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6.2.2. Distribution and Marketing Channels
Unless the product team works at a proprietary trading firm, they will need to raise
investment capital in order generate sufficient fee income to operate the system continu-
ously. Costs associated with designing and developing new trading systems are very high.
Gone are the days of placing $50,000 in a trading account, leasing a seat on a trading
floor, and becoming a millionaire. Today, management expenses for servers, high-speed
leased lines, back office accounting software, personnel, and data alone can easily exceed
$500,000 annually.
In a very short amount of time, financial markets have evolved from a world where
very simple business models could generate exceptional returns on capital, to a world
where high hurdle rates exist just to generate positive cash flow. The idea of using a small
amount of seed capital and generating enough investment return or management fees to
support the infrastructure is becoming outdated. So, for most trading/investment systems
there is a minimum, or threshold, sum of capital that the product team must raise prior to
launch. For all business structures (i.e., mutual funds, hedge funds, proprietary trading
groups), the bear minimum to support a very small operation might roughly be $500,000
in fixed costs.
An analysis of ongoing expenses will in part drive analyses of potential distribution
channels and how best to market the trading investment system. For example, the
system may be distributed as an open-end mutual fund, where brokers market shares
to the general public, or as a closed-end fund. The trading system could be packaged
as an Exchange Traded Fund (ETF) so it would need to be marketed to and through an
exchange. The system could also be marketed as a hedge fund or as part of a fund of
funds. The choice of distribution channel will impact how the product team will build the
trading/investment system, some strategies such as the use of leverage may not be avail-
able for different structures. Choice of distribution channel also impacts time-to-market,
and time-to-market affects cash flow and profitability.
Here is a brief analysis of cash flow under typical fee structures for mutual funds,
hedge funds, and proprietary trading firms. For start-up mutual funds that might receive
75 basis points annually, investment capital of at least $66,666,667 is required to break
even. This is certainly not a trivial amount of money.TABLE 6-1Capital $66,666,667
Fees .75%
Cash flow $500,000For a new hedge fund to break even with fees of 1% on assets under management plus
10% of the excess returns over and above its benchmark, the assets required are some-
what lower. Let ’ s assume that a hedge fund returns 20%, while its benchmark returns
15%. The assets to break even under this scenario are $33,333,333. Lower than that for
the mutual fund, but still not an insignificant amount.
Working at a proprietary trading house, where management invests in start-up trad-
ing systems, is the most direct avenue of raising investment capital, but a high hurdle
rate very often makes it difficult to build a consistent track record and a scalable trading
system. In large proprietary trading firms, fixed costs are usually shared among multipleCHAPTER ◆ 6 STAGE 0: The Money Document