the market. This could be several hours per trading day. If allthis weren’t enough, there’s the normal high risk associated with futures trading. To give you a better idea of how all this meshes together, Paul Lovegren, a senior futures trader, shares his rules forday trading the S&P 500. The fact that he has a written set of rulesimmediately available reinforces the importance of discipline.1. Select a market with sufficient volume to permit daytrading, the S&P in this case.2. The market selected must have enough daily volatility tooffer profit opportunities.3. Cover your downside risk. A put and a call are held permanently for each unit to be day-traded. This is insurance against limit-up or limit-down days. These optionspositions can be exercised to exit any position in whichyou become trapped.4. Roll options positions when they begin to approach expiration, so you don’t suffer total loss due to time decay.5. Always have a strategy planning session with your broker well before you start trading. During this session,agree on what you both expect the trading range will be
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for the day. Then decide exactly what you plan to do—for example, get in at the opening, wait until a specificsupport or resistance level is reached, and react to a givenprice formation.6. When your expectations are totally incorrect, avoid thatsession and start planning for the next one.7. Always trade with trailing stops and continually adjustthem as necessary.8. Don’t enter the market late in the trading session, after3:30 EST (U.S. Eastern Standard Time) on the S&P, because the market is thin and volatile.9. Have a definite system to identify the short-term trendsand your entry and exit points.10. Be psychologically prepared to reverse your positionwhen the trend moves against your position or a pivotpoint is hit.11. Have a cutoff point for profits and losses. (For example,Paul quits after he makes $1,000 per position during asession. This keeps him from overtrading. He also quitsafter he has two or three losers in a row.)12. Know your breakeven to the penny, including commissions.13. Use quote equipment, or be sure your broker has quoteequipment, that allows you to access a wide variety ofstudies, like 5-minute RSI, stochastics, premium calculations, moving average bands, trend lines, directionalmovement, equivolume, Japanese candlesticks, etc.14. Be geared to making decisions immediately. If the marketgoes against you, get out. If your entry point is hit, get in.
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10
Giving Trading Discretionto Someone Else
Key Concepts◆ Using Modern Portfolio Theory to Structure an InvestmentPortfolio◆ How Various Types of Discretionary Authority Can BeUsed to Reach Your Trading Objectives◆ Step-by-Step Procedures for the Evaluation of Any Type orClass of Investments, with an Emphasis on ManagedFutures Programs
Research studies by several experts indicate that a diversifiedportfolio with a futures position added may have more balance andstability and even increased return. The pioneers of this approachwere such notable financial theoreticians as Harry Markowitz, JohnK. Lintner, and William R. Sharpe. Many of their ideas and researchevolved into what is currently known as modem portfolio theory(MPT). MPT can be simply stated as “don’t put all your eggs in onebasket.” They also developed sophisticated methods of structuringand evaluating the performance of portfolios.MODEM PORTFOLIO THEORY
Both active money managers and academicians subscribe to thistheory. The essence of the theory is that it is the duty and obligation
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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of the prudent investor to seek combinations of assets that yield themaximum return with the lowest associated risk. The key phrase iscombinations of assets.With this as their goal, and access to virtually unlimited computer time, several renowned business schools began to crunchnumbers. They loaded their mainframe with historical data detailing the performance of all major classes of assets: stocks, bonds, realestate, commodities, cash equivalents, etc. Then they played “whatif” games. They arranged and rearranged their experimental portfolios. They constantly changed the asset mix and evaluated itagainst historical returns generated over the last 10 years, last 20years, etc.NEGATIVE CORRELATION
They developed some extremely useful information, and they popularized the concept of balancing a portfolio with negatively correlated assets. This simply means that when a certain asset class goesup due to a given set of economic circumstances, other asset classesgo down or remain the same.Now this may not sound like much, but it is. If you can quantify the positive or negative reaction of various investment opportunities to given sets of economic data, you can begin to build sampleportfolios that can withstand various types of adverse conditions.What’s the single most serious, long-term disease that your networth faces? Most investors will probably say inflation. Many economists attempted to develop a portfolio resistant to inflation.The most prominent researcher of the group was a professorfrom Harvard University, Dr. John Lintner. He used data from July1979 through 1982, comparing 15 futures portfolio managers and 8public futures funds to stock and bond portfolios. At Boston University, Zvi Bodie and Victor Rosansky took a longer-term view,1950 through 1976. Jack Barbonel, Phil Lipsky, and John Zumbrunnstudied the period of 1960–1982, while Scott Irwin and B. WadeBrorsen (Purdue University) analyzed data for 1963–1983.A common conclusion of this number crunching was that thestock market and the futures market are negatively correlated. Thisbecomes particularly critical during periods of inflation. Inflationpushes prices and interest rates higher. The cost of doing business
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increases while sales decrease—stock prices suffer and the marketdrops.At the same time, inflation pushes prices higher. Futures investors profit from bull markets, particularly in the physical commodities. Inventory managers, fearing higher prices, buy more,which fuels the fires of inflation.The recommendation resulting from much of the work on thesubject was to spread your risk by reducing volatility while at thesame time enjoying an increase in the return from your total investment package. A common theme was to put from 5 to 15 percent ofyour investment portfolio in futures.While many investors showed interest in doing this, most werenot willing or able to make the commitment necessary to trade a futures account directly. For this and other reasons, investors havesought the help of various professional (and even nonprofessional)traders to assist them. This is accomplished by signing over to thetrader, called a third-party controller, the authority to trade the account. The authority used is usually a limited power of attorney.TYPES OF DISCRETIONARY ACCOUNTS
There are a wide variety of trading approaches that can give yourassociated person (broker) or a third-party adviser varying degreesof freedom to act in your behalf in your futures trading account. Forexample, you can give your broker just price or timing discretion ina trade. This allows your broker to decide at what price level or timeto enter your order in the market. This type of discretionary authority does not require giving power of attorney. But it must be toyour (the customer’s) benefit, not at the broker’s convenience.For example, you are very busy or will be out of touch duringa particular day, but you want to place some trades. You discuss thesituation with your broker the night before. You decide on the futures market, month, quantity, side (long or short, put or call), andstrike price in the case of options that you wish to trade. You let yourbroker pick the time or the specific target price or range. Situationslike this occur when you want to get a feel for the day’s market before you commit. You might tell your broker to go ahead and placeyour order if the market opens higher tomorrow. This would be atime-only discretion order.
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Or you might want to wait for a certain trading range. You instruct your broker to enter the market if the commodity you wantto trade hits a certain price. “Buy me 5 December S&Ps if it tradesover 322.” When you use price-only discretion, you should limityour broker to a trading range.There is another type of discretionary trading that also does notrequire you to sign a limited power of attorney. This is called a guided account. With a guided account, a third party, who must be registered with the NFA as a CTA, suggests all trades. The CTA explainsthe thinking. You, the client, must accept or reject the trades.Another possibility is turning over your account to a third party who isn’t required to have a formal disclosure document. To dothis, you’ll be asked to sign a limited power of attorney and a written statement explaining why this third-party account controller isnot required by the CFTC to provide you with a disclosure document. There are four reasons a disclosure document is not requiredby an account controller:1. If the controller advised less than 15 people over the last12 months and does not generally hold himself or herselfout to the public as a CTA2. If the controller is a dealer, broker, processor, or seller inthe cash market for the commodity to be traded or provides advice incidental to the conduct of the normal cashmarket business3. If the person is properly registered in another capacity andwhose advice is solely incidental to the normal conduct ofbusiness4. If the person is a relative of the person doing the tradingOther than these four exceptions, all third-party advisers arerequired by the Commodity Futures Trading Commission to provide their clients with a formal disclosure document. Additionally,clients must sign a written acknowledgment that they have readand they understand the disclosure document. The purpose of thedisclosure document is to make you aware of all the pertinent facts,i.e., the amount of risk involved, explanation of the trading system,fee schedule, past performance, etc.Be aware that your broker may be exempted from the disclosure document requirement based on exception 3 listed above. An
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individual broker who is not registered as a CTA would be considered someone who is “properly registered in another capacity andwhose advice is solely incidental to the normal conduct of business.” The section about the advice being incidental means that abroker cannot trade all, or the majority, of accounts on a discretionary basis. Brokers also must have 2 years of experience in handling accounts before they are allowed to take discretion in otherpeople’s accounts.Brokers who don’t have 2 years’ experience and want to takediscretion in accounts can do one of two things. First, they can petition the NFA for a waiver of this requirement. (The NFA seldomhonors such requests.) The other option is to register as a CTA. If abroker takes this route, a disclosure document must be prepared. Init, the broker’s experience must be revealed. Therefore, it behoovesyou to read all disclosure documents carefully before investing. Being registered as a CTA doesn’t mean that the person can trade profitably or even ably.Other than the discretionary options mentioned, you can electto invest in a managed account program. There are basically twotypes: individual and limited partnerships. With an individuallymanaged account, the CTA takes complete control of trading youraccount and trades it. The size of the portfolio or the diversificationpossible depends upon the amount you put in the program. Whilesome CTAs will trade amounts as low as $5,000, most require$50,000 or more. Many are asking $100,000 to $200,000, so the accounts have some staying power and can spread the risk over 10 to15 markets.Your other choice is a limited partnership, which may be eitherpublic or private. The basic difference between the two is the size,meaning the amount of money that can be raised by the commodity pool operator (CPO) and the number of investors that can participate. Private offerings are somewhat more restricted by theCFTC than public.NEARLY $44 BILLION
Limited partnerships have become popular in the last decade. Theamount under management was estimated at $43.9 billion at the endof 1998, according to the Managed Accounts Report newsletter. This
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growth has likely occurred because of some benefits intrinsic to thisform of investment. For example, an individual can invest as littleas $5,000 and receive the following:Diversification into a wide variety of markets, far more than onecould accomplish with most individual futures portfolios. Thisgives your account more stability, putting it in a better position to take advantage of major moves.Leading CTAs to manage your account. You might not normallyhave access to this caliber of traders.Lower than normal commission rates. Most funds, because oftheir enormous volume, trade at or near discount rates.Freedom from margin calls. The fund or the limited partnershipis responsible for all margin calls.Defined risk. Your initial investment is usually all you areobligated for, but be sure to carefully read the particularprospectus for the investment you are considering.Interest income. You gain interest income from funds held inTreasury bills by the fund or limited partnership.No restrictions or upside potential. Remember, many of theCTAs that manage these types of investments have very impressive trading histories, which will be detailed in the disclosure document.
WORD TO THE WISE!
It is extremely important to read, study, and understand the disclosure document or prospectus for any fund or limited partnershipyou are considering. It explains your rights, risks, and obligations.Be sure to understand what you are signing and the risks involved.When you begin to do your research on an investment opportunity, the first thing you usually hear about is its past rate of return(ROR) or its expected ROR. Brokers of all classes of assets hype thisnumber. If a product has a high ROR, it is supposed to overcome allother obstacles.ROR is important, but it is not the number one indicator. Thekey issue is risk management. This is especially true of any investment involving the futures markets.
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Consider this situation. You invest in a limited partnership(LP). The first month your LP has a 50 percent drawdown of equity. Month 2 it appreciates 50 percent. Are you back to breakeven?No, you are still behind. To recover from a 50 percent loss, you needa 100 percent gain. If the fund began with $1,000,000 and lost$500,000, a 50 percent gain brings it to $750,000. Only doubling itsremaining equity can make it whole again (see Figure 10.1). Studythe table in Figure 10.1 to get an insight into the effect that loss ofequity has on an LP.As you can see, the greater the loss, the greater the effort it takesto recover. Recovery from a substantial drawdown could takemonths, if recovery is even possible.
F I G U R E
10.1
Loss-Recovery Table% Loss
% Needed for BE
5203040507090100
5.2625.0042.8666.67100.00233.33900.00Impossible
RISK MANAGEMENT RANKS NUMBER 1
CTAs are no different from anyone else. If they try too hard and succumb to the pressure involved in recouping from a severe setback,they fail. For this reason, the first qualifications to look for in anyCTA who is going to manage your money are management skillsand experience. You want to know what downside volatility can beexpected on average. How deep are the drawdowns of equity? Howfrequent? What was the maximum consecutive drawdown, andhow long did it take to recover? In trading futures, there will alwaysbe months where you lose money. But if you can’t quickly recover,you dig a hole that is near impossible to climb out of.
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CONSISTENCY RANKS NUMBER 2
You should get a queasy feeling when you see a limited partnershipthat rocks up and down. Up 32 percent one month, down 26 percent, up 22 percent, down 17 percent, up 19 percent, down 13 percent. It may be making money, but it seems too anxious to enjoy it.What you want is consistency. The last thing you need is to geta statement from your broker telling you your investment zaggedtwice in a row when it should have zigged. Steady and reasonablegains are more comforting than wild, uncontrolled energy.How do you measure consistency? You chart out the monthlygains and losses of the CTAs you are considering. Are the monthlyand annual gains impressive? Are the losses controlled and reasonable? A loss of 10 to 15 percent is not a problem if it is quickly recovered. But wide swings can leave you in a state of uncertainty.NOW . . . ROR!
Once you’re satisfied the investment vehicle you are evaluatingmanages risk and performs consistently, you begin to pay more attention to its rate of return. Keep in mind that the ROR means nothing until you’re satisfied with steps 1 and 2.The importance of ROR only comes into focus when you consider what you must give up or are expected to withstand to receiveit. This is called the efficient frontier. It is the amount of risk, measured in standard deviation, that can be expected to obtain a givenamount of reward, measured by the mean (average) return. Most ofus draw a line regarding how much risk we can or will accept forany expected reward.HOW TO MEASURE VOLATILITY?
One of the easiest methods to determine the amount of the volatility you’ll be facing is to draw a simple bar chart. On a blank piece ofpaper, draw a straight line across the middle of the page. Let thisrepresent zero percent change in the monthly rate of return. Now,plot a bar for the positive rates of return above the line and the negative months below. You find these figures in most disclosure documents on the “Performance Summary Page.” Study the chart you
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create. How wide are the swings from positive to negative? How often are there consecutive drawdowns of equity? How deep are thedrawdowns?Another important aspect is the length of the study. You willneed to know how the CTA(s) performs in bull and bear markets.Some traders and systems do better in one or the other. Certaintrend-following systems, for example, do better in bull markets because they last longer than bear markets. Once trends are established, the trend followers jump aboard and ride them for all they’reworth. You can’t always do this with bear markets. Markets can turnaround, and the moves are over before some trend-following systems can take advantage of them.Markets moving sideways or in channels up or down presentunique problems. Trend-following systems are virtually uselesshere. Discretionary traders who pick and choose each trade tend todo better in these markets.You can also plot the CTA’s month-to-month performance,using the Value Added Monthly Index (VAMI) table from the disclosure document on a chart with a long-term commodity marketindex. The index used should match as closely as possible the portfolio the CTA trades. For example, if the trader deals primarily withthe physical markets, use an index such as the Wasendorf Composite Index. If the portfolio is only meats, metals, or grains, use one ofits subindexes. Long-range charts are ideal for the purpose. If theCTA is into all commodities, including gold, you might want to usethe Commodity Research Bureau (CRB) Index.This combination of the CTA’s performance and the compositeindex value of the futures markets provides an important insightinto how the trader handles the upsides and downsides of the market. You want to know if the performance drops substantially whenthere is an abrupt change of direction of the market. Or does thetrading system quickly adjust? Ideally, the line representing thetrack record increases each month, no matter if the index is going upor down.The Commodity Futures Trading Commission requires theVAMI to be calculated for each CTA’s track record that is printed ina disclosure document. The CFTC reviews all disclosure documentsprior to the time they can be offered to the public. Its review doesnot in any way equate to an endorsement. It examines the docu-
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ments to see that its regulations are heeded—not to evaluate thechances of the offering generating a profit!The CFTC is the investors’ watchdog. It tries to root out disclosure documents that may mislead the public. This is the thinkingbehind the VAMI. It is required by the CFTC so an investor can easily compare one offering against another over a given period oftime.The CFTC requires the CTA to re-index the VAMI to $1,000 atthe beginning of each year. Therefore, you may want to calculateyour own cumulative VAMI for track records over longer periodsof time.As you evaluate past performance, always keep in mind that itis not a reliable forecaster of future performance. That’s why youwant to look at as long a period as possible—3 years, 5 years, orlonger. The period of time should include bear and bull moves.Again, that’s why you chart the VAMI against a commodity priceindex.All VAMIs are calculated using the same formula, as prescribed by the CFTC. The formula isVAMI for Period ZZ  (1  rate of return of period Z)  VAMI for prior period
Therefore, the VAMI for any particular period increases or decreases based on the rate of return for that period. Calculating thenumber can become complicated when there are a lot of monthlyadditions and withdrawals. If all the withdrawals take place at thebeginning of the period and all the additions at the end, they canskew the rate of return to the downside. The opposite is equally true.It is hoped that over a reasonably long period of time this evens out.THE SHARP RATIO
The Sharp ratio is another way of evaluating trading programs. It isa method of determining the rate of return of an investment, aftermaking an allowance for risk. You do this by subtracting the currentrate of return available from what is generally considered a risk-freeinvestment, such as Treasury bills, from the average annual ROR ofthe investment you are considering. This quantity is used as the numerator. The denominator is found by dividing the standard devi-
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ation of the average annual ROR of the investment into the remainder of the subtraction operation.The product of the division generates the Sharp ratio, whichcan be used to evaluate one investment opportunity against another. It doesn’t matter if they are in the same class of investments ornot. You can calculate the Sharp ratio on a monthly or annual basis,depending on the data and time available. Do this on a monthly basis and then graph the data points of the various investments beingevaluated. You should be looking for a Sharp ratio that is very consistent and increasing.STERLING RATIO
Another evaluation tool is the Sterling ratio. It is a measure of therisk-adjusted return you might expect from an investment. Defineit as the return you should reap for each unit of risk you are willingto accept. The more risk you take, the more you should receive forliving with that risk.With the Sterling ratio (SR), the higher it is, the better. A ratioof 2 is theoretically twice as attractive as a ratio of 1. The formula forthe Sterling ratio isSR
average annual return for the last 3 calendar yearslargest average cumulative losses for the last 3 calendar years  10%
Notice that the average annual return for the last 3 calendaryears is evaluated. Divide this figure by the largest average cumulative loss for each of the last 3 calendar years plus 10 percent. Thisextra 10 percent is added to the average cumulative losses becausequarterly and monthly returns tend to underestimate the actualmaximum loss periods.A comparison of two commodity trading advisers might looklike this. The first one has an average annual return for the last 3 calendar years of 30 percent. The average cumulative loss for the 3-yearperiod is 20 percent. The second CTA has the same return, but losses are lower, 15 percent. What are their Sterling ratios?ReturnLossSR
CTA 130%20%1.00
CTA 230%15%1.20
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The calculation of the SR for CTA 1 would be: 30 divided by thesum of 20 plus 10 (or 30). The SR for CTA 2 is 30 divided by the sumof 15 plus 10 (or 25). From this analysis, CTA 2 appears to be 20 percent better than CTA 1.
Look Beyond the RatioYou must pay particular attention to drawdowns and when they occur. If analyzing two CTAs with the same returns and losses as usedin our example, adviser 2 looked good. However, the CTA’s trackrecord in the disclosure document may show CTA 2 had an averageloss of 15 percent per year, but it was 30 percent over a 6-month period of time—October, November, December, January, February,and March. The “calendar” year splits the 30 percent loss into two15 percent losses.Now, a couple of things usually happen when a CTA losesmoney for 6 months straight. First, some investors lose faith andjump ship. This, combined with the losses, reduces the CTA’s equity base. The lower the equity, the harder it is for the CTA to recover(see Figure 10.1). Second, when a CTA is losing money and clients,personal confidence suffers.Using calendar years as part of this formula seriously flaws theresults, but this is not the only problem.In another hypothetical situation, CTA 1 has an average annual return of 30 percent and a maximum average cumulative drawdown of 20 percent. CTA 2 has the same. Therefore, the Sterling ratio is the same for both, namely 1. That makes them equal—right?Which CTA would you be most interested in if the average lossof the CTAs were as follows: CTA 1 has an even loss of 20 percenteach year; CTA 2’s average drawdown of 20 percent is composed of10, 20, and 30 percent. Both average 20 percent, but CTA 2’s lossesare increasing each year. CTA 1’s losses are fairly consistent. Whatif CTA 2’s losses are 0, 20, and 40 percent, or 0, 0, and 60 percent?Volatility like this can mean trouble—a fact that is not reflected inthe Sterling ratio.
Where Did 10 Percent Come From?There are also problems with the arbitrary 10 percent added to thelosses. If you add 10 percent to an average loss of 15 percent, you
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increase it by 67 percent. If you add it to an average loss of 35 percent, you only increase it 29 percent. This, of course, substantiallychanges the Sterling ratio.ReturnLossSR
CTA 125%15%1.00
CTA 250%35%1.11
CTA 2 is more volatile and yet has a better Sterling ratio. It appears to us that the more consistent traders are penalized by the arbitrary 10 percent assessment to the loss column.When your broker begins to brag about the Sterling ratio of theCTA, take the time to go beyond the ratio. Find out how it is put together. How stable and consistent is the CTA? That’s what counts.CTA BATTING AVERAGES
Since there are some problems with the Sterling ratio, an alternativeis needed. One devised by Nick Vintila, a commodity pool operator,overcomes some of the shortcomings of the Sterling ratio. It’s calledthe CTA batting average. Its formulas areLong-term batting average  compounded annual RORgreatest cumulative drawdown ever experienced by the CTAShort-term batting average  compounded ROR over the last 36 monthsgreatest drawdown experienced by the CTA over the last 36 months
What Are the Differences?There are several important differences between the CTA battingaverage (BA) and the Sterling ratio. To begin with, the BA utilizesa present-value–future-value calculation in the numerator ratherthan a simple average. In our opinion, this much more accuratelyreflects the ROR.The denominators of these equations are even more important.In the SR, you use the maximum average drawdown. It is based ona calendar year. This can be very misleading if a drawdown continues over more than one calendar year, as was pointed out earlier.With the BA, the greatest cumulative drawdown for the last 36
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months, or the entire track record, is used. This may seem somewhatunforgiving, but it illustrates a worst-case scenario. If this drawdown occurred more than 36 months ago, it doesn’t affect the shortterm batting average. Then the long-and short-term batting averages can be compared. Has a CTA improved or regressed? Havingtwo views is also an important feature not available with the SR.The BA also provides a new view each month. The numbersused are rolling constantly. You don’t have to wait for the end of theyear to recalculate the ratios. This allows you to do two importantongoing analyses. (1) You are alerted sooner to uptrends or downtrends in performance. This gives you time to react. (2) You can evaluate your CTA’s performance in given market conditions shortly after they occur. If a major bull or bear market develops, how is yourCTA performing? Can the CTA trade a trendless market? By recalculating the BA on a monthly basis and charting it on an index thatreflects the CTA’s portfolio, you’ll know. You may want to switch location of your funds between CTAs depending on the long-termtrend of the market.