One of the managers we work with, Dean Hoffman of Hoffman Asset Management, has an interesting piece up on his blog today. As he points out, there are thousands of CTAs for an investor to choose from when they start investing in managed futures, and dozens of statistics you can reference as you sort through your options. Some of these are metrics you’ll find us frequently referencing on the blog, such as max drawdowns, length of drawdown and risk ratios like Sharpe, Sortino and Sterling. However, as Hoffman points out, these statistics, no matter how excellent, are going to fall short of what many think they can do:
What investors want (or should want) is excellent risk adjusted performance, but in my opinion, the standard performance measures only succeed at hindsight reporting. Those same measures perform miserably when trying to predict future risk adjusted performance.
In other words, metrics of evaluation for CTAs relate to past performance, which (say it with us, now) is not necessarily indicative of future results. In fact, Hoffman provides some pretty interesting charts which pretty effectively confirm this idea. What was most interesting to us, however, was his reliance on a metric which, in our opinion, is not often enough considered in the evaluation of a CTA: their margin-to-equity ratio.
The margin-to-equity ratio indicates what percentage of a CTA managed account is posted as margin, on average. Essentially, it tells us how much money they have tied up in margin at any given point in time relative to the nominal investment amount. For example, if you have a $1,000,000 nominal investment in a CTA, and the margin requirement on that account is $100,000 – the margin to equity on that account is 10% (100k/1mm). Note that it is on the nominal amount, so if you have $200K traded as $1 million through the use of notional funds, and the same $100k in margin , the ‘official’ margin to equity is still 10%, even though it would be 50% on a cash basis.
…margin-to-equity ratios can be an excellent way to predict future drawdowns. Empirical data show us that higher margin usage leads to higher average and maximum drawdowns. Also, unlike returns and drawdowns, margin-to-equity ratios are fairly easy to predict.
… lower margin-to-equity ratios, correlate to superior risk adjusted performance.
In summary, we believe that to help prevent serious drawdowns and get superior risk adjusted performance that one is better off with managers who have low margin-to-equity ratios than with managers who have high margin-to-equity ratios.
While the conclusions drawn here are certainly worthy of contemplation, the word that jumps out at us is “predict.” It appeals to the most basic inclination of an investor- the desire to effectively see into the future and determine returns before allocating funds. Unfortunately, despite what the data in this piece may suggest, we don’t agree with Mr. Hoffman’s crystal ball theory.
The data analyzed here in regards to margin-to-equity comes from the Barclay Hedge database. The listed margin-to-equity ratios found for a program there are not calculated levels, but are submitted to the database by the managers themselves. Given that, while they give a rough idea of the average margin-to-equity ratio for each program, they aren’t necessarily reflective of actual margin-to-equity ratios. And unfortunately, CTAs rarely keep this statistic up to date in the various performance reporting databases. While they will update their monthly performance regularly, other information in the database can become a little stale, especially since updating that information is not a requirement for continued listing in the database.
Investors can always ask a manager about past margin-to-equity levels (and indeed, if a manager can’t provide a detailed report on their margin usage – that’s a red flag from a due diligence standpoint), but even here, the ratio can change substantially depending on the market environment. In fact, in our experience, this ratio, for most managers, ends up being fairly fluid, fluctuating between 10-30%, as managers engaged in profitable trades will often have higher margin allocations than they would at another point in time. The moving target here means that, unless you’re monitoring the margin-to-equity ratio for all of these programs in real time, the relationships you find between their ratios and performance are tenuous at best.
We’re not saying margin-to-equity ratios aren’t an important consideration; we use it regularly in our analysis of CTAs. It’s just that the metric should be more specific – with the low, average, and maximum margin to equity levels reported – not just a single number that we’re left to interpret (though it’s likely the average level). Much like the Sharpe ratio and max drawdown and other metrics, the margin-to-equity ratio is not a magic bullet when it comes to CTA evaluation. It’s only in the context of a myriad of other statistics that it has value, and, much to the chagrin of investors everywhere, it still can’t predict the future.