge fund…” [2]

I love the idea of not having direct access to clients’ funds. I am not setting up a [hedge] fund and I am only looking to trade as many accounts as I can log into individually. While the power of attorney may therefore be part of the arrangement, I still think this could still leave me open to additional liability if I don’t go through legal channels with compliance mandates, registration, and consent forms.

These comments give me very useful content to discuss with a lawyer. I don’t fear clients would sue me because I traded for them. I fear they might sue trying to claim that I was not qualified and/or that they did not understand something.