“Kat’s Meow”

By: Harry M. Kat, The Cass Business School, City University (London) 

David and Ken both work for a large market making firm and both have the same dream: to start their own company. One day, David decides to quit his job and start a traditional market-making company. He puts in $10m of his own money and finds 9 others that are willing to do the same. The result: a company with $100m in equity, divided equally over 10 shareholders, meaning that each shareholder will share equally in the company’s operating costs and P&L. David will manage the company and will receive an annual salary of $1m for doing so.

Ken decides to quit as well. He is going to do things differently though. Instead of packaging his market-making activities in the traditional corporate form, he is going to start a hedge fund. Like David, he also puts in $10m of his own money. Like David, he also finds 9 others willing to do the same. They are not called shareholders, however. They are investors in a hedge fund with a net asset value of $100m. Just like David, Ken has a double function. Apart from being one of the 10 investors in the fund, he will also be the fund’s manager. As manager, he is entitled to 20% of the profit (over a 5% hurdle rate); the average incentive fee in the hedge fund industry.

At first sight, it looks like David and Ken have accomplished the same thing. Both have a market-making operation with $100m in capital and 9 others to share the benefits with. There is, however, one big difference. Suppose David and Ken both made a net $100m. In David’s company this would be shared equally between the shareholders, meaning that, including his salary, David received $11m. In Ken’s hedge fund things are different, however. As the manager of the fund, he takes 20% of the profit, which, taking into account the $5m hurdle, would leave $81m to be divided among the 10 investors. Since he is also one of those 10 investors, however, this means that Ken would pocket a whopping $27.1m in total. Now suppose that both David and Ken lost $100m. In that case David would lose $9m, but Ken would still only lose $10m since as the fund manager Ken gets 20% of the profit, but he does not participate in any losses.

So if you wanted to be a market maker, how would you set yourself up? Of course, we are not the first to think of this. Some of the largest market maker firms in the world disguise themselves as hedge funds these days. Their activities are typically classified under fancy hedge fund names such as ‘statistical arbitrage’ or ‘managed futures’, but basically these funds are market makers. This includes some of the most admired names in the hedge fund business such as D.E. Shaw, Renaissance, Citadel, and AHL, all of which are, not surprisingly, notorious for the sheer size of their daily trading volumes and the relative consistency of their alphas.

The above observation leads to a number of fascinating questions. The most interesting of these is of course how much of the profits of these market-making hedge funds stems from old-fashioned market making and how much is due to truly special insights and skill? Is the bulk of what these funds do very similar to what traditional market-making firms do, or are they responsible for major innovations and/or have they embedded major empirical discoveries in their market making? They tend to employ lots of PhDs and make a lot of fuzz about only hiring the best, etc. However, how much of that is window-dressing and how much is really adding value?

Another question is whether market-making hedge funds get treated differently than traditional market makers when they go out to borrow money or securities. Given prime brokers’ eagerness to service hedge funds these days, one might argue that in this respect market-making hedge funds are again better off then traditional market makers.

So what is the conclusion? First of all, given the returns posted by the funds mentioned, it appears that high volume multi-market market making is a very good business to be in. Second, it looks like there could be a trade-off going on. Market-making hedge funds take a bigger slice of the pie, but the pie might be bigger as well. Obviously, all of this could do with quite a bit more research. See if I can put a PhD on it.

- Harry M. Kat, February 4, 2007

Professor Harry Kat is an occasional contributor to AllAboutAlpha.com.  The opinions expressed herein are those of Professor Kat and not necessarily those of Alpha Male or AllAboutAlpha.com.   

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