Diversification rebates are parts of the execution commissions paid by investors in DARWINs that Darwinex pays back to investors at the end of each market day.
Execution commissions, which are paid to Darwinex for getting a trade on the market are not to be mistaken for performance fees, which are paid to DARWIN providers as a success fee for profits. Execution commissions are already factored into your open P/L with each DARWIN, therefore they are not as visible as performance fees.
Darwinex perceives two goals with paying diversification rebates
The first is to compensate for the negative effects of paying performance fees per DARWIN in diversified portfolios. Investors pay performance fees for each and every DARWIN with whom they are having profits when their investments' quarter end comes even if on the portfolio level they are losing. To put a very simple example, imagine an investor with two DARWINs in his portfolio; with the one he gains 1000 euros at quarter end, with the other he loses 1000 euros at quarter end. This investor would pay 200 euros as performance fee on quarter end despite having a P&L of 0 on the portfolio level. Diversification rebates are meant to compensate for this.
The second is to compensate for the effects of charging a fixed execution commission independently from a portfolio's risk. A portfolio of a single DARWIN is more risky, thus it can both gain and lose more than a portfolio of several DARWINs. Therefore, we believe that investor who diversify their portfolio and this way have a lower profit potential, should pay lower execution commissions. Let's see this with an example.
Investor A invests 1000 euros in DARWIN NTI and pays each day 2 euros as execution commission.
Investor B invests 500 euros in DARWIN NTI and 500 euros in DARWIN PFL. As both DARWINs have a similar trading volume, investor B also pays each day 2 euros as execution commission.
Now, with DARWINs having a 10% monthly value at risk, investor A's investment at risk is 10%, that is 100 euros each month.
Investor B's investment at risk is lower due to diversification. Assuming zero correlation between NTI and PLF, after doing the math we get that investors B's monthly investment at risk is 70.71 euros or 7.07%.
With both investors paying the same execution commissions, investor B has a lower investment at risk and thus a lower profit potential due to diversification. Should we leave it this way, we would incentivize investors NOT to diversify. However, diversification is the only way to lower the probability of suffering from unknown events. Unknown events, like the flash crash of the pound on October 7th 2016, are not factored into the calculation of value at risk. Therefore, diversification is the correct way to prepare for such events. As a consequence, at Darwinex believe is the right thing to do to incentivize diversification.
Therefore, our goal is that investor B's commission per risk be the same as investor A's commission per risk. After doing the math, we get that theoretically investor B should pay 0.7 times the commission paid by investor A. As a consequence, theoretically, investor B shall receive 0.3 times his daily commissions as diversification rebates.
This is theory behind diversification rebates.
In practice, however 0.3 times, or 30%, of investor B's daily commission can't be 30% of the 2 euros he paid. Why?
The reason is that the bigger part of those 2 euros is not Darwinex's money. Let's see some examples of how that part gets spent:
- It is used to pay commissions of liquidity providers
- It is used to pay fixed business costs of Darwinex and
- It is used to cover costs of unknown events, a budget category every responsible broker has to have
To put it differently, Darwinex can only only pay back any money from its margin, which is approximately 40% of commissions pays by investors. This is the part of paid commissions that the diversification rebate % gets applied to. In our example, investor B would get paid each day 30% of 0.8 euros which is 40% of the 2 euros he paid as execution commission.
In the following spreadsheet you may check out approx. % of diversification rebates depending on the number of DARWINs in your investment portfolio: https://goo.gl/WuZxA0