Originally published by www.focuspointpress.com on June 18, 2007
CTA ConfidentialSM
"An ongoing series of qualitative investigations
into managed futures trading programs"
SPECIAL CASE STUDY
Managed Futures:
A Model for Incubating Talent
The idea of traders staking other traders for a slice of profits is probably as old as trading itself. Fast forward to the late 1970s and one unearths Commodity Corp. which is remembered for launching the renown careers of Michael Marcus and Bruce Kovner. And in 1983 Richard Dennis is legendary for having made a bet with William Eckhardt which led to his recruiting and training the "turtles."
One of Richard Dennis' earliest if not first client was Bradley N. Rotter,[1] who established a successful track record by investing early with traders like Joe and Bob Hickey, Willis-Jenkins, Mississippi River, EMC Capital and Hawksbill Capital. In 1990 Rotter founded a company called The Echelon Group with the idea of forming joint ventures with talented traders and then helping them grow into niche money management firms.
Then there is Arpad "Arki" Busson, who began his career raising capital for Paul Tudor Jones and is the founder of EIM Group with $8bn in assets. Busson made his name betting not in stocks, bonds or derivatives, but rather in upstart managers some who became hedge fund titans.[2]
The common thread between these trailblazers is the niche segment within the alternative investments industry they got their start in -- managed futures.
Managed futures has always been the little kid brother to the hedge fund juggernaut. Nonetheless its impact upon the industry is writ large in two significant and related ways: first, the managed futures industry unlike its brethren hedge funds operate in a highly regulated environment; second, this same regulated environment which imposes disclosure and reporting requirements lends itself to fomenting lower barriers of entry for new talent to evolve.
Money managers within the futures industry operate under registrations either as Commodity Trading Advisors (CTA) or Commodity Pool Operators (CPO). The latter in practice is a regulated hedge fund,[3] but it is the CTA structure we're most interested here.
Key to the development of any emerging trader is the ability to establish a legitimate performance record and quickly raise assets. Managed futures addresses both of these concerns.
With respect to raising client investments, managed accounts are an established and widely accepted vehicle within the managed futures industry. This arrangement provides a variety of benefits from the investors' perspective. Advantages include the fact that futures accounts are mark-to-market daily, transparent and easy to monitor, and most importantly liquid in the sense that an investor can easily fire a CTA (as a matter of practice CTAs usually liquidate positions on instruction in 24 hours or even less). On this basis it can be argued that the managed account structure is a more attractive vehicle for investors who focus on emerging traders, especially when compared to concerns about hedge funds' delay in performance reporting (often it is quarterly), lack of transparency, as well as investment lock-ups and intermittent redemption periods.
Sophisticated investors in managed futures utilize what is known as the cross-margin account structure where a cash account is capitalized and collateralizes trading accounts traded on a nominal or notional basis. The result is a customized multi-advisor portfolio with the ability, at least hypothetically, to control the leverage utilized by CTAs that capital is allocated to.
Managed accounts provide several advantages for emerging traders too. The legal, administrative and audit costs in setting up a hedge fund can be prohibitive and requires traders to try and raise at least $5 to $10 million in client assets before they commence trading. Meanwhile, it is not uncommon for CTAs to establish themselves starting with $100k in assets. Minimum account sizes within the industry range from $25k (this is the exception rather than the rule) to $5 million, with smaller minimums obviously making it easier to attract clients.
The other advantage managed futures provides emerging traders -- a regulated environment for establishing a money management business -- is exactly that aspect which many traders perceive as a major disadvantage. It is in actuality quite the opposite situation.
The Commodity Futures Trading Commission and the industry's self regulatory organization, the National Futures Association, have set forth clear accounting and disclosure guidelines with respect to CTA managed account composite performance reporting. The rules are also well established in regards to disclosure of client trading versus proprietary trading as well as hypothetical performance presentations.
There are too many nuances for this article to delve into a detailed examination of certain issues regarding reported CTA performance data. Suffice it to say that the formalized composite methodology and the ability to publicly disseminate composite performance numbers on managed accounts, something which is a significant regulatory constraint for private placements, is a great boon to emerging CTAs in terms of their ability to publicly market their track record.[4]
In fact, the only consistently reported data in the early days of alternative investments initially came from CTAs, not hedge funds. This data became the basis for an academic body of research on managed futures which includes studies by Lintner (1983), Baratz and Eresian (1985, 1989), Oberuc (1990) and Schneeweis (1996) to name a few.
One can point to the beginning of the institutionalization of alternative investments as partly a result of CTA performance tracking databases such as Managed Account Reports which grew into MAR/Hedge, and TASS Management which became acquired and is now Lipper/TASS. These organizations, like many focused on managed futures in the 1980s and 1990s, subsequently evolved from boutique businesses to industry insiders within the hedge fund universe.
This returns us to the original idea that managed futures is and has always been a fertile area of the industry for developing emerging talent apart from those with institutional pedigree.
Managed futures remains mainly a boutique shop industry. Start-up costs are relatively immaterial and many CTAs are or began as one-man shops by leveraging proprietary track records, registering with the NFA and filing a disclosure document. Established industry databases collect and present CTA performance via websites such as www.ma-research.com and www.barclaygrp.com. At the same time, there is an established network of Introducing Brokers (IBs) and Associated Persons who focus primarily on marketing CTA programs.
There are pitfalls, however. Due diligence on many of these operations would reveal that they are light on the operational side. While certain administrative activities can be outsourced, it still remains the trader's responsibility to establish sound practices and comply with the ever-expanding burden of rules and regulations. Yet a trader focused on operations and marketing is not focused on the markets, research and trading.
Another approach to starting up a CTA is partnering with operationally minded personnel that can relieve many of the administrative requirements from the trader's shoulders.
This is the approach my business partner and I took when we established Cervino Capital Management LLC, a CTA and RIA. Leveraging my background with Rotter in the 1990s incubating emerging traders and then running the operations-side, I co-founded Cervino with Davide Accomazzo. Davide also has prior experience in managed futures previously running a CTA as a one-man operation as well as an offshore hedge fund.
Besides the segregation of duties -- Davide is Cervino Capital's principal trader and concentrates his attention on the markets -- development of our trading program began by first considering how we would differentiate our product from competitor programs. We achieved this by creating a well-defined yet robust mandate in which the trading program operates. This was done in view of what we thought prospective clients would desire in terms of various factors including but not limited to upside performance objectives versus allowable equity volatility, margin-to-equity utilization which allowed leverage through notional funding, and a best practices approach to operations.
This is atypical of how many CTAs get their start, and reveals other questions for investors to consider when allocating to an emerging CTA program, including: applicability of proprietary results as representative of prospective trading in client accounts; amount of leverage used to generate returns, serious consideration and commitment by trader as to the program's capacity limitations; as well as accessibility and organizational professionalism.
Unfortunately, while "past performance is not necessarily indicative of past results," there is a tendency with many who invest in managed futures to chase hot performance. Rather, what should take priority in investor's thinking is the robustness of the underlying trading strategy as it pertains to varying market environments -- when does an approach work best, when does it not work and how does the CTA manage risk and drawdowns during such periods?
Investors who invest with emerging CTAs (and the same applies to investing in established CTAs) should seek to develop robust multi-advisor portfolios with these questions in mind.
Likewise, if making allocations to emerging CTAs is considered an attractive investment, then what about the business model of incubating CTAs? The economies of scale that derive from leveraging standardized and professional operations with multiple sources of trading talent, has from my experience, always been an attractive opportunity.
[1] Futures Magazine, "Rotter thrives on investing from the gut" by Staff, published February 1991
[2] Financial Times, "To live and dream hedge funds" by Stephen Schurr, March 29, 2006
[3] Report of The President's Working Group on Financial Markets, "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management," April 1999
[4] Note: this is not necessarily applicable to CPOs who mostly operate concurrently under the same SEC exemption rules as hedge funds; CTAs are normally not subject to such rules because they trade managed accounts.
