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Invest at lower minimums through Notional Funding
April 5, 2010
One of the main benefits of investing in managed futures is the ability to do so through Notional Funding – whereby you don’t have to put up a cash deposit equal the program’s minimum investment amount in order to invest in that program. For example, it is possible to trade the $800,000 Mesirow Financial Commodities Absolute Return program with a cash deposit of just $100,000 to 200,000.
If you are saying, so what…. you can put up just a portion of the investment amount in all sorts of investments: stocks via a margin account, real estate via a mortgage, art via a credit card; you are missing the one big difference. That difference is that there is a cost to buying stocks on margin or purchasing real estate with a mortgage. That cost is the cost of money, or the interest rate you pay to borrow the funds to purchase the investment you are interested in.
With notional funding, there is no borrowing of money and therefore no interest rate and no cost of money. How can there be no borrowing? Because we’re not talking about having someone assist you in getting your account to $800K to meet the minimum (or about trading a smaller version of the program with $200K), we’re talking about having $200,000 traded as $800,000 via the use of notional funding.
But as my old history professor would say - 'that begs the question(s)' – ‘What is Notional Funding?’ And when I answer notional funding is funding an account through the use of notional funds, he would again say that begs the question: ‘What are Notional Funds?’
Notional funds represent the difference between a managed futures investment’s minimum investment amount and the amount of cash an investor is willing to put towards a managed futures program at that time. An investor may not have the full amount of the minimum, or wish to only put up a portion of the minimum and use the rest for another investment. In a way, notional funds can be thought of as fictitious or imaginary money which is used to bridge the gap between the cash outlay an investor is willing to put towards a managed futures program at that time, and the stated minimum amount of that program.
A quick example is probably the easiest way to describe it. Take the aforementioned Mesirow program with its minimum investment amount (at Attain, it is higher elsewhere) of $800,000. An investor does not actually have to have all $800,000 into her account in order to trade the program. Levels of notional funding vary between managers, but for this example, Mesirow will allow clients to use notional funds to cover up to 75% of the investment minimum.
That means the investor only has to have $200,000 in her account, and can meet the minimum investment amount by pledging an additional, "imaginary" amount of $600,000. The actual cash balance plus the "imaginary", or notional funds, balance equals the required minimum investment amount of $800,000. Another way to think of how this works is to imagine having that $200,000 account, but telling the manager to trade is as if it was $800,000.
If you're asking "how in the heck can you use imaginary money" right about now – let us explain further.
To understand how an investor can use these imaginary, notional funds, we must first back up a step and understand how a managed futures advisor arrives at their minimum investment amount. Minimum investments could, or perhaps should, be further split up into three distinct levels, specified as:
- The Margin Minimum: the technical minimum amount needed to actually place the trades on the exchanges
- The Drawdown Minimum: the amount for an investor to withstand any eventual drawdown of the investment
- The Window Dressing Minimum: the amount to make the percentage drawdowns and returns attractive to the greatest number of investors.
1. Technical Amount: The first part of the minimum investment amount - the amount technically needed to place trades - is what the exchanges and clearing firms refer to as the margin requirement. Any account which wishes to trade a futures contract on a regulated futures exchange like the Chicago Mercantile Exchange must first have enough money in the account to cover the performance bond requirement of the exchange (the margin) This insures that the exchange can make the trader who takes the other side of the trade good should the trade go against the account [if Washington is serious about financial reform and removing too big to fail, all they need to do is require all derivatives to be traded through an exchange, so that any losses are backed by performance bonds and covered by the exchange]. Margins can sort of be thought of as the amount of money which could be lost on that position in a single day - and the exchanges and clearing firms make sure each account has that much money - or else the whole system doesn't work. If this wasn't in place, where would a winner get her winnings from - the loser could disappear.
2. Drawdown Amount: The second part of the minimum investment amount - the amount an investor needs to withstand any eventual drawdown - is another technical level of sorts, in that an account must have at least that amount in order to stay above zero. If the investment has the possibility of losing $150,000, for example, in the normal course of operation - than an investor better have at least that amount in order to proceed. If they didn't, they would have to get out of the investment during the normal ups and downs of the investment. Think of it like a tank of gas. If you are driving 100 miles and need 5 gallons of gas to get there - you better have at least 5 gallons of gas in the car - or else you'll never get there.
3. Window Dressing Amount: The third part of the minimum investment amount - the amount needed to make the percentages appealing to potential investors, or "window dressing" amount - is simply a subjective amount the advisor computes in order for the average returns and risk of his or her program to come out "nicely", for lack of a better term. Imagine an advisor with average annual returns of $100,000 and drawdowns of $50,000. If that advisor sets his minimum at $100,000 - the average annual return in percentage terms is 100% with a 50% drawdown; while if the advisor sets his minimum at $1,000,000 - the average annual return in percentage terms is 10% with a 5% drawdown. While the returns in dollars are exactly the same, the advisor would likely find much more success raising money with the $1 Million minimum amount, because investors will ignore programs with large drawdowns such as the 50% drawdown number. The difference between the desired minimum and the minimums needed for margin and drawdown is the window dressing amount, and it is often this amount which can be "notionalized".
If we look at Attain Portfolio Advisor's Strategic Diversification program as an example, those levels would be:
Technical Amount (Margin)
Window Dressing Amount
Total (minimum investment)
Understanding that up to 80% of a managed futures program’s stated minimum investment amount can be nothing more than window dressing gets us a step closer to understanding how you can use imaginary, notional funds, when investing in a managed futures program.
It should be clear that while an investor actually needs both the 'technical amount' for margins and 'drawdown amount' to stay alive, the investor doesn’t necessarily need the window dressing amount. If it is only there to make the returns and drawdowns more palpable for most investors; an investor who can stomach much larger percentage gains/losses (you will have the same dollar gains/losses) doesn’t need window dressing.
How can you use notional funding?
For those investors who don’t require the window dressing, (those who can handle 3 to 5 times the percentage gains and losses), notional funding is perhaps the most efficient form of investing available to investors. Once investors understand that the window dressing amount is only to make them feel better about how much (in percentage terms) they have made or lost – they are free to take that window dressing amount and use it for other purposes.
For example, say you have a portfolio of $750K cash and $250K in stocks; and find the $800,000 Mesirow program intriguing. But you aren’t willing to get out of your whole stock portfolio during the current market rally in order to fund Mesirow. Once you understand the notional funding, you don’t have to sacrifice. You can keep your stock portfolio intact, and put $200K into a futures account to trade Mesirow. You will have taken on additional leverage (as you are now trading $750K in stock plus $800K in managed futures, for a total of $1.55 Million in investments backed with just $1 Million), but that has appeal for those investors who understand the risks associated with it.
Notional funding also allows for the trading of multiple managed futures programs with a single cash allocation. Assume the same investor above wishes to get out of stocks at these higher levels and put the whole $750K into managed futures. Now, he could invest in just Mesirow with that amount, or he could use notional funds to diversify his managed futures investment into several programs. If on the aggressive side, our investor could trade a balanced managed futures portfolio of Mesirow ($800K), Paskewitz ($500K), Dominion ($1,000K), and Emil Van Essen ($500K), totaling $2.8 Million in initial investment amounts, with just the $750K in cash.
This would represent leverage of roughly 3.7 to 1 in the account ($750K traded as $2.8 Million), and the investor would see percentage gains and losses on his $750K that are 3.7 times what an investor putting up the full $2.8 Million would see.
Many of Attain’s clients who can handle having 3 to 4 times the percentage gains and losses do a simple calculation to determine how much cash they will put up to trade a managed futures program. They ask what the margin to equity ratio is (a ratio of the technical margin requirement divided by the minimum required capital) to back out the technical amount needed, than look at the worst max DD and sum the two to come up with the bare bones minimum they need to invest in a program.
You can also go straight to the source, so to speak, as most managed futures advisors also provide a minimum cash funding amount (or looked at in reverse – a max notional funding amount) in their materials, defining what notional levels they will accept. Notional levels of funding usually range from 25% to 75% of the minimum investment amount, meaning investors can put up between 25% and 75% of the minimum investment in cash to be traded as the full amount of the minimum.
Now come the fun part touched on in the beginning of our discussion. The cost of doing this is zero. There is no interest rate charged on the notional amount like you have in the stock market when buying shares on margin or when buying a house with a mortgage. This is because there isn’t any real money behind the notional funds, thus you aren’t borrowing any money and thus there is no charge for the notional funds you employ. The notional funds are, in a way; nothing more than the amount of leverage you are taking on. The more notional funds you use; the more leverage you are applying to your investment.
What are the risks of notional funding?
While there is no physical cost to notional funds, one "cost" is that the fees charged by the manager are on the nominal amount of the investment (meaning the full minimum amount), not the cash balance in the account. So if the program you're participating in has a 2% management fee, that will balloon to an 8% annual fee on your cash amount if you used 25% cash with 75% notional funds to meet the minimum. Likewise, commissions will have a much bigger impact on the account in percentage terms.
It is important to note, however, that the fees and commissions will not be any different, in dollar terms, than they would be if fully funding the account. Consider a $1,000,000 minimum investment program, which an investor invests in using $250,000 cash and $750,000 notional funds (25% cash/75% notional). The 2% management fee on this account would be charged on the $1,000,000 minimum nominal level of the account, meaning the charge would be $20,000. That $20K charge would be the same for an investor doing 100% cash/0% notional, 50% cash, 50% notional, and our 25% cash/75% notional example; but it would represent a 4% charge ($20K/$500K) for the 50%/50% account, and an 8% charge ($20K/$250K) for the 25%/75% account.
So while leverage through notional funding increases the percentage amount of fees and commissions, it has no effect on the dollar gains and losses. The key to understanding notional funds is to understand that while the percentages change – the dollars do not. The $20,000 in fees does not become larger – they stay at $20,000 no matter how much notional funds you use. They only become larger as a percent of the cash in your account, and only when the cash in your account gets smaller. So 2% of $1 MM = 4% of $500K = 8% of $250K. They all equal $20,000.
There is also a greater risk that you may lose more than you deposited in the account when using notional funds. If a $1 Million minimum program loses $500K, and you are notionally funding that account with just $250K (having $250K traded as $1 Million), your account will have lost $250K more than you deposited in it, and you will owe that money to the clearing firm. Of course, even if you had fully funded the account, you would still lose the same $500K (again, the dollar amount of gains and losses does not change, only the percentage amount), and whether you notionally fund or fully fund – there is always the possibility with a futures investment of losing more than you deposit in your account.
The last negatives to consider are the mental anguish you may go through seeing percentage drawdowns 4 times those that are reported (but again, you're still losing the same amount of dollars) and the nervousness you may encounter when/if the a drawdown takes the account down to within a few hundred dollars of a margin call. And finally, if the account goes on a margin call in which you have to deposit more money into the account in order to keep trading with the program, the risk that you choose to cease trading the program instead of adding more money, and then miss out on the upside when and if the program rebounds.
For more on the benefits and risks involved with notionally funding, please call us at 800.311.1145 or email email@example.com
- Walter Gallwas
Disclaimer: Notional Funding involves the use of leverage, the use of which can substantially increase the risk of loss.
IMPORTANT RISK DISCLOSURE
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Feature | Week In Review: Sugar & grain sell off; stock and energy rally aids multi-market managed futures programs
Aside from the grain markets and Sugar, market action in March was fairly firm in most sectors as another month of positive economic data and indications by government heads in the U.S. that more stability/growth is evident in the economy helped investor optimism grow further. Investor confidence found added fuel from the FOMC that interest rates will remain low for the foreseeable future despite the recent increase in the discount rate. The European Union and the IMF came to an understanding on aid for Greece if the Greek government was in danger of defaulting on their sovereign debt which had been an albatross to market activity of late. The Chinese central bank was fairly quiet in March after increasing bank reserve requirements earlier in the quarter which aided world growth support. The Stock Index complex was one sector that reflected that sentiment with Russell 2000 futures +8.30% leading the rally followed by NASDAQ 100 futures +7.71%, Mid-Cap 400 futures +7.15%, S&P 500 futures +6.06% and Dow futures +5.36%.
U.S. stock index futures posted their best monthly performance since November as economic data most of February showed overall growth happened at a better rate than previously expected. Mid-Cap 400 futures +5.19% led the rally followed by NASDAQ 100 futures +4.56%, Russell 2000 futures +4.48%, S&P 500 futures +3.08% and Dow Jones futures +2.94%.
The Industrials led the metal complex higher in March with better economic growth in the U.S. and in the Far East aiding investor confidence. Palladium futures +10.65% had the biggest leap followed by Copper futures +8.21%, Platinum futures +6.64% and Silver futures +6.08%. Gold futures -0.50 were fairly subdued for most of the month.
Energy futures sentiment continued to gain upside momentum during March as stronger signs in world growth helped aid a price rally to new 2010 highs foe Crude Oil and its products. For the month Heating Oil +6.35% lead the surge followed by RBOB Gasoline +5.15% and Crude Oil +4.69%. Natural Gas -20.70 % remain hampered due to heavy supplies in the U.S. after lighter than expected winter demand.
Market activity in currency futures for March was mixed despite an agreement between the EU and the IMF to protect the sovereign debt of Greece in the case of a possible bankruptcy situation. Investors in this sector focused more on yield than any other geopolitical situation which featured support in the Swiss Franc +1.87% and the U.S. Dollar Index +0.67%. The Japanese Yen -4.86% hurt by low yielding fixed income instruments led the lower trade of this sector followed by the Euro -0.82% and British Pound -0.38%.
In grains and softs, the Ides of March took dead aim at the food and grain sector last month with heavy losses in both sectors attributed to a return of price action being linked to supply/demand scenarios rather than recent pro-growth inflationary ideas. Sugar Futures lost -29.70% in March after hitting 29 year highs just a month before, fading on news that global stock deficits will be alleviated in the upcoming 2010/2011 growing seasons with normal weather patterns in several world growing areas. The grain complex followed suit as March USDA reports indicated that not only domestic stocks, but world supply are now heading into more normal stocks to usage ratios with record crop being reaped in the Southern Hemisphere. Corn futures -21.31% led grains and oilseeds lower followed by Wheat futures -13.25%, Cotton Futures -2.32% and Soybean futures -2.08%.
Most multi –market managers enjoyed a great week of trading last week, which resulted in a positive month of March for most of the products we track. The top overall performer was the APA Modified Program, which was up approximately 5.00%. Hopefully, this is the start of a nice run in the upwards direction for Modified, which has had its fair share of struggles over the last 15 months. Other managers that posted nice winning months include Applied Capital Systems at +3.74% est. as well as Accela Capital Management Global Diversified at +3.33% est.
Overall, there were quite a few multi-market managers in the black this past month. The Dominion Capital Management Sapphire led all short-term traders at +1.83%. Dominion found success trading in the metals, energies, and currencies in March. Integrated Asset Management Global Concentrated also had a nice month at +1.66% est. This program has now officially completed 1 year of trading and will be added to our Recommended List shortly. 2100 Xenon Managed Futures 2X also did well at +2.00% est. Robinson-Langley Capital Management bounced back with a nice month of trading as well at +1.23% est.
Other multi-market programs in the black include: APA Strategic Diversification +1.53% est., Clark Capital Worldwide +1.21% est., Hoffman Asset +0.50% est. and Sequential Capital Management +0.14%. DMH finished the month at breakeven.
Unfortunately, not everyone was able post positive numbers as early month struggles proved too hard to overcome for some. Multi-market managers in the red include: Mesirow Financial Commodities Low Volatility -0.08% est., Mesirow Financial Commodities Absolute Return -0.18% est., Covenant Capital Aggressive -1.58% est., Dighton Capital USA Aggressive Futures Trading -2.02% est., Quantum Leap Capital -2.02% est., GT Capital -3.05% est., Clarke Global Basic -3.50% est., Futures Truth MS4 -4.06% est., Clarke Global Magnum -4.59% est., and Futures Truth SAM 101 -7.71% est.
Option traders had mixed month of trading. The top performer was Crescent Bay BVP at +2.49% est., closely followed by ACE DCP at +2.03%. HB Capital Management had a nice month of trading as well at +0.69% est., as did Cervino Diversified 2X +0.43% est. and Cervino Diversified +0.25% est. ACE SIPC also made it into the black at +0.14%. Managers in the red included Crescent Bay PSI -0.27% est., FCI OSS -0.83% est., and FCI CPP -3.79% est.
Short-term stock-index traders are hoping too quickly put March behind them as the stock market’s slow and consistent upward crawl made life very difficult on these programs. Paskewitz Asset Management Contrarian 3X Stock Index was down -12.26% est., while Pere Trading Group fell -12.14% est.
In fixed income trading the 2100 Xenon Fixed Income program was down -0.52% est.
Finally, in ag trading, Rosetta had their best month of trading since Sept ’08 at +4.21% est., while OAK Capital Management had a very difficult month trading Cattle Spreads and was down -23.00% est. NDX was also down for the month with NDX Shadrach at -0.37% est., and NDX Shadrach at -0.64% est.
March was a solid month for the trading systems, with 14 out of the 24 systems that we actively traded posting positive numbers. The best performance was achieved by Strategic v2 at +$6275.00, which took advantage of the steady uptrend in the S&P500 index. Not far behind was the Bam 90 system at $5930.00 which trades the e-mini S&P 500 contract. The MoneyBeans trading system, which trades in the Soy Beans market, was able to perform well in a sideways trading action by finishing nicely at +$3378.33. Other positive results were Jaws +$1970.00, ATB TrendyBalance v2 at +$1807.50, Bam 90 Single contract at +$1580.00, MoneyMaker at +$877.50, Rayo Plus +$797.50, Upperhand at +$535.00, Waugh Swing +$477.50, Waugh CTO +$250.00, Polaris +$160.00, Strategic +$100.00, and Waugh +$35.00.
On the downside in March, AG Mechwarrior was close to profits, but not quite there, finishing March at -$115.00 while PSI! was not far behind at -$190.00. Some of the other results were Clipper at -$400.00, EVP 1 at -$496.73, Jaws US 400 at -$497.50, BetaCon 4/1 at -$570.00, Ultramini at -$787.50, Compass at -$1011.38, TZAR at -$2494.59, and LTS Optimum at -$2552.50.
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.