, floor trading practices, and standardsof business conduct. Although an exchange primarily operates autonomously,the CFTC must approve any rule additions or amendments. Exchanges alsoare regularly audited by the CFTC to verify that their compliance programsare operating effectively.
Managed Futures Investing
241
During 2002, the CFTC continued to pursue regulatory reform inaccordance with the Commodity Futures Modernization Act, including ahard look at derivatives clearing organizations, rules governing margins forsecurity futures, and dual trading by floor brokers. The agency alsoembarked on a massive review of energy trading in the wake of the2001 Enron scandal and has been acknowledged publicly due only to widespread public interest. In addition, fraud related to unregistered commodity pool operators (CPOs) and CTAs, as well as Ponzi schemes, tops theCFTC’s list of issues. A comprehensive risk management assessment is alsoan agency focus.To further protect investors, the provisions of the 2001 U.S.A. PatriotAct now require certain registered CTAs to establish anti–money laundering provisions.
HEDGERS VERSUS SPECULATORSIndividuals or entities that transact in futures markets historically have beendescribed as one of two types: hedgers or speculators. Hedgers use futurescontracts to protect against price movements in an underlying asset thatthey either buy or sell in the ordinary course of business. For example,farmers who rely on one crop for all of their revenue cannot afford a sharpdecline in the price of the crop before it is sold. Therefore, they would sella futures contract that specifies the amount, grade, price, and date of delivery of the crop. This agreement effectively reduces the risk that the price ofthe crop will decline before it is harvested and sold. Speculators, however,have no intention of physical settlement of the underlying asset. Rather,they simply are seeking short-term gains from the expected fluctuation infutures prices. Most futures trading activity is, in fact, conducted by speculators, who use futures markets (as opposed to transacting directly in thecommodity) because it allows them to take a significant position with reasonably low transaction costs and a high amount of leverage.Managed futures investors attempt to profit from sharp price movements. However, the main distinction is that a speculator trades directlywhile the managed futures investor employs a CTA to trade on his or herbehalf. Managed futures investors can take the form of private commoditypools, public commodity funds, and, most recently, hedge funds. Althoughhedge funds that engage in futures trading are considered to be managedfutures investors, they differ from private pools and public funds in thatfutures are not the core of their strategy, but rather are a single componentof a synthesis of instruments.Managed futures portfolios can be structured either for a single investor or for a group of investors. Portfolios that cater to a single investor are
242
MANAGED FUTURES INVESTING, FEES, AND REGULATION
known as individually managed accounts. Typically these accounts arestructured for institutions and high-net-worth individuals. As mentioned,managed futures portfolios that are structured for a group of investors arereferred to as either private commodity pools or public commodity funds.Public funds, often run by leading brokerage firms, are offered to retailclients and often carry lower investment minimums combined with higherfees. Private pools are the more popular structure for group investors and,like individually managed accounts, attract institutional and high-networth capital. Private pools in the United States tend to be structured aslimited partnerships where the general partner is a CPO and serves as thesponsor/salesperson for the fund. In addition to selecting the CTA(s) toactively manage the portfolio, the CPO is responsible for monitoring theirperformance and determining compliance with the pool’s policy statement.CTAs typically rely on either technical or fundamental analysis, or acombination of both, for their trading decisions. Technical analysis is derivedfrom the theory that a historical study of the markets themselves can revealvaluable information that can be used to predict future commodity prices.Such information includes actual daily, weekly, and monthly price fluctuations, volume variations, and changes in open interest. Technical tradersoften utilize charts and sophisticated computer models in their analyses.In contrast, fundamental analysis relies on the study of external factorsthat affect the supply and demand of a particular commodity to predictfuture prices. Such factors include the nature of the economy, governmental policies, domestic and foreign political events, and the weather.Fundamental analysis is predicated on the notion that, over time, theprice (actual value) of a futures contract must reflect the value of the underlying commodity (perceived value) and, further, that the value of the underlying commodity is based on these external variables. The fundamentaltrader profits from the convergence of perceived value and actual value.Methodologies employed by CTAs fall into three general classifications:discretionary, trend followers, and systematic. However, as will be illustrated, these categories tend to overlap. Discretionary advisors, in theirpurest form, rely on fundamental research and analytics to determine tradeexecutions. For example, a fundamental advisor may come to understandthat severe weather conditions have reduced the estimate for the supply ofwheat this season. Basic rules of supply and demand dictate that the priceof wheat (and, hence, wheat futures) should rise in this circumstance.Whereas the systematic trader would wait until these fundamental data arereflected in the futures price before trading, the pure discretionary advisorimmediately trades on this information.Few advisors are purely discretionary; rather, almost all of them rely onsystems to some extent. There is simply too much information that diversi-
Managed Futures Investing
243
fied advisors must digest in order to make sound trading decisions. Forexample, a discretionary advisor may use automated information to spottrends and judgment to determine position size. Another possibility is thatafter deciding to make a trade based on fundamental research, a discretionary advisor may analyze technical data to confirm opinions and determine entry and exit points. The main distinction between discretionary andsystematic advisors is that discretionary advisors do not rely primarily on acomputerized model to execute trades.The main argument against discretionary advisors is that they incorporate emotion into their trades. Like other investment strategies, managedfutures investing is only as successful as the discipline of the manager toadhere to its requirements in the face of market adversity. Given the extremevolatility often found in managed futures trading, discretionary traders maysubject their decisions to behavioral biases. Another argument is that theheavy reliance on individual knowledge and focus creates a serious investment risk. The ability of the advisor to avoid ancillary distractions becomesparamount when the CTA uses discretionary tactics.Systematic advisors lie at the opposite extreme. These advisors usesophisticated computerized models, often referred to as black boxes, thattypically include neural nets or complex algorithms to dictate trading activity. Advisors differ in what factors they use as inputs into their models andhow their models interpret given factors. Some systematic advisors designsystems that analyze historical price relationships, probability measures, orstatistical data to identify trading opportunities; however, the majority relyto some extent on trend following.For a trade entry signal, systematic advisors rely on technical data suchas price patterns, current price relative to historical price, price volatility, volume, and open interest. Profitable positions may be closed out based on oneof these signals, if a trend reversal is identified, or the end of a trend is signaled based on an overbought/oversold situation. Some systematic advisorsuse a single system approach. However, others employ multiple systems thatcan operate either in tandem or in mutual exclusivity. An example of a multisystem approach operating in tandem is when one system generates a buysignal and the other system indicates a flat or sell signal. The result will beno trade because both systems are not in agreement. Systems that operateindependently would each execute a trade based on the respective signal. Themain advantage of a multisystem approach is diversification of signals.Although systematic trading effectively removes the emotional elementfrom trade execution, the use of a systematic methodology does not implythat there is a human disconnect. On the contrary, the systems typically aredeveloped and monitored by humans with extensive trading experience. Inaddition, although specific market entry and exit points usually are deter-
244
MANAGED FUTURES INVESTING, FEES, AND REGULATION
mined by the system, human discretion often is included in decisions suchas portfolio weightings, position size, entry into new markets, stop losses,margin/equity ratios, and selection of contract months.The final classification of methodologies is trend following, which is atrading method that seeks to establish and maintain market positions basedon the emergence of major price trends through an analysis of market pricemovement and other statistical analyses. This technique is consistent withthe underlying concept of managed futures investing, according to whichprices move from equilibrium to a transitory stage and back to equilibrium.Trend followers attempt to capture this divergence of prices through thedetection of various signals. Although trend followers may either employcomputerized systems or rely on human judgment to identify trends, theytypically choose the former. As a result, trend followers often are classifiedin the general category of systematic advisors.One common misconception about trend followers is that they attemptto time the market perfectly—that is, entering and exiting markets at themost favorable prices. On the contrary, trend followers are reactionary—they do not attempt to predict a trend; rather, they respond to an existingtrend. Generally, they seek to close out losing positions quickly and holdprofitable positions as long as the market trend is perceived to exist. Consequently, the number of losing contracts may vastly exceed the number ofprofitable contracts; however, the gains on the favorable positions areexpected to more than offset the losses on losing contracts.
RISK MANAGEMENTCTAs manage risk in three fundamental ways: (1) through diversification,(2) the use of stop losses, and (3) the use of leverage.
DiversificationAs mentioned, CTAs can diversify in a number of ways, such as trading different markets or employing different strategies or systems. These systemsoften determine and limit the equity committed to each trade, each market,and each account. For example, the risk management system of one CTAattempts to limit risk exposure to any one commodity to 1 percent of the totalportfolio and to any one commodity group to 3 percent of the total portfolio.
Stop LossesUnprofitable positions often are closed out through the use of stop losses,where every position in a program has a price barrier associated with it
Managed Futures Investing
245
that, if hit, will result in executing orders to close out the positions. Stoplosses are designed to limit the downside risk on any given position. Theycan be based on price stops, time stops, volatility stops, and the like.
LeverageThe easiest way to think of leverage is as the ratio of face market value ofall the investments in the portfolio to the equity in the account. One common misconception is that leverage is bad; an example of a good use ofleverage is to lever markets with less movement to match volatilities acrossa portfolio. In other words, the manager is equalizing risk across the opportunities within that portfolio. The amount of leverage then will change overtime based on ongoing research, program volatility, current market volatility, risk exposure, or manager discretion. For example, during periods ofhigh volatility, managers often reduce the amount of leverage because thetotal number of contracts needed to satisfy the position has been reduced.Another example is that managers often decrease leverage during periods ofdeclining profits to preserve capital and limit losses. There is no “standard”amount of leverage; however, in general, CTAs use leverage as a multiple ofbetween three and six times capital.
TIMING CONSIDERATIONSRegardless of the chosen methodology, managed futures investments can beshort, medium (intermediate), or long term. Short-term trades typically lastbetween three to five days, but can be as short as intraday or as long as onemonth. Intermediate trades, on average, last 12 weeks while long-term tradestypically exceed 9 months.Managers focusing on short-term trades try to capture rapid moves andare out of the market more than their intermediate and long-term counterparts. Because these managers base their activity on swift fluctuation inprices, their returns tend to be noncorrelated to long-term or general advisors or to each other. In addition, they are more sensitive to transaction costsand heavily rely on liquidity and high volatility for returns. Strong trendingperiods, which often exceed the short-term time frame, tend to hamper thereturns of these advisors and favor those with a longer time horizon.When analyzing potential alternative investment opportunities, it isimportant not only to review past performance returns and variability ofreturns, but also to carefully analyze the degree of correlation of a particular strategy with other types of traditional and alternative investments.Managed futures investments are low to negatively correlated with fixed income and equity asset classes, as well as other hedge fund strategies. This
246
MANAGED FUTURES INVESTING, FEES, AND REGULATION
fact provides support for managed futures as a diversification vehicle. Further, recent research conducted by Schneeweis, Spurgin, and Potter (1996)provides evidence that managed futures offer downside protection as aresult of their negative correlation with equities and other hedge fundswhen those investments experience poor performance.Similar to equity portfolios, multimanaged CTA portfolios benefit fromincreased diversification. Investors seeking to gain from the benefits ofmanaged futures can lower their portfolio risk by investing in a diversifiedportfolio of managed futures advisors. Of course, the number of managersto include in a particular portfolio depends on the current diversification ofthat portfolio (i.e., current allocation to stocks and bonds), as well as thepercentage of capital that the investor is willing to commit to managedfutures. For example, an investor seeking to commit 30 percent of a diversified portfolio to managed futures would want to employ more managersthan an investor looking only for 5 percent exposure. These same investorsthen would want to analyze their current portfolio weightings of traditionaland alternative investments before determining how many managers will beallocated capital. Given that there are different styles (i.e., discretionary andsystematic) as well as diversified futures markets (i.e., commodities, financials, and currencies), diversification can be accomplished with relativeease. Note, however, that there tends to be a high degree of correlationbetween trend-following managers. Although these managers may be utilizing completely different techniques to make trading decisions, they arestill essentially relying on a common source of value to make profits.The evidence supporting managed futures and other alternative investment strategies should not be surprising. Investors who have historicallybeen long only in equity and fixed income markets have experienced periods of positive performance and periods of negative performance. The ability to take long or short positions in futures markets creates the potentialto profit whether markets are rising or falling. Due to the wide array ofnoncorrelated markets available for futures investing, there can be a bullmarket in one area and a bear market in another. For example, U.S. soybean prices may be rising while the Japanese yen is falling. Both of theseoccurrences offer the potential to gain.Like any investment strategy, managed futures present some shortcomings. It is important to illuminate some of these weaknesses to ensure thatinvestors can make educated decisions based on as much complete information as possible.First, as a stand-alone investment, managed futures tend to be highlyvolatile, producing uneven cash flows to the investor. This is because annualreturns are heavily generated by sharp, sudden movements in futures prices.Because the nature of this strategy is primarily based on such movements,
Managed Futures Investing
247
returns undoubtedly will continue to be volatile. However, managed futurestypically are not chosen as a stand-alone investment. Rather, they are selectedas a single component of a diversified portfolio. Due to their historicallylow correlation with other alternative investments, their volatility actuallycan reduce the overall risk of the portfolio.Investors also have voiced negative sentiment regarding the lack ofadvisor attention to the customized fit of managed futures into their portfolio. Due to the many different styles and markets of managed futuresinvesting, clients certainly can benefit from specialized attention. In thislight, consulting services can be truly beneficial to a client’s portfolio. Consultants can offer their clients a careful explanation of CTA investmentobjectives, and comfort that careful due diligence of CTAs has been performed. As CTA performance varies greatly, these services can be of paramount importance.
CONCLUSIONOverall, investors are becoming increasingly educated about the universe ofalternative investments and, in particular, managed futures. As more sophisticated investors become aware of the noncorrelated nature of managedfutures to hedge funds and equities, asset growth into this category is expected to continue. Institutional participation will increase as a result of theincreased use of insurance products and investable indices. Increased use ofequity trading may become prevalent, as the performance of managedfutures still lags the S&P 500. Overall, increased globalization should resultin more opportunities for managed futures investors. To succeed, manyadvisors may have to make some important changes to their organization,such as increasing staff size, enhancing coordination, improving communication, and employing greater technology.
CHAPTER
13
The Effect of Managementand Incentive Fees on thePerformance of CTAs: A NoteFernando Diz
his chapter examines the effect of management and incentive fees on theperformance and volatility of CTA track records. Evidence of a structural change in incentive compensation is presented that points to a largerreliance on incentive fees as opposed to management fees. Management feeshave no relationship to performance. No systematic performance or volatility penalty is suffered by investors by this type of compensation. Incentivefees are found to be positively related to both net of fees returns and volatility. An increase in the incentive fee parameter from 10 percent to 20 percent will increase performance by an average of 6.58 percent per year. Theperformance increase is net of the effects of leverage and other variablesaffecting performance. There is also a small tendency for CTAs with largeramounts of assets under management to have slightly better performance.
T
INTRODUCTIONThis chapter empirically examines the effect of incentive compensation contracts of commodity trading advisors (CTAs) on their performance. Theanalysis is an extension of Golec (1993) and examines the effects of incentive compensation contracts on the risk and return of CTAs. The contribution of this chapter is twofold. In Golec, the sample used was too small to
Partial support for the completion of this study was provided by a grant fromthe Foundation for Managed Derivatives Research. The author wishes to thank theFoundation for its support, and Sol Waksman for his invaluable comments.
248
The Effect of Management and Incentive Fees on the Performance of CTAs
249
draw reliable inferences about the effect of incentive compensation on therisk and return of CTAs. Current events in the money management worldassociated with manager compensation abuses have heightened the importance of measuring the effects of compensation more accurately. A muchlarger database than the one used in Golec allows us to measure theseeffects with less error. The advantages of using a larger database are evenmore important in view of the structural changes in the composition of totalcompensation in managed futures, as documented by Diz and Shukla(2003). In addition, this study measures the effects of management andincentive fees on the risk and returns of CTAs more accurately by controlling for known effects that other very important variables have on thesemeasures of performance (see Diz 2003).
CTA COMPENSATION STRUCTURECTA compensation contracts generally contain two types of fees: a management fee, km, which represents a fixed percentage of end-of-period assetsunder management, and an incentive fee, ki , which represents a fixed percentage of investment gains over a year period.The CTA total fee income for period t can be written as:Φt = km At +
{
ki ( At − At −1) if Rpt > 0,0if Rpt ≤ 0,
or
(13.1)
Φt = kmAt + ki max[0,At − At − 1]where At − 1 and At = dollar value of assets under management at the endof periods t − 1 and t respectively.Defining Rpt as the CTA’s portfolio rate of return for one period (t − 1to t), we can redefine At as At − 1(1 + Rpt). We can then rewrite the totalcompensation equation as:Φt = kmAt − 1(1 + Rpt) + ki max[0,At − 1Rpt]
(13.2)
Equation 13.2 shows the dependence of CTA total compensation onthe level of assets under management (At − 1), the one period performance(Rpt), the management fee (km), and the incentive fee (ki). Base compensation is a linear function of the level of assets under management. Incentivecompensation is a nonlinear function of performance. Table 13.1 containssummary statistics for the variables included in equations 13.1 and 13.2.The median management and incentive fees for a sample of 974 CTAs over
250
MANAGED FUTURES INVESTING, FEES, AND REGULATION
TABLE 13.1
Summary Statistics for CTA Management and Incentive Fees,Assets Under Managementa Variables, and ReturnsVariable
Mean
Std. Dev.
Median
Managementfee (%)
2.46
0.013
2.00
Incentive fee (%)
20.27
0.044
20.00
Assets(Millions$)
34.68
186.950
1.80
Monthlyreturnb(%)
0.99
0.013
0.94
Q(1)
Q(3)
Min
Max
2.00
3.00
0.00
6.00
20.00
20.00
0.00
50.00
0.50
10.52
0.10 2,954.00
0.38
1.50
−5.23
10.00
a
Assets under management can and often do include notional assetsReported returns are net of management and incentive fees.
b
this study sample period (1974 to 1998) were 2 percent and 20 percentrespectively.Although the management and incentive fees presented in Table 13.1appear high when compared to mutual funds (e.g., Golec 1993), averagemonthly returns appear higher than what one finds for mutual funds for thesame time period. This is especially telling if one considers that CTAreported performance figures are net of all fees. To date, no study has accurately accounted for all fee-adjusted performance of mutual funds whencomparing them to fee-adjusted performance in the managed futures industry. Further, it is a known fact that mutual fund fees have continued toincrease and that this increase has not translated into higher returns forindividual investors. It is generally acknowledged that higher fees in themutual fund industry have reduced returns to investors (Trzcinka 1998).Management fees in the managed futures industry have followed a downward trend from an average high of 2.81 percent in 1982 to an average lowof 1.85 percent in 2002. More of CTA compensation in 2002 came in theform of incentive fees (Diz and Shukla 2003). The results in Table 13.2highlight the change in the total compensation structure for CTAs. Almost50 percent of total CTA compensation came from management fees in 1982while in 2002 only 35 percent of total CTA compensation came from theseasset-based fees. Two-thirds of CTA compensation came from performancebased fees in 2002. Golec’s study used CTA data from 1982 to 1987. Thestructural change that is evident in the 1990s is a third reason for reviewing Golec’s (1993) findings.Because the purpose of this study is not to explore the theory of compensation contracting, we refer the reader to Golec (1993) for such a review.
251
The Effect of Management and Incentive Fees on the Performance of CTAs
TABLE 13.2
Evolution of Management, Incentive Fees, and Total Compensationin the Managed Futures Industry, 1982–2002N
Year
497110515820226230935741747356262262658258256253651548745996
198219831984198519861987198819891990199119921993199419951996199719981999200020012002
AverageAverageMF as % ofManagement Fee a Incentive Feea Fee Revenue2.812.722.832.822.722.732.772.792.712.692.522.402.362.142.152.122.061.981.921.901.85
17.1417.3617.7017.4617.3117.4618.0919.1719.3119.6819.6019.7819.8320.0320.0319.9920.1320.1020.2120.3120.48
494848494848474645454342413939383837363535
IF as % ofFee Revenue515252515252535455555758596161626263646565
aManagement and incentive fees are reported fees. Actual average fees are likely to
be lower since these are subject to negotiation.Source: Diz and Shukla (2003).
What is clear from equation 13.2 is that total CTA compensation is a function of performance (Rpt), the level of assets under management (At), andthe management and incentive fee rates (km and ki).
DATAThe data used in this chapter consist of individual CTA monthly returnsprovided by the Barclay Trading Group. The database contains recordsfor 1,253 CTAs and includes both programs that were still listed as ofFebruary 1998 as well programs that were delisted anytime from 1975 toJanuary 1998. Of the total 1,253 programs, 798 had been delisted by February 1998. Only 455 programs were listed as of February 1998. Of the1,253 programs, only 989 (80 percent) reported margin to equity ratios.
252
MANAGED FUTURES INVESTING, FEES, AND REGULATION
Fifteen programs were eliminated from the sample for various reasons ranging from missing observations to duplication. This left us with a sample of974 programs. Golec’s sample includes only 80 CTAs. The time spanned bythe two samples is also worth noting. Our sample spans a period of 24years starting in 1975 and ending in 1998. Golec’s sample spans only a fiveyear period from May 1982 to December 1986. Summary statistics werecalculated for each CTA in the sample. Table 13.3 provides a summary ofthe averages for these statistics.The average length of a CTA track record for the sample is about 5.5years. The longest track record is 23 years and the shortest only 5 months.The average monthly rate of return for the combined CTAs was 1.31 percent and the annual standard deviation of returns for the cross section ofCTAs was 26.24 percent. These results are consistent with Brorsen (1998)for his combined CTA sample. Golec’s study reports a monthly average rateof return of 1.35 percent with an annual standard deviation of 11.56 percent. The sample used in this chapter is more similar in size, composition,and performance to Brorsen’s.The average management fee for the sample is 2.46 percent while thesame average is 3.96 percent in Golec’s sample. More strikingly, the medianmanagement fee for this study’s is 2.00 percent while it is 4.00 percent inGolec’s sample. The average incentive fee for the sample in this study is20.27 percent while the same average is 16.33 percent in Golec’s sample.The median incentive fee for this study’s sample is 20.00 percent and only15.00 percent in Golec’s sample. Finally, the average assets under management in this study were $34.68 million compared to $5.01 million in
TABLE 13.3
Summary of CTA Average Attributes, February 1974–February1998, 974 CTA ProgramsAttribute
Mean
Std. Error
Min
Max
Months listedAverage monthly return (%)Margin to equity ratio (%)Annual compounded rateof return (%)Annual standard deviation (%)Maximum drawdownManagement fee (%)Incentive fee (%)Assets (Millions $)
65.141.3119.40
45.911.3410.58
5.00−3.141.03
278.0013.47100.00
12.7526.24−0.272.4620.2734.68
15.1418.410.181.314.45186.95
−47.510.79−0.990.000.000.10
139.00142.890.106.0050.002,954.00
253
The Effect of Management and Incentive Fees on the Performance of CTAs
Golec’s sample. The median amount of assets under management for thissample was $1.8 million versus $1.5 million for Golec’s sample.It is clear from the data that the sample is our study is broader incoverage, size, composition, performance variability, and time span thanGolec’s. As such, it is perhaps more suitable to accurately measure theeffects of compensation structure on CTA performance.
CTA COMPENSATION PARAMETERSAND PERFORMANCEIn this section we empirically explore the relationship between CTAreturns and the standard deviation of returns to their compensationparameters by replicating Golec’s (1993) analysis. We examined the issueby fitting two ordinary least squares (OLS) cross-sectional regressions onthe means and standard deviations of returns of the CTAs on their feeparameters as follows:ARORj = b0 + b1km + b2ki + b3ln(At − 1) + ej
(13.3)
sj = a0 + a1km + a2ki + a3ln(At − 1) + uj
(13.4)
where ARORj = annual compounded rate of return for CTAjsj = annual standard deviation of CTAj returnsej, uj = error terms.Because the distribution of assets under management is clearly skewed, weuse the natural logarithm of assets under management as the “size” variable. Significance tests use White’s