A Primer on Managed Futures - Part 3
The Trading Plan
The first question to ask your CTA is what type of trading plan will he or she employ. Basically, two types of trading plans exist in the CTA community, trend trading and market-neutral trading. Trend traders use proprietary technical or fundamental trading systems (or a combination of both). These systems provide signals that point to "long" or "short" positions in certain futures markets. Market-neutral traders look to "balance" the investments (one against another) to protect the portfolio from severe market swings. Although market-neutral trading takes a balanced approach, some might argue it is more risky because it tends to employ riskier trading methodologies, such as options, and all of the trading permutations within that area. Many variations exist on these two basic approaches, and the details of a plan are not found here, but, in essence, these two trading approaches formulate a majority of the trading plans most CTAs will offer.
Drawdown
One important piece of information to look for in a CTA's disclosure document is the maximum portfolio drawdown. This represents the CTA's largest cumulative decline in equity of a trading account. The worst-case historical loss, however, does not mean the portfolio drawdown will remain the same in the future. It does, however, provide a framework for assessing risk based on past performance during a specific period, and it shows how long it took the CTA to make back those losses. Obviously, the shorter the time required to recover from a drawdown, the better the performance profile. Regardless, CTAs are only allowed to assess incentive fees on new net-profits (that is, they must clear what is known in the industry as the "previous equity high watermark" before charging additional incentive fees).
Annualized Rate of Return
Another factor you want to look at is the annualized rate of return, which always includes "net fees" and trading costs. Keep in mind, you want a "fair and reasonable" return, not necessarily the highest return. Remember, high returns mean high risk. Although these performance numbers are provided in the disclosure document, they may not represent the most recent month of trading. CTAs must update their disclosure document no later than every nine months, but if the performance is not up to date in the disclosure document, you can request information on the most recent performance, which the CTA should make available. You especially want to know the most recent portfolio drawdown number and the most recent statement of returns, both annualized and risk-adjusted.
