Note also that the BA does away with the arbitrary 10 percentadded to the denominator of the Sterling ratio. This does not discriminate against conservative and consistent CTAs.With the BA approach, a CTA with large drawdowns cannothide them in an average. For example, let’s go back to the CTA with0, 0, and 60 percent drawdowns over a 3-year period. Using the Sterling ratio, these averaged to 20 percent. With the BA, you would usethe 60 percent loss.When evaluating CTA track records, accumulation of losses isa key concept. The more equity lost, the more difficult it is for theCTA to recover.Another aspect about the BA approach is being able to see if theCTA’s performance is affected by changes made in the trading system used or in the amount of money under management. CTAs willoften tell you that they “fixed” their system. By studying performance on a rolling basis, you can substantiate these claims.How does a CTA’s trading react to a big influx of equity? Comparing the results of the BA with the additions to equity on a monthby-month basis answers that question. Performance often dropswhen large amounts of equity are added if the CTA’s back roomand/or system isn’t up to the challenge.
MD6988.227-252
9/28/01
10:57 AM
Page 241
Giving Trading Discretion to Someone Else
241
IT PAYS TO BE A LITTLE PARANOID
This old saying in the futures business simply means there is no perfect method of determining who will outperform whom in the futures market. You must use all the tools available to you and makeyour own decision. And there are more ways than one to calculatethe return on investment. The various approaches produce differentanswers. The real ROR question is often not what the return computes to, but how it was calculated. To evaluate the performance ofa commodity trading adviser, take the CTA’s disclosure documentand calculate the following VAMI figures:Period
VAMI Value
% Increase
End of 1988
$2,928
End of 1989
$8,766
End of 1990
$8,882
1.32
End of 1991
$l2,828
44.43
299.38
A $1,000 unit invested in this particular CTA increased in value from the inception of the fund to $2,928 at the end of 1988. Thenext year was a big year for the CTA, with an increase of almost 300percent. The year 1990 turned out to be rather flat, and 1991 broughtan increase of over 40 percent.Now, how should the overall return for the 3 years in questionbe calculated? The simplest method is to add the returns for the 3years together and divide by 3:299.38%  1.32%  44.43%  345.13%/3  115.04%
This would give us an average annual return of just over 115 percent.Option 2 would be to first calculate the total amount of gain.You would do this by subtracting the initial amount from the ending amount, or $12,828 less $2,928. The remainder is $9,900. Youwould then divide this remainder by the beginning amount—$9,900 divided by $2,928. The result is 338.11 percent over the 3-yearperiod. On a per-year basis, it is 112.70 percent, which is 338.11 percent divided by 3.What happens if a more sophisticated technique is used? Youdecide to do some time-value analysis. You want to determine thecompounded annual rate of return. With the present value of $2,928
MD6988.227-252
242
9/28/01
10:57 AM
Page 242
CHAPTER 10
and the future value of $12,828, you decide to calculate the RORover 3 periods, representing the years. This produces a figure of63.63 percent as the compounded annual rate of return.If you wanted to do this same calculation on a monthly basis,you would use 36 periods, rather than 3. This would generate amonthly compounded return of 4.19 percent. To annualize themonthly return, you would multiply it by 12, resulting in a figure of50.27 percent.This gives us four different ROR figures, using the four formulas. Once you select a method for a specific class of investment,always use the same one. If a broker provides some RORs to you,make sure you find out which method was used to calculate them.If necessary, you may have to recalculate the figures so they are consistent with your other data.For evaluating a CTA, method 3 may provide the best measurement. Once you have an annual compounded ROR for theCTAs you are considering, you can evaluate them against an indexof other CTAS. Figures on the performance of public and privatefunds can be obtained from the Managed Accounts Report newsletteror Futures Magazine. This provides an insight into how an individual CTA compares with other CTAs. It is similar to evaluating theperformance of your stock portfolio with the S&P 500 Index.THE IMPACT OF ADDITIONS AND WITHDRAWALS
The annual rates of return just discussed are the composite of 12monthly trading periods. You need to take a closer look at how theseperiods are put together in order to have confidence in the ROR figures you calculate.As mentioned earlier, one of the stickiest tasks any accountantor statistician has is accounting for additions and withdrawalswhen calculating performance. This is because of the timing of thesetransactions. Let’s say an account receives an additional $10,000 ofequity on June 15. Should it be included for the entire month, half,or not at all? What if the addition comes in on the first or the thirtieth?You face the same problem with withdrawals. Money comingout of an account on the first of the month may make more of an impact on that month’s return than a withdrawal on the last business
MD6988.227-252
9/28/01
10:57 AM
Page 243
Giving Trading Discretion to Someone Else
243
day of the month. The commodity trading advisers will theorizethat if they had the money all month, the return would be higher.The point is simply this: When you attempt to calculate a ROR,you divide the gain or loss by the amount of equity. Much dependson how the denominator (or amount of equity) is determined. If youassume in your calculations that the funds always come in at the beginning of the month and always leave at the end, you’ll skew theROR to the downside. The opposite is also true.Historically, here’s how the Commodity Futures Trading Commission has done it. The monthly ROR is determined by dividingthe net monthly performances (gain or loss) by beginning equity.For example, let’s say a commodity pool operator has a fund of $1million. Three CTAs are given $300,000 each, and $100,000 is heldback in reserve. The CTAs use the $300,000 as their beginning equity for the first month.If CTA 1 generates $18,000 in profits the first month, the RORwould be $18,000 divided by $300,000, or 6 percent. This changeshis beginning equity for the second month to $318,000. If $5,000is gained for the second month, the ROR would be 1.6 percent($5,000/$318,000).Losses are calculated the same way. Let’s say in the third monththe CTA takes a $6,000 loss. The beginning equity for the month isnow $323,000, which is divided into the loss of $6,000. Therefore, themonthly ROR is a negative 1.8 percent.This method works well, especially for small accounts thathave very few additions or withdrawals. But once you get into a situation where there are a lot of large movements of money in andout, these ROR figures can become less meaningful. They can become very distorted, especially when the changes in total equity exceed 15 to 20 percent in a given month.The entire process can become even more distorted whenyou’re evaluating composite performances. This could be the trackrecord of all the accounts traded by one CTA or the composite trading records of several CTAs advising a single fund. The reason issimply the large number of additions and withdrawals that it wouldprobably include in multiple and long-term track records. To overcome this problem, the CFTC now requires additions and withdrawals to be time-weighted over the period of time the CTA has access to the funds.
MD6988.227-252
9/28/01
10:57 AM
Page 244
244
CHAPTER 10
AN ALTERNATIVE METHOD
With Nick Vintila’s alternative method, you would base yourmonthly performance calculations on a $1,000 unit. If you opened a$60,000 managed account, you would have 60 units of $1,000.Therefore, if your account was worth $64,000 at the end of thefirst month, barring any additions or withdrawals, each unit wouldbe worth $1,066.66. This is an increase of 6.66 percent for the month.A loss is determined the same way, always calculated on a per-unitbasis.What about withdrawals? Let’s say you needed to withdraw$16,000 after month 1. You would divide that amount by the unitvalue to figure how many units you were withdrawing. It would be$16,000 divided by $1,066.66, or 15 units. You now have 45 unitswith the same value of $1,066.66 each, or $48,000, which is $64,000less the $16,000.In the next month, you make $3,000. You add this to the beginning value of $48,000 and divide by the 45 remaining units($51,000/45) for a unit value of $1,133. Next, you subtract the original $1,000 and divide by 1,000 to convert to a percentage. The return is therefore 13.33 percent for this month.The most important consideration is that you deal only withfunds in your account. This provides more validity and makes iteasier to compare one CTA with another.
A MILKING STOOL
Solid investment programs are built like old-fashioned milkingstools. The three legs are rate of return, risk control as measured byvolatility, and consistency of performance.Having considered the first two, what about the third? Whycare about consistency? Can’t a high enough ROR overcome all other obstacles to success? Actually, a high rate of return often coversup the true picture. You need to analyze the ROR figure to determine when the gains were generated.Consider two CTAs who have posted RORs of 300 percent overa 3-year period of time. CTA 1 had an ROR of 100 percent each year,while the second CTA gained 300 percent in one of the years andbroke even the other two.
MD6988.227-252
9/28/01
10:57 AM
Page 245
Giving Trading Discretion to Someone Else
245
Now, if you just happened to be investing with CTA 2 duringthis “hot” 12-month period, you’d be extremely happy—an ROR of300 percent! However, what if your timing wasn’t so perfect? Wouldyou rather have had your money with CTA 1 for any 12 months during the 36-month period? It almost comes down to choosing between trying to be very lucky or learning how to discover adviserswho produce consistent returns.TIME-INTERVAL ANALYSIS
Another statistical technique, suggested by Nick Vintila, is calledtime-interval analysis (TIA). A CTA’s track record is broken down intotime intervals of 3-, 6-, 9-, 12-, 18-, and 24-month periods. TIA takesthe position that calendar years are not any more important thanany other 12-month periods. If you open an account in March andby the following April it’s losing money, it’s not any consolation thatthe CTA performed well from January to December. TIA gives youa higher number of observations at which to look compared withhaving only calendar performance statistics.Therefore, you quickly team two things: the CTA’s volatilityand consistency. If you run TIA over 3-, 6-, 9-, 12-, 18-, and 24-monthperiods, it tells you immediately if the CTA has been more consistent when given 12 months, instead of 1 or 3 months to trade.If a CTA has a 12-month ask record, you could calculate ten 3month time intervals, seven 6-month time intervals four 9-monthtime intervals, and one 12-month time interval (see Figure 10.2).Each time interval is determined by rolling one month forwardand dropping the last month, similar to moving averages. The RORis calculated based on the VAMI. Next, you take the results of thevarious time intervals and create bar charts. The midpoint of thecharts is zero ROR. All intervals with positive RORs are chartedabove the midline and all negative intervals below. This techniqueprovides a very graphic picture regarding a CTA’s consistency.Pay particular attention to the 12-, 18-, or 24-month interval futures. You’re trying to find out how consistent the ROR is over longperiods of time. The hope is that this period of time would includeboth bull and bear market moves, plus periods where the marketmoves sideways or is choppy.Ideally, the ROR will be consistent no matter what the market
MD6988.227-252
9/28/01
10:57 AM
Page 246
CHAPTER 10
246
F I G U R E
10.2
Time-Interval Analysis over 12 MonthsTime Intervals
3 Months
6 Months
9 Months
12 Months
123456789101112
12345678910
1234567
1234
1
is doing. By doing this analysis, you’ll find out exactly when themoney was made and over what period of time, i.e., at the beginning of the CTA’s career or consistently throughout the CTA’s entirecareer. You’ll easily be able to see if you need to be lucky and guesswhen to invest or whether you can invest anytime because the performance is consistent.“GIVE ME ANOTHER 3 MONTHS . . .”
When you have money in a managed account or a fund and you’reunhappy with the current performance, you may be trying to decidewhen and if to cash out your investment. At that time, your brokeror CTA may ask for another few months to get things going. If thishappens to you, you can easily compare the 1-month, 3-month, or6-month time intervals and immediately see what you can expect.Does this CTA perform well over the short term? If you calculate thepercentage of profitability over the different time intervals, you willknow if it makes any sense to put off your decision to liquidate.WHAT THE TERM “DUE DILIGENCE” MEANS
In a legal sense, it means undertaking a study of a person or an entity to uncover as much background as possible. The word diligence
MD6988.227-252
9/28/01
10:57 AM
Page 247
Giving Trading Discretion to Someone Else
247
carries the connotation of perseverance and determination—an unwavering drive to uncover the essence of the subject being studied.When preparing a “due diligence report” on CTAs, learn asmuch as possible about these traders, their systems, and their performances. A study of this sort is done to make sure their trackrecords can be relied upon as an accurate representation of theirtrading. Additionally, a due diligence study provides valuable insights into how certain CTAs will help reach investment goals. Alsolearn if they are compatible with you. Can their staff (back room) respond to the challenge of trading more funds?One of the best places to start is the disclosure document. Thisinstrument should contain all the information that is pertinent to investors who are considering investing in a particular CTA or a fund.For a fund or limited partnership, the document is called a prospectus. In addition to information about the futures traders, the document also includes the risk disclosure statements required by theCommodity Futures Trading Commission. It also includes background on other entities—such as the organizer (commodity pooloperator) and clearing firm (futures commission merchant)—thatwill play a major role in the investment.Your goal in examining the disclosure documents is to read between the lines and to validate all salient points. Keep in mind thatthe offering documents are written by attorneys who are paid to interpret the facts of any case or argument in light of their clients’ bestinterests.The unfortunate part of this situation is that these documentshave grown longer and more complicated each year. The investingpublic would be better served if the CFTC stressed simplicity andunderstandability, as well as risk disclosure, in these documents.Prior to being made available to prospective investors, theseoffering documents are sent to the CFTC for review. The CFTC reserves 21 days to make comments and order required changes. If thepromoter of the offering doesn’t hear from the CFTC within thistime period, it can begin the selling process. Depending on the specific type and size of the offering, this process may include reviewsby the secretaries of state of the various states in which it is to besold. Many of these investments are considered a security duringthe selling process. Therefore, they are under the jurisdiction of theSecurity and Exchange Commission or each state’s secretary of state
MD6988.227-252
9/28/01
10:57 AM
248
Page 248
CHAPTER 10
at this stage. Once they begin trading futures, the jurisdiction ispassed to the CFTC and the National Futures Association.The CFTC and state and federal regulatory bodies can still require changes or additions to these documents even if the 21-day review period by the CFTC has expired and the offering document hasbeen printed. Therefore, from time to time, you may find additionsor changes pasted or bound into an offering document.WHAT TO LOOK FOR
There are various levels of due diligence investigations. Take the examination of a CTA’s track record as an illustration. Professionaldue diligence studies might use accountants to test the CTA’s trackrecord, just as you would test a company’s accounting records. Theywould randomly select specific periods of trading for review. TheCTAs would be asked to produce the order tickets (the NFA requiresmembers to retain each order ticket for 5 years) covering the period.These would be checked against records of the range the markettraded on that day to make sure the trade was possible. The accountants would track the trade until it was closed, calculating theprofit or loss for all trades for the period. This would then be compared with what was presented in the performance tables.The analysis of the rate of return and how it was calculated isanother example of a less intensive, but equally important, level ofinvestigation.To help this due diligence process, there is so much more in theoffering document than the track records. It is possible to review thebackgrounds of all the principals: CPO, general partner(s), advisers,clearing firms, etc. Do they have enough experience to satisfy you?As you study the offering document, write down your questions. Don’t hesitate to call or write the administrators of the investments (their addresses and phone numbers are in the front ofthe documents) with your questions.Another important area covers the conflicts of interest. Arethey acceptable? For example, if the advisers receive per-trade commissions, as well as management and/or incentive fees, will theyhave the tendency to overtrade?The fees involved critically affect performance. Think of themas drawdowns of equity. It is money paid out of the trading equity
MD6988.227-252
9/28/01
10:57 AM
Page 249
Giving Trading Discretion to Someone Else
249
and can no longer be used to generate profits. If the fees are unreasonable, they drain the equity. Reasonable fees are needed to compensate all those involved for the work and risk assumed in bringing the investment to market.Do your homework before you invest. Most investments thatsound too good to be true are! You are the only one who can makethe decision to invest. Take care that you have looked over the entire offering very carefully.DIVERSIFYING CTA TRADING SYSTEMS
When you or the investment vehicle you are considering uses morethan one CTA, consider the concept of using CTAs that have diversified trading systems. Just as the prudent trader has a diversifiedportfolio, the prudent investor does not invest in CTAs that use similar trading systems.The reason is simple. If all the CTAs in a fund are trend followers and the trend takes an abrupt change of direction, they allget caught in the move. If one CTA is a trend follower and the second a contrarian, the trend change just described may not impactthe investment as severely.There are several other ways of looking at diversification withregard to CTAs managing futures trading accounts. Futures portfolios should normally be diversified in accordance with the marketsin which they are traded. The risk involved in trading all of one’sequity in one or two markets is great.The second test for diversification among multiple CTAs sharing management responsibilities for a managed account program isnegative correlation, discussed earlier in this chapter. Analysis ofthe long-term trading results of the different CTAs would need toindicate they do not incur drawdowns at the same time. This givesthe program balance.Your objective in creating diversity in a group of CTAs is to understand how their systems trade the market.CTA SELECTION SUMMARY
In review, the steps you should take when you select a trading adviser are:
MD6988.227-252
250
9/28/01
10:57 AM
Page 250
CHAPTER 10
Step 1Locate a group of CTAs that interest you. Since futures trading is very speculative and involves such a high degree ofrisk, you naturally expect a high return for assuming therisk. Therefore, the first number to look for is the rate ofreturn.There are several methods of calculating ROR. Using thecompound annual ROR method is preferable. This was theformula that utilized the present value and the future valueto determine the ROR over the length of the track record inyears.Avoid or at least be very wary of track records that areshorter than 3 years or are hypothetical. Simulated or hypothetical performance tables are often generated to test tradingsystems developed through “paper trading.” These trackrecords have certain limitations, such as eliminating the human emotional factor that comes into play when a trader isactually risking personal or client money. Any offering memorandum, such as a prospectus or disclosure document, reviewed by the CFTC requires hypothetical performancerecords to be clearly stated as such and to carry a specialdisclosure statement.Step 2High ROR is not the most important factor to consider whenselecting CTAs. A stable and consistent performance record ismore important than an occasional astronomical ROR figure.Be much more comfortable with a trader who produces a 40percent or 60 percent return year in and year out than withone who produces a 100 percent or 200 percent return onetime with equally high drawdowns.Remember the loss-recover table in Figure 10.1. To recoverfrom a 70 percent loss, the CTA needs a 233.33 percent gain ora 900 percent gain to recoup a 90 percent loss. Whenever theequity is seriously depleted, chances of success geometricallydecline.Review the pros and cons of various methods of evaluation—ROR, VAMI, Sharp ratio, Sterling ratio, CTA battingaverage, and time-interval analysis. The batting average usually is the best.
MD6988.227-252
9/28/01
10:57 AM
Page 251
Giving Trading Discretion to Someone Else
251
Step 3Once you isolate CTAs that have acceptable trading recordsand whose performance is stable and consistent, you canmove on to the more time-consuming analysis. Start with theanalysis of the numbers because it is the easiest informationto obtain. You’ll find it in each CTA’s printed disclosure document distributed to prospective clients. Check the date on thecover to make certain you are dealing with current numbers.The CFTC requires the CTA to update the disclosure document every 6 months.This step involves due diligence—learning as much aspossible about the integrity, trading acumen, and operations of the CTAs under review. You’ll want to check withthe National Futures Association Information Center(800-621-3570) to see if it has ever disciplined the CTAs.Request client and professional references from the CTA.Study the CTA’s trading system. If it is a trend-followingsystem, how well does it adjust to trend changes? What impact has it had on the ROR?By telephone or in person, interview the CTA and/or commodity pool operator in the case of a fund, limited partnership, or pool. What kind of people will you be dealing with?Will they be responsive to any questions you may have?Also, take a look at the CTA’s back room, if possible. Theback room is where the paperwork for the trading takesplace. Are the orders handled efficiently? Is the operationwell staffed and equipped? What quote equipment is beingused? If you’re investing in a fund that will give a CTA another $500,000 or $1 million to trade, can the increase involume be handled without problem? How has volumeincreases affected ROR in the past?Are fees in line with industry standards? Keep the loss-recovery table (Figure 10.1) in the back of your mind. Moneypaid out as management fees is not any more available totrade than equity loss trading. Exorbitant fees can crippletraders as fast as a large drawdown.Step 4You are now down to a short list of CTAs that have passed allyour tests. As always with futures trading, diversify. Select
MD6988.227-252
252
9/28/01
10:57 AM
Page 252
CHAPTER 10
more than one CTA or invest in a fund that uses more thanone. Match your CTAs so they are negatively correlated.Step 5Develop an ongoing monitoring procedure. One of the best istime-interval analysis. Keep your eye on the target of increasing your equity.All of the above is the minimum you should do when selectinga professionally managed futures trading program, but it is not afoolproof way of making money. Even the best CTAs experiencedrawdowns. You may well have your money with them when theydo. You have heard it before—only invest what you can afford to lose.The high rewards associated with futures trading are matched withthe high losses that can also be sustained.
MD6988.253-268
9/28/01
10:58 AM
Page 253
C H A P T E R
11
Knowing Your Rights andRecourse as an Investorin the Futures Markets
Key Concepts◆ Investing Advantages in a Federally Regulated Industry◆ Knowing the CFTC and NFA Regulations for Protectionagainst Swindlers◆ Sorting the Ethical from the Unethical Commodity Broker◆ Asking 15 Key Questions Before You Invest◆ Communicating with Your Broker◆ Recognizing Three Cardinal Sins Committed by Brokers
If you understand your rights before you become a participant inthe futures market, you’ll have a far better chance of being successful than if you plunge into it without fully understanding the risks.Over the years, most individual traders have been net losers, but theopportunity to make a 200 percent or 300 percent or more return onone’s money in a few months, weeks, or even days brings a steadyflow of investors to the pits.If you do lose, whose fault is it? Should you accept the blameno matter what? Or is your broker, the IB, the clearing firm, or theexchange completely or partially responsible? If so, what can youdo about it? How can you evaluate what you are being told? Howcan you protect yourself against swindlers? What action can youtake if you ever feel you have been cheated or mistreated? What areyour rights in relationship to the FCM and the exchanges?Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
253
MD6988.253-268
9/28/01
10:58 AM
Page 254
254
CHAPTER 11
CHECK WITH THE NFA WHEN IN DOUBT
The first point to remember when you consider futures and/or options on futures (also known as exchange-traded options, as opposedto some metal options that involve the cash metals market that areunregulated) is that the futures market is regulated by the NationalFutures Association. It is an industry-supported organization authorized by Congress via the Commodity Futures Trading Commission.No person or firm can engage in any business involving thebuying or selling of futures contracts for the public without becoming an NFA member or associate member. In other words, to conduct any futures business you must be an NFA member, and members can only do business with other members. An exception is theassociated person (AP), who deals with the customer. APs are commonly known as commodity brokers.Most APs work for introducing brokers. The IB introduces theperson or firm that wishes to trade to the futures commission merchant. The FCM is the entity that enters orders into the marketthrough floor traders. The floor traders are the ones that do the actual trading in the pits of the exchanges.The FCM is also responsible for the back-room operation. Thisoperation deals with the accounting involved in maintaining thetrading account of each person or entity that is trading. Each exchange has a clearing operation to balance each day’s trading.If you are approached by anyone regarding an investmentin the futures market, that person must be a member or an associate member of the NFA. To check a person’s standing, i.e., a salesperson (broker) or firm (IB) that sent you a letter about openingan account, all you need to do is make a toll-free call to the NFA(1-800-621-3570, or 1-800-572-9400 from Illinois) and ask.If the person or firm is not registered with the NFA, tell theNFA’s representative exactly what was sent or offered to you, andthe NFA will investigate. Don’t do any business with a salespersonor firm until you clear up, to your satisfaction, this point. The typeof investment being promoted may sound like it should be part ofthe futures industry, but if it isn’t, it doesn’t require NFA registration. If the product is not federally regulated, you will more thanlikely have difficulty getting satisfaction if something goes wrong.
MD6988.253-268
9/28/01
10:58 AM
Page 255
Knowing Your Rights and Recourse as an Investor in the Futures Markets
255
If the person or firm soliciting you is registered with the NFA,you know that person or firm must adhere to all NFA and CFTCrules and regulations. By reviewing the guidelines the NFA has setdown for promotional material, you’ll know if the firm that is soliciting your business is in compliance. If its advertising clearly violates these dictates, you should consider yourself forew