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Normalizing managed futures programs by their "true minimums"

December 22, 2008

 

Will a $1 Million investment in Pere Trading Group provide the same potential returns as a $1 Million investment in Clarke Capital Management’ Global Basic program? Is a $100,000 allocation to Dighton Capital as equally volatile as a $100,000 allocation to NDX Capital?

While these questions may seem rather simple and straightforward on the surface (the answer to both is NO), it is actually a rather advanced topic we have been working on with some clients lately in reviewing their multi-advisor portfolios.

The issue we’ve been looking at is how best to equalize a portfolio containing 2 to 20 different CTA programs. The simplistic yet naive solution is to merely put an even amount of money with each advisor in the portfolio – say $1,000,000 split evenly between 10 advisors by allocating $100,000 to each one.

This would work with stocks, bonds, or real estate, as the amount of money you put up is the amount of money you risk with that investment; but gets much more complicated with managed futures investments due to the ability to trade $500,000 “as if” it were $1 Million through a practice called notional funding.

You can view our past newsletter on notional funding by clicking here, but the quick overview is that a managed futures program minimum investment amount is best thought of as three separate components – the margin, the risk, and the window dressing amounts.

The margin is the amount technically needed to place trades and is a small fraction of the reported minimum. The risk is the amount needed to cover any future volatility and drawdowns, and the “window dressing” amount used to make the program’s returns more appealing to investors. More “window dressing” would cause less annual volatility, while less would result in higher returns (and risk).

This “window dressing” amount is what throws a monkey wrench into portfolio creation models for most people, as there is no consistency between managers on how much “dressing” they use. Some managers set their minimums at lower levels so that their annual returns in good years are at the top of the lists of top performing CTAs, while other managers use higher minimums so that they appear less volatile.

It becomes a marketing game of sorts, with each manager setting his or her minimum investment amount at a place he or she feels they will get the returns and volatility (in percent terms) which are most appealing to investors.

What is the true minimum?

The fact that there is a marketing, or “window dressing”, component to the minimum investment amount for many managed futures programs begs the question – what is the true minimum?

We don’t have this problem when investing in stocks, bonds, or real estate. If you want to purchase $100,000 of stock, for example; the minimum is the same $100,000. You can put up less and borrow money to make up the difference in stock trading, but the minimum required is still $100K, it is just $50K of cash and $50K of borrowed money. In contrast, futures accounts allow you to trade $50K as $100K without borrowing any money, because of the difference between the technical amount needed and the “window dressing” amount.

So how can we figure out what the “true minimums” are for different managed futures programs? That is the data we will need in order to correctly balance out a portfolio. That is the data we will need to correctly say that $300K in NDX has the same absolute risk as $100K in Dighton, for example.

One way is to think of the “true minimum” as an amount equal to the risk of the investment, and to breakdown the percentage risk numbers we’re all so used to looking at into actual dollars. What does a max DD of -30% really mean in dollars. For a $100,000 minimum CTA program, it means a DD of -$30,000 in your future (simple math of multiplying -30% by $100K). What does average margin usage of 12.50% look like for a $1 Million minimum CTA? You guessed it, $125,000.

Armed with these dollar based levels, we can start to assign our own dollar based risk numbers to each CTA. Some people may want to view risk as equal to the past max DD. Some may think of risk as the average margin usage. Other may wish to equate risk to the volatility of the CTA.

The table below breaks down the dollar based “risk” in terms of DD, margin usage, and volatility for numerous CTAs. The results may surprise you somewhat, as you will see similar dollar based risk levels for CTAs with much different minimum investment amounts.

Dollar Based Risk Levels for various CTAs




CTA

Avg Margin Usage

Expected Max DD

Std Dev

Average "Risk"

APA Modified

$ 37,500.00

$ 75,000.00

$ 87,500.00

$ 66,666.67

APA Strat Div Prog

$ 100,000.00

$ 150,000.00

$ 125,000.00

$ 125,000.00

Cervino Diversified Options

$ 15,000.00

$ 5,000.00

$ 3,750.00

$ 7,916.67

Clarke Global Basic

$ 20,000.00

$ 20,000.00

$ 20,000.00

$ 20,000.00

Clarke Global Magnum

$ 15,000.00

$ 15,000.00

$ 15,000.00

$ 15,000.00

Clarke Worldwide

$ 62,500.00

$ 75,000.00

$ 62,500.00

$ 66,666.67

Claughton Capital

$ 175,000.00

$ 150,000.00

$ 125,000.00

$ 150,000.00

Crescent Bay

$ 15,000.00

$ 7,500.00

$ 5,000.00

$ 9,166.67

Dighton

$ 25,000.00

$ 75,000.00

$ 50,000.00

$ 50,000.00

DMH

$ 15,000.00

$ 20,000.00

$ 15,000.00

$ 16,666.67

FCI

$ 50,000.00

$ 40,000.00

$ 25,000.00

$ 38,333.33

Hoffman Asset Mgmt

$ 10,000.00

$ 42,500.00

$ 25,000.00

$ 25,833.33

MSLO

$ 20,000.00

$ 50,000.00

$ 65,000.00

$ 45,000.00

NDX Shadrach

$ 50,000.00

$ 40,000.00

$ 70,000.00

$ 53,333.33

Pere

$ 15,000.00

$ 80,000.00

$ 75,000.00

$ 56,666.67

Rosetta

$ 15,000.00

$ 40,000.00

$ 50,000.00

$ 35,000.00

Once we get a handle on what the dollar based risk levels look like for each CTA, we can take a stab at defining what each CTA’s “true minimum” should be. One simple way is to simply take the average of the various risk levels and use that as the “true minimum”. Another measure used by many clients at Attain is to take the projected Max DD and add the average margin usage to it. This insures you would have enough capital to cover margin requirements should the account go into a new max DD.

The table below lists the reported minimums by each CTA along with the “true minimums” we have calculated using the method above of adding the average margin usage to the projected future max drawdown.




CTA

Reported Min

“True Minimum”

APA Modified

$ 250,000.00

$ 112,500.00

APA Strat Div Prog

$ 1,000,000.00

$ 250,000.00

Cervino Diversified Options

$ 50,000.00

$ 20,000.00

Clarke Global Basic

$ 50,000.00

$ 40,000.00

Clarke Global Magnum

$ 50,000.00

$ 30,000.00

Clarke Worldwide

$ 250,000.00

$ 137,500.00

Claughton Capital

$ 1,000,000.00

$ 325,000.00

Crescent Bay

$ 25,000.00

$ 22,500.00

Dighton

$ 100,000.00

$ 100,000.00

DMH

$ 100,000.00

$ 35,000.00

FCI

$ 100,000.00

$ 90,000.00

Hoffman Asset Mgmt

$ 125,000.00

$ 52,500.00

MSLO

$ 100,000.00

$ 70,000.00

NDX Shadrach

$ 100,000.00

$ 30,000.00

Pere

$ 100,000.00

$ 95,000.00

Rosetta

$ 100,000.00

$ 55,000.00

You can now see that the “true minimum” can be much different than the reported minimums. NDX Shadrach, for example, only has a “true minimum” 1/3 of its reported minimum due to its low drawdown and margin usage. The riskier Pere and Dighton, in contrast, have “true minimums” basically equally to their reported minimums.

Once we have the “true minimums” for each CTA, we can go back to the issue first brought up at the beginning of this piece – how can you best equalize a portfolio of multiple CTA programs. Or put another way, how many units of CTA 1 does it take to equal the risk of CTA 2, how many of CTA 2 to equal CTA 3, and so on.

The table below is a matrix which lists how many units of each CTA it takes to equal each other CTA based on each CTA’s “true minimum” as defined above. Two disclaimers to make are 1. the projected Max DD is a subjective number created by Attain based off the past Max DD of each CTA, the amount of history each CTA has, and our due diligence on the CTA; and 2. the average margin usage is an average number, subject to change and at risk of spikes much higher.

CTA Risk Equalization Matrix













In Units of















CTA

Cervino

Cresc Bay

Clarke Global Mag

NDX Shad

DMH

Clarke Global Basic

Hoffman Asset Mgmt

Rosetta

MSLO

FCI

Pere

Dighton

APA Mod

Clarke World

APA Strat

Claught Capital

Cervino Diversified Options

1.0
















Crescent Bay

1.1

1.0















Clarke Global Magnum

1.5

1.3

1.0














NDX Shadrach

1.5

1.3

1.0

1.0













DMH

1.8

1.6

1.2

1.2

1.0












Clarke Global Basic

2.0

1.8

1.3

1.3

1.1

1.0











Hoffman Asset Mgmt

2.6

2.3

1.8

1.8

1.5

1.3

1.0










Rosetta

2.8

2.4

1.8

1.8

1.6

1.4

1.0

1.0









MSLO

3.5

3.1

2.3

2.3

2.0

1.8

1.3

1.3

1.0








FCI

4.5

4.0

3.0

3.0

2.6

2.3

1.7

1.6

1.3

1.0







Pere

4.8

4.2

3.2

3.2

2.7

2.4

1.8

1.7

1.4

1.1

1.0






Dighton

5.0

4.4

3.3

3.3

2.9

2.5

1.9

1.8

1.4

1.1

1.1

1.0





APA Modified

5.6

5.0

3.8

3.8

3.2

2.8

2.1

2.0

1.6

1.3

1.2

1.1

1.0




Clarke Worldwide

6.9

6.1

4.6

4.6

3.9

3.4

2.6

2.5

2.0

1.5

1.4

1.4

1.2

1.0



APA Strat Div Prog

12.5

11.1

8.3

8.3

7.1

6.3

4.8

4.5

3.6

2.8

2.6

2.5

2.2

1.8

1.0


Claughton Capital

16.3

14.4

10.8

10.8

9.3

8.1

6.2

5.9

4.6

3.6

3.4

3.3

2.9

2.4

1.3

1.0

[in reading this table, the number listed is the amount of units of the top row which equals one allocation of the CTA in the left column. For example, 1.1 units of Cervino to equal 1 unit of Crescent Bay, or 2.3 units of Clarke Global Basic to equal 1 unit of FCI]

Conclusion

We can see from the tables above that the minimum investment amounts as reported/required by the CTAs can be quite different than what is actually needed per the “true minimum” values we’ve calculated above, resulting in much different equalization formulas than would first appear logical.

Take the Pere Trading Group and DMH programs for example, which both have $100,000 minimums. At first blush, it may seem that splitting a $200,000 portfolio evenly between the two would have equally diversified between the two CTAs.

However, our calculations above show that it takes almost 3 allocations of DMH, or $300,000; to equal the risk of a single $100,000 allocation of Pere. The supposedly equalized $100K each portfolio of Pere/DMH would therefore have its risk significantly skewed towards Pere if left alone.

This is definitely a more advanced topic which builds on other characteristics of managed futures which must first be understood (such as notional funding), and we hope we haven’t confused more people than we’ve taught.

But for all its complexity, it can be boiled down to a simple thought that not all CTAs are created equal from an absolute dollar risk standpoint. So when combining programs in a portfolio, make sure you double check what the dollar based risk of each component is; and don’t simply rely on the advisor’s recommended minimum investment level for equalizing the different components.

- Jeff Malec

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Sectors start to diverge in a mixed week

Overview

Volatility was very high last week leading to large swings in most sectors as news events did little to give stability to any one direction of trade. Early week news of the FOMC cutting its benchmark rates from 1% to a floating rate between 0% to .25% seemed to give most sectors a boost, but as the week moved forward weaker economic developments worldwide seem to erode support. The move by U.S. government to give U.S. automakers a share of the TARP funds didn’t seem to be a market mover nor did the cut in production from OPEC that had been widely advertised leading up to the actual event. In fact right after the OPEC announcement the energy markets continued in their downward trend as sort of a buy the rumors sell the fact event. For the week Crude Oil dropped -13.87%, RBOB Gas fell -10.37%, Heating Oil shed -6.88% and Natural Gas was down -2.55%.

The metals sector was mostly firm as indications by the FOMC that they would use all means necessary to turn the current economic situation around sparked inflationary talk on ideas they would continue to pump more U.S. Dollars into the system to push spending. This sparked gains in most sectors with Silver +5.82% leading the way. Platinum was up +3.54%, Gold gained 2.12% and Palladium rose +1.76%. Copper -7.25% was the lone exception as pressure stemmed from added stockpiles along with ideas expected growth in emerging countries would not come near earlier expectations.

Commodity and food sectors also experienced gains from the inflationary ideas sparked by the FOMC along with worries about production in the Southern Hemisphere due to weather issues during the current planting season. The grains were led higher by Wheat +8.92%, Corn gained +1.99% and Soybeans ended +1.96% higher. The soft sector was mixed with Cocoa up +7.77% followed by Cotton +3.98% and OJ +.98%. Sugar ended -5.93% and Coffee -1.17% found pressure from larger than expected supplies. In the livestock sector Live Cattle ended the week +4.68% and Lean Hogs fell -.39%.

The U.S. Dollar Index lost -2.29% on news of the U.S. Fed announcement especially with their indications that they would pump more currency into the system to stimulate buying. Most continentals found support on this news with the Swiss Franc gaining +6.13%, Euro added +3.93% and the Japanese Yen was +1.91% higher. The British Pound -0.45% could not sustain its gains due to news of worsening economic conditions. 30-year Bond futures ended up +3.38%, and 10-year Notes futures gained +1.85% as support stemmed from the moves by the FOMC which cut rates to historic lows.

Stock Index futures saw both sides of unchanged during the past week as the moves by the FOMC and a government TARP allocation to U.S. automakers did support the sector, but some other news events relating to economic conditions and the stability of some large corporations super ceded the positive developments in some areas. The small cap sector fared the best with Russell futures ended +3.45% higher and Mid Cap futures up +1.47%. The large caps were led down by the Dow futures -1.62% with the S&P 500 futures -.58% and the NASDAQ futures -.43 ending marginally lower.

Managed Futures

After posting positive returns in October and November multi-market trend following managers continue to have success in the last quarter of 2008 with another round of gains this month. The recent rally in Treasury futures along with downward trends across many commodities sectors have provided a plethora of trading opportunities for managers to take advantage of. With one week of trading left the Attain Portfolio Advisors Modified program is the top performer with approximate returns of +3.14%. Unfortunately, the APA Strategic Diversification program has not performed quite as well and down approximately -4.80% this month.

Other top performing programs this month include Hoffman Asset Management with returns of +1.54% (est). Clarke Capital is profitable as well with approximate returns of +1.06% in the Global Basic program and +0.77% in the Global Magnum program. Lone Wolf Asset Management has bounced back strong with approximate returns of +2.85% after a disappointing start at Attain last month. Finally Robinson Langley is also up for the month with estimated returns of +0.78%.

Despite the strong numbers posted by the mangers above there are a few that are still hoping for a strong Santa Claus Rally to finish the year. Managers in this group that are down thus far in December include DMH at -1.59% (est), Claughton Capital at -3.21% (est) and Dighton USA at -19.93% (est).

For the first time in many months, this past week's index option expiration came and went without much excitement. As a result all of the active index option mangers we track are currently posting estimated gains for the month. Leading the way back has been Ace Investment Strategists with an estimated +7.28% gain thus far in December. Other index options mangers estimates are as follows: Cervino Diversified +0.11%, Cervino Diversified 2x +0.18%, Crescent Bay PSI +0.39%, Crescent Bay BVP +1.42%, Rathiel +0.54%, and Zenith remained out of the market.

Commodity option selling has been a slightly different story this month as unprecedented moves in the several markets (Euro Currency, Crude, etc) worked against mangers like FCI. FCI is currently down aprox 15% for the month in open and closed trade equity. Aprox 8% of the loss is in current open trade equity that has a short term expiration.

Agriculture and Grain traders are having a mixed month thus far. NDX Shadrach is leading the way with an estimated gain of +4.7% followed by NDX Abednego that is +1.04%. Rosetta is current down aprox 2.2% for the month.

Systems

With the exception of the two hours following the Fed announcement on Tuesday, trading conditions were extremely slow last week. Trading systems would like to see the volatility return to the markets but there is likely to be a holiday lull with several major players already on vacation through the end of the year.

The majority of the day trading systems wished they could rewind to the beginning of the week and stay out of the market because of the choppy conditions. Compass SP was a diamond in the rough last week +$1,875 on two trades as was newcomer Upper Hand ES which was +$2,402.50 on two trades in its debut at Attain. Waugh eRL managed to escape the week mostly unscathed relative to some of the other programs down -$736.74 for the week.

Elsewhere, systems trading the European stock index futures had a tumultuous week with losses between -$170 on the low side (Beta Con 4/1 ESX) to -$5,330.50 (ATB Welcome v1 Dax) and several in between. The good news is that these programs are bound to return to their winning ways if and when volatility picks back up as they proved in October in November.

Moving on the swing programs, Strategic ES had one long trade for +$432.50 on a closed trade basis. Strategic US got caught short before the Fed lowered rates more than analysts had predicted, sending bond prices sharply higher and stopping the system out for a loss of -$5,253.10 on its debut at Attain. AG Mechwarrior had one long trade on Monday that lost -$875.25 in the blink of an eye.

In long term trading, several trends have started to reverse course signaling exits as well as new entries. The long US Dollar/short foreign currency trade dried up last week signaling exits for most trend followers.

IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.