A Primer on Managed Futures - Part 4
Risk-Adjusted Return
After determining the type of trading plan (trend-following or market-neutral) and the potential return based on past performance, you should take a more formal approach when discussing risk. If you are mathematically inclined, you can use some simple formulas to better compare CTAs. Fortunately, the NFA requires CTAs to use standardized performance capsules in their disclosure documents, which is the data used by most of the tracking services, so it's easy to make comparisons. In any case, understanding and comparing the risk-adjusted, rate of return to other potential CTAs is important because it gives you a tool to determine how much risk you are comfortable with in your investment posture.
For example, a CTA with an annualized rate of return of 30% might look better than one with 10%, but such a comparison may be deceiving. The CTA program with the 30% annual return may have average a portfolio drawdown of -30% per year, while the CTA program with the 10% annual returns may have an average drawdown of only -2%. This means the risk required to obtain the respective returns is quite different: the 10%-return program with a 10% return has a return-to-drawdown ratio of 5 (see Calmar Ratio in following paragraph), while the other has ratio of 1. The first therefore has an overall better risk-reward profile.
Dispersion2 is another tool for evaluating risk-adjusted returns. Many CTA tracking-data services provide these numbers for easy comparison. As well, these services provide other risk-adjusted return data, such as the Sharpe3 and Calmar Ratios4 .
Accounts Types
Unlike investing in a hedge fund, investing with CTAs allows investors to open their own accounts and with the ability to view all the trading that occurs on a daily basis. Typically, a CTA will work with a particular futures clearing merchant (FCM) and does not receive commissions. In fact, it is important to make sure that the CTA you are considering does not share commissions from his or her trading plan, as this could pose certain potential conflicts of interest.
Account Size
All accounts have minimum entry size. They can range dramatically between CTAs, and they can range from a low $25,000 to a high of $5,000,000. The size of the account could signal the quality of the CTA, but not always. Sometimes success breeds complacency, which leads to a lack of personal attention. So give the young CTA a look, as he or she might very well be "hungry" enough to give you the personal attention you need, and he or she might work a lot harder to achieve success for you. Generally, though, you find most CTAs requiring a minimum between $50,000 and $250,000.
2 The distance of monthly and annual performance from a mean or average level3 Sharpe looks at annual rates of return (minus the risk-free rate of interest) in terms of annualized standard deviation of returns
4 Calmar looks at annual rates of return in terms of maximum equity drawdown
Conclusion
Being armed with more information never hurts, and it may help you avoid investing with a CTA that don't fit your investment objectives or your risk tolerance, an important consideration before investing with any CTA. If you do your due diligence, however, managed futures can provide a viable alternative-investment vehicle for small investors looking to diversify their portfolios and thus spread their risk. So if you are searching for ways to maximize your portfolio returns, while hedging your risk, take a serious look at managed futures.
If you'd like to find out more, the two important objective sources of information about CTAs and their registration history are the NFA's website and the U.S., CFTC's website. The NFA provides registration and compliance histories for every registered CTA, and the CFTC provides additional information about any legal action filed against non-compliant CTAs.
