We ran into a CTA recently who had a nice-looking track record, and we were excited about where the conversation was headed. But upon further review, we realized that this pretty track record was comprised of non-compounded returns.
What a shame.
Why is this such a big deal, you ask? Essentially, if a manager chooses to use this approach to managing client’s accounts and the resulting performance reporting, they’re pretending as though the balance in an account never changes, no matter how many winning or losing days/months/quarters go by. If the CTA gets a $100K investment, they trade the account as if it has $100K in it day in and day out, no matter what the current balance of the account is, absent further instructions from the client to increase or decrease the allocation level.
This is a problem for a website such as ours, which analyzes programs based on monthly percentage returns to derive statistics such as compound return, max drawdown, and so forth. On a fixed capital basis, many of those stats simply don’t apply (how can you calculate a compound return when the returns aren’t being compounded?). This means Attain is left having to remove a good-looking program from our website to avoid an apples vs. oranges comparison problem within our rankings and statistics.
But really, this is mostly just an annoyance for us (and a marketing loss for the CTA). The real problem with this CTA misstep and several other common shortcuts is that it often hurts or deters the one person the manager wants to impress most – investors. Investors are used to putting money into an investment, and earning money not just on the principal, but also earning money on the investment gains. As Albert Einstein is reported to have said: “Compound interest is the greatest invention in human history.” So to run your CTA differently, using a fixed basis instead of compounding, is going to at best confuse your investors, and at worst leave you without much interest (pun intended) in your program.
So, to that end, here is our free PSA for those starting a CTA, or even those established CTAs who are looking at taking things to the next level:
Starting a CTA? Don’t be tempted to take the easy way out. Run your CTA like a pro in five easy steps!
1. COMPOUND YOUR RETURNS – It may seem simpler to trade based off of fixed equity levels (doing 1 contract per $100,000 or similar and then relying on the investor to tell you when to increase), but at the end of the day, it’s just a bad idea. Don’t do it. While it may be simpler in the short term (keeping you from having to write formulas in an excel sheet calculating position sizes off of increasing/decreasing equity amounts), this matter of convenience may cost you allocations from investors down the line who don’t want to have to instruct you to do something they view as standard practice
The overwhelmingly “normal” way that CTAs manage their accounts is to base their position sizing off of the compounded equity in the account (maybe they use a moving average of equity or some other smoothing mechanism, but they will eventually increase position sizing over time when the account grows). This is what investors expect – automatic compounding of their investment by you, the professional. They don’t want to have to make the decision to tell you to increase or decrease the investment level. Do it for them; you’re the pro.
2. REPORT COMPOSITE RETURNS – While NFA rules require CTAs to report a performance track record which is a composite of all similar accounts being managed by the CTA – there are a few “4.7 exempt” CTAs out there who choose to report their performance off of a single “model” account. It is definitely easier to go this route, with only one set of balances to follow and numbers to calculate.
Unfortunately, this is neither common practice nor a complete picture. Most CTAs will utilize a composite record of all accounts being traded via the listed program, which helps to reflect differing account sizes, varying commission and fee structures, how the manager gets new clients into positions, and so on. This gives a better overview of performance, and in most cases keeps CTAs from having to field calls from investors asking why their account didn’t receive the same performance as the “model account” last month or quarter. If you think the model account has value, don’t worry – investors can always ask for the performance of a model account (and most standard due diligence processes will require to see the performance of a single account). But going back to try to compile composite performance is not always so easy. It’s better to just do it right from the beginning.
3. THINK DAILY PERFORMANCE TRACKING – You’re not necessarily required to track your performance daily, but you definitely should. Any substantial money you hope to attract down the line is going to want to see those daily results to ascertain what the intramonth drawdown has been, what the intramonth volatility has looked like, and more. Further, you should be tracking your average margin usage on a daily basis to help investors do more sophisticated calculations of your returns per risk unit (as measured by margin).
4. KNOW WHY YOU ARE MAKING (OR LOSING) MONEY – This one sounds easy, but all too often we run into CTAs who either don’t know, or don’t care which positions have benefitted their program and which are causing losses. One CTA put it this way: “I’m a systematic trader, I don’t care what the market is that is being traded, I just care about the end result”. That may be what you think, but that isn’t going to interest many clients, who do care what market is being traded.
CTAs should keep exacting detail on what positions, sectors, markets, and types of trades drove performance over each day, week, month, quarter, year, etc. While this is good info for new clients who may want to know the breakdown of the risk and return per sector, it is usually just as effective if not more so in retaining clients – with the ability to point to certain markets, sectors, or events during down periods.
5. TRADE ALL ACCOUNTS THE SAME FROM THE START – This one again comes down to investor expectations. There is nothing worse than a new client seeing losses while you are reporting gains on your composite track record, and you having to explain to the new client that it didn’t make sense to get them into the existing positions which had made a bunch of money (thereby increasing the risk on that trade). The investor wants to get the performance you report this month, this quarter, and this year, period. They want to get in line with the equity curve immediately, so do that by getting them into all positions immediately (this may not apply for some types of programs such as an option seller who only has pennies to be made on an expiring option but unlimited upside) In our experience, investors would happily accept any extra risk up front in exchange for “getting in line” with the program.
Managed futures is a tough business. Don’t handicap yourself from the start by creating investor/reporting mismatches. Do it right.