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So You Want to Be a CTA...

April 30, 2013

 

From managed futures billionaire David Harding of Winton, to the legend of John Henry leveraging managed futures success into ownership of the Boston Red Sox, to the tale we recently told of Bill Eckhardt and the Turtle Traders – there are plenty of alluring stories to entice skilled traders to try their hand at becoming professional Commodity Trading Advisors (CTAs). Taking the leap from trading your own money to managing others’ is the first step toward building a legend of your own, but how realistic is it to turn that gleam in your eye into a successful enterprise and tens of millions in the bank? 

You might think that your worries extend no further than: 1. Make money, 2. Be operationally sound, and 3. Be properly registered and compliant.  But even when you do everything you are supposed to do, the assets don’t always just come pouring in. What other challenges must an upstart CTA overcome? Well, for starters…

Managed Futures AUM Breakdown

Jumping into the managed futures space means entering a David versus Goliath situation, as just a handful of huge CTAs control the bulk of managed futures wealth (in terms of assets under management). Does this mean all hope is lost? Definitely not. It isn’t easy, but there are a few things you should know before getting started.

So You Want to Be a CTA…

The CME has a nice piece on becoming a CTA titled Issues and Insights for Starting a CTA Business, but with all due respect to them – it isn’t as easy as they make it out (and they really don’t make it sound very easy). Why? Well, it starts with the fact that the numbers aren’t all that pretty for someone looking to break into the managed futures world – and it’s not just the huge lead that the big CTAs have in terms of assets.

If you were just one CTA going up against those big guys – the proverbial David versus Goliath – maybe you’d have a chance. But the reality is you are one of more than a thousand Davids, and you are competing against all of them just as much as you are against the big boys.

Managed Futures Industry Breakdown

More Bad News - Taleb’s Take:

In fact, Nassim Taleb of “Black Swan” fame took this a step further – actually recommending people shy away from the world of finance because of the asymmetry between assets commanded by the top of the heap, and those just getting started.

He penned a short paper last year before the release of his newest book, arguing that those who are doing well in the investment business are just benefitting from luck (or more technically – spurious returns), plus the compounding effect of “winners win.” That latter part is the idea that success begets more success (in terms of raising assets), via the advantage of a larger pool of money allowing the big firms to hire top talent, get beneficial terms (see Buffet’s 10% paying preferred shares in Goldman), and so on – making it that much more difficult for smaller managers to compete.

Taleb’s logical conclusion to this phenomenon as it relates to career advice:

To conclude, if you are starting a career, move away from investment management and performance related lotteries as you will be competing with a swelling future spurious tail.

In English: the lucky few have amassed huge asset bases, which will make it that much harder to knock them from their perch, and that much harder for the small guy to make a dent. That’s quite a claim – but is he right? Should you stay away from investment management entirely?

But David Can Beat Goliath

You know we’re big Taleb fans, and there’s certainly something to be said for his argument, but we’re not so sure Taleb’s argument applies to the managed futures space.

You see, we’ve pointed out a few times that the really big CTAs tend to have lower volatility, and lower average rates of returns than managers with smaller AUM. In our experience, as managers get bigger, their returns tend to turn over and flatten out. Case in point – the three biggest CTAs have all sported shrinking risk/return figures over the last several years:

Diminishing Average Monthly Returns

Disclaimer: past performance is not necessarily indicative of future results.

Average ROR by AUM

Source: BarclayHedge Database. Disclaimer: past performance is not necessarily indicative of future results.

This could be intentional, or a result of big CTAs being unable to access big moves in smaller markets (like the recent rally grain markets). But there is no doubting the statistics above showing a strong relationship between size, and the shrinking of returns on both the up side and down side (they likely sell the fact that they are reducing the downside…but it’s hard to do one without the other).

So, while we agree with Taleb that a hedge fund manager may become “luckier” the bigger he gets and continue to see outsized returns, the argument for the same happening in the futures space may not match up. Unlike hedge funds, CTAs have limited ability to add ever-increasing positions in exchange traded futures markets (see Bacon’s recent return of investor money). In fact, there is likely some upper bound for hedge fund managers as well – when their size stops begetting more size and starts to become an impediment (see the London Whale).

So You’re Telling Me There’s a Chance

So if the smaller to mid-range programs can outperform their larger counterparts thanks to structural differences – maybe things aren’t quite as bad as they seem. To paraphrase Jim Carey in Dumb and Dumber, “maybe there’s a chance”

Dumb and Dumber

And with a little over a thousand CTAs out there, your chances are probably quite a bit better than one in a million. How to you best nurture that chance? Can you outperform the big boys with $1 million under management and expect capital to come pouring in? No. Can you have a great year while Winton struggles and expect capital to come pouring in? No. Can you outperform over 3 years with tens of millions under management? Maybe.

Skill Meets Opportunity

An old football coach used to say there is no such thing as luck – luck is merely when skill meets opportunity. Well, we’re not so sure there is no such thing as luck – but we do believe you can make your own luck. And in the managed futures world, that means setting yourself up for success.

How?  We believe the following four items are the key to success:

Make Money

How?  For starters, you have to make money. A losing year or two is fine, but an investor isn’t going to sit through 4 years of losses because of the institutional grade operational soundness and compliance procedures.  The first priority is delivering alpha in terms of absolute returns and/or higher risk adjusted returns than traditional asset classes or other alternative assets.

The second part to making money – have someone else prove that you are. We don’t think you need a $50,000 audit of your track record by a big audit firm right out of the gate, but the numbers should be calculated on a monthly basis by a third party. It’s not that investors don’t trust you…. Well, it is, they don’t trust manager calculated performance. They want a third party to calculate the monthly numbers.

Get Old Fast

So, assuming you are making money, the next most important step to raising significant assets is time. This is frustrating for most people, as time is the one thing you can’t buy, outsource, or create via skill. The only way to get time is the old fashioned way – experiencing it day after day like the rest of us.

A typical minimum acceptable track record for a high net worth investor may be 12-18 months, while a third party allocator like Attain is likely to require 3 to 5 years. For bigger allocations from pensions and other institutional money – you may need 10 years of history or more. 

There is nothing more frustrating to an upcoming manager than being told “we like what you’re doing, but we need more history,”but it is what it is… just batten down the hatches and get through those first three years.  After 36 months, doors should start to open.

Get Bigger

The only thing more frustrating than not having enough time under your belt is being told that’s still not good enough. A common line heard by many smaller CTAs is “we like what you’re doing and want to allocate to you, but we only allocate in $25 million blocks and we can’t be more than 10% of your assets”   They’ve essentially just told you not to bother them until you are at $250 million in assets under management, which is sort of like telling someone that more experience is needed to get a job which will give you that very experience. 

What’s it take to start getting on radars? $50 million is a good start, and paired with a long enough track record will start to get you noticed. After that – the bigger you get, the bigger money you will attract in a sort of self fulfilling prophecy.  Over $100 million will open the doors for some 40 Act funds and family offices, and over $500 million is the holy grail so to speak where it would be hard for someone to not allocate to you because of your size.  Then there is the $1 billion and up club, where you probably won’t care about it any longer.

Keep Upgrading Your Business

While a lot of guides to becoming a successful CTA may start here, with upgrading your operations and staff of a sort of institutional grade – we don’t believe that is cost efficient in the beginning of a CTAs life.  Why? Because the type of people who are looking at your operations and doing that sort of due diligence are going to have certain levels of performance, history, and assets under management they require before making an allocation based on your operational soundness. Without first meeting the performance, history, and AUM limits – there’s no need to focus on operations beyond building for the future.  A piece from a few years ago on thebusiness of running a hedge fund lays out the ‘green zone’ for managers getting started out where the goal should be fixed costs below the management fees earned.

But – eventually, when you can afford to – building out your operations and upgrading you business will be key components. Investors don’t expect you to have Citadel’s Chicgao headquarters when your managing $10 million, but they will expect more and more the larger you get, with the requisite business plans, procedure documents, compliance manuals, and so forth. The good news – there are quite a few firms these days specializing in assisting new CTAs get those documents and institutional grade policies and procedures in place. Call us for some recommendations.              

A Golden Rolodex?

So in order to raise money, you must first… raise money? Well, we didn’t say that there was nothing to Taleb’s argument that “winners win.” But there are still other decisions to make that can affect your ability to get old fast and build that asset base to meet the minimum AUM thresholds some firms institute. You can go the managed account route, the commodity pool route, or a mixture of both.

If doing managed accounts, there can be difficulties managing more and more individual accounts as you find more success; but before that point the main difficulty can be finding enough well-heeled investors to meet your minimum. Say your program has a $1 million minimum – it may be harder for you to find a single $1 million investor than it is to find ten $100k investors. 

For that reason, many CTAs starting out choose to go the commodity pool route where they can pool many smaller allocations together to meet their minimum trading level. But there’s a problem with that approach, too. But there’s a problem with that approach, too. The commodity pool is a privately offered security – meaning you can’t market it or advertise the offering in any way.

Strictly speaking, that means no posting it to databases such as BarclayHedge and others, no soliciting at conferences such as AlphaMetrix and the CTA Expo, and so on. And just to confuse things – commodity pools are regulated by the National Futures Association (NFA), but the NFA has no rules saying that a commodity pool can’t be solicited to the general public. That rule comes from the SEC, because a pool is technically considered a security, even though it is registered with the futures regulator. 

We often tell new CTAs debating the pool versus managed account routes to only go the pool route if you have a “Golden Rolodex” where you can raise all of the money you need via your own network and contacts. If you need third party help and want your program mentioned in newsletters (like this one) or elsewhere, you’re better off starting out on the managed account path, in our opinion, as your managed account performance can be advertised and marketed without the SEC restrictions against such for the pooled vehicle.

Of course, the best approach would be to do both – enabling money to come in from both sources, but there are additional costs and complexities involved there.

Nobody wants to raise you money

Can you just call a brokerage firm or put your fund at one of the big clearing firms, and they will put their clients into your program. Likely not, as one of the common conversations we have with up and coming CTAs goes something like this:  “we’re currently at ‘xyz big FCM’, and have some managed accounts and our fund there, but they have done nothing for us in terms of raising money… “

Well, we don’t really blame the FCMs, after all – their business is clearing, and at the end of the day they want your clearing (they want you to do trades through their firm). Their business is not really raising money and working with clients to understand your trading.

A quick test of how involved your brokerage will be at raising money for your CTA can be seen in their public persona. Are they writing managed futures white papers? Sponsoring managed futures conferences? Writing a managed futures blog ? For many very new CTAs trading for accounts through Interactive Brokers or TradeStation – there is clearly a mismatch between what you are trying to do and their business models.  Find a firm who specializes in managed futures – not just futures. 

Allocations come when it’s a Fit

Attain’s business is working with clients to understand different CTAs and assisting them in allocating to those CTAs. That’s what we do. But… that doesn’t mean every CTA we talk with gets new allocations form our clients. For one, our clients do not have an unlimited supply of funds with which to keep making new allocations.

But the more important gate between new CTAs and allocations from Attain is the completion of the due diligence process, and getting the trading in front of our research and sales team on a daily basis via a managed account on our platform.

At Attain, we don’t review CTAs for approval, and then push those CTAs to our clients. Instead, we review CTAs for certain unique traits, and then match those traits with the targeted characteristics outlined by our clients in our conversations with them.  In this way, our daily trade review is more than just due diligence, it is more like a match making service. 

Once we know what a CTA looks like on a daily basis, we can alert our clients what they will and won’t like about that CTAs style. For example, they put on their positions before the Fed announcement or USDA crop report may worry some clients, others may want a systematic model to have some discretion for outlier events such as the Flash Crash.

The take away – anyone can clear your business. Not everyone will clear it with an eye to understanding how it works. In our (admittedly biased) opinion, being at a firm just for clearing takes away one of the tools in your arsenal for raising money, which is clearing your CTA at a firm which works with CTAs and looks to allocate to ones which fit with their clients.

If all else fails - You Could Get Lucky

Back to Mr. Taleb for a minute, who believes a few big hedge funds have simply gotten lucky (what he calls spurious returns). He posits that by simple luck, half of all managers can make money in a year, and the year after that half of those winners again winning, and so on until after 10 years you can end up with someone who has never had a losing year just because of dumb luck. If 10,000 hedge funds start out and half make money each year just based on pure luck – after 10 years you will have about 19 who have never had a losing year. 

How many managed futures programs today might be looking at no losing years just by pure luck? We ran Taleb’s simple luck experiment on the BarclayHedge managed futures database. With 326 managers in the BarclayHedge database in 2002 – the number of managers currently who should have had no losing years over the past 10 should be 326/2=163/2=81/2=40/2=20/2=10/2=5/2=2/2=1/2 = 0.5/2 = 0.25.  That’s pretty much zero, meaning we luckily shouldn’t expect any great managed futures track records based solely on luck. That’s good news.

But our look was only at how many there were in 2002 (10 years ago). If we look at the end of 2007, there were 918 CTA programs in the database, meaning we could see 1.8 CTA programs to have perfect 10-year winning in 2017.

Ready Your Sling

If you build it, they may or may not come. If you build it, manage risk, post attractive returns, and run your business well, they still may or may not come.  For proof, consider that there were 312 new CTA programs added to the BarclayHedge database in 2008, and just 65 of those (20%) are still reporting. That’s not a whole lot better than the notoriously difficult restaurant business.

What does it mean for clients? That there is a constant evolutionary battle going on where the fittest survive (and a few lucky ones per Taleb), resulting in those remaining with longer track records being higher quality. Some call this survivorship bias - we call it survival of the fittest.

What does it mean for new CTAs out there? It means it isn’t going to be easy. But there are steps you can take to improve your odds. There are partners you can enlist to improve your odds. And there’s the fact that Goliaths don’t stay Goliaths forever – just ask John W. Henry. We’re not saying it’s going to be easy, but we don’t think it means staying away altogether as Taleb recommends. 

 

IMPORTANT RISK DISCLOSURE


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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.