Earlier, we talked about indices from the consumer’s perspective. Now, let’s take a closer look at how we’d operate an index trading business.

To begin with, we’ll need to create a set of flagship products. These will be the off-the-shelf indices that form our core business via scale and convenience. Additionally, these products will act as building blocks for sophisticated clients to form more complicated portfolios. Across the street, most banks pitch the same combination of beta/enhanced beta + risk premia products as their flagships. In the commodities space, beta exposure means passive exposure via front month rolling futures contracts. We’ll have our braintrust “enhance” this exposure by tweaking the details: nearby contract selection, rolling period, curve + seasonality adjustments, etc. In contrast to beta, risk premia products look much more similar to hedge fund alpha-seeking products.

There’s an interesting business selection problem here. Offering risk premia products is both a riskier and more rewarding business proposition. While risk premia is more expensive to build, we can also justify charging more for them. Some investors are fickle with risk premia and may pull the trade the moment it starts going south. Other investors might not even be interested because they prefer going to a hedge fund for their risk premia needs. From a business building perspective, if we want our comparative advantage to be in building bespoke risk premia, 1) we’ll need to charge more to justify the production costs and 2) we need to own the intellectual property for each bespoke product so that we can sell it to other clients.

On the other hand, building a business around enhanced beta products is like a strategy mill – our focus is going to be on volume and low fees. These products are simple enough that everyone on the street sells the same product. Our goal is to become the Amazon of enhanced beta by capturing market share and operating at scale. There are two aspects of gaining an edge in this market, 1) compete to distinguish our  products via client customization, complete with all the bells and whistles and 2) increase stickiness of our products via ease of access – platforms, APIs, excellent client service.

Once we’ve built the products and have found interested clients, how do we actually trade? From the client’s perspective, they pay a fee to enter a cash for strategy swap with us. The client regularly pays or receives cashflows equivalent to the mark-to-market of their swap. All maintenance costs of the strategy are already baked into the strategy level and included in their mark-to-market. Additionally, if the client wants to post less cash in the swap, they can pay a ongoing funding fee, borrowing cash from us using our balance sheet to fund their strategy.

Our traders replicate the strategy and pass the returns to the client. Ideally, this pass through mechanism would look very similar to agency execution. We agree with the client ahead of time when and how the strategy trades its underlying contracts. When it comes time to trade, we just act as an execution platform for the strategy’s trades, passing them directly to the client. In practice, trading our strategies looks more similar to principal execution. We promise to the client a swap which walks and talks like the strategy but is not guaranteed to be the strategy. Often times, the strategy may be difficult or unprofitable to perfectly replicate at times. The fixed maintenance costs might not cover the actual transaction costs of replication. For example, temporary illiquidity in certain contracts can make trading the contract too expensive. Our traders might decide to leave the strategy unhedged or attempt to gradually build the hedging position. Furthermore, when managing a book of strategies, the underlying trades will often net against each other, allowing us to internalize the flow and pocket the maintenance costs of those underlying trades. Note that it’s our responsibility to ensure there’s no conflict of interest for how we manage these strategies.