In this paper we take a high-level view from two different perspectives on managed accounts versus pooled investment structures. Emerging managers domiciled in the U.S. with limited or no access to institutional capital may find the pros and cons of each account type covered here to be insightful. Managers with more advanced operations or further along in their capital raising cycle can look for a future paper on other structures.
One of the first steps to establishing a managed futures program is to register with the Commodity Futures Trading Commission (“CFTC”) and the National Futures Association (“NFA”). The two agencies charge one-time and recurring fees for registration, depending on whether your CTA will offer Separately Managed Accounts (“SMAs”) or form a Commodity Pool (“CPO”). The purpose of this paper, however, is to discuss the economics of one versus the other. We’ll also look through the lens of both the investor and of the manager. A manager can offer both vehicle types to the investor marketplace, but we’ll discuss why we see many begin with offering SMAs first. To do that the reader will need to understand the investor’s point of view.
It’s important to consider the types of investors each type attracts. Since managers are held accountable for their trading decisions, meetings, phone conversations and other communication types will be integral to the operations of the business. The communication aspect to running an active alternative investment company is a distinction from running the trading side of the business. Even the most savvy, experienced trend following managers must have a clear line of communication with their investor base. A phone call from a high net worth client who is a Texas landowner may go very differently from an Illinois family office even if both share the same trading circumstances.
One of the most important distinctions between pools and SMAs or “managed accounts” is that with SMAs a manager grants control of capital to the investor. Commodity Trading Advisors make trading allocations to the SMAs but the investor is the entity that “controls the cash”. This means that only the investor is authorized to wire funds accounts in and out to banks, futures commission merchants (FCMs) and brokerage firms. Through the lens of the investor, this is an advantage as the manager retains only a limited power of attorney. The manager cannot “move” money around to across bank accounts. The only action a trader at a CTA can take is to allocate trades to the brokerage accounts held in the name of the investor entity.
There are three more advantages of SMAs for managed futures investors:
- Liquidity – an investor in a SMA can request immediate access to funds with the ability to liquidate an account usually by the end of the business day
- Transparency – SMA investors usually have their own access to their accounts through the FCMs and brokers with which the CTA executes and clears. With SMAs the investor can see the position level detail.
- Leverage – SMA investors control the amount of leverage in the account. Otherwise known as user defined leverage, the investor dictates to the FCM how much to fund (aka “funding level”) to assign to this account, guided by the minimum investment amount, or notional value.
These features of a separately managed account will attract or deter investors, depending on their type and mandate. Some professional allocators and institutional investors have mandates that govern how much administrative control is given up to an investment manager. Commodity trading advisors with pool only vehicles may be looked over by these investors because the managers are not able to “touch” or have administrative rights with respect to cash management on behalf of the investor.
Liability is a consideration for all investor types. Managed accounts provides investors with little protection on margin calls should market volatility increase dramatically or risk management skills decline or disappear by a CTA manager. For example, an SMA funded with US$1M may have a US$5M trading level and a US$750K margin level. Short positions have unlimited risk and if the account value were to decline by an amount greater than US$250K in a day on a US$5M position, the investor is on the hook for an amount that exceeds the funding level in order to maintain the position. The responsibility is in the name of the account holder to bring the account back to initial margin once maintenance has been breached. Pools, on the other hand, limit the investor risk to what’s been funded in the account. It’s the responsibility of the manager to ensure that maintenance margins are maintained otherwise in the event of a forced liquidation or a default, the pool operator is on the hook for funds that exceed the value of investor equity.
The transparency of SMAs is an important marketing tool for managers and provides investors with a level of comfort. With managed accounts investors can visually see positions daily. Many managers find this appealing as they can more easily share their strategy with their investors, leading to fewer phone calls and e-mail inquiries into the execution of a strategy. On the other hand, some managers see this as a con because such transparency risks “giving away” proprietary strategies. Most learn over time that reverse engineering is harder than it looks. Moreover, vetting investors through due diligence processes can ferret out those with nefarious intentions reducing the likelihood of intellectual property or proprietary trading theft. Building a network of best-in-class accountants, lawyers, introducing brokers and futures commission merchants will help in this process.
Pros through the lens of an Investor
Pros through the lens of a Manager
As discussed above, investors are responsible for controlling leverage in SMAs. Investors may be required to move funds from bank accounts to the FCM(s) or vice versa. Tasked with monitoring margins and administering cash funds requires infrastructure and experienced commodity market investors. In contrast, investors may prefer a pool investment vehicle because they don’t want the responsibility of controlling leverage. In commodity pools the onus is on the manager to monitor funding levels and margin requirements.
We’ve heard many industry professionals speak negatively about running a pool. They focus on difficulty in marketing these investment structures and the administrative costs absorbed by managers unable or unwilling to pass costs on to investors. There are four main reasons seasoned managers, industry brokers, capital raisers and investment professionals scoff at commodity pools:
- Marketing is difficult
- Fraud is more readily associated with pools
- Regulatory and administrative hassles
- Lack of liquidity and visibility
While we do not dispute the first two listings, we don’t see the final two to being as much of an impediment to starting and running a pool. The NFA will audit a pool, often more closely than a CTA running SMAs. There are other administrative burdens a CPO must undergo such as cash withdrawals, disbursements to investors, investor contributions, etc. However, much of this bias against pools has lessened as fund administrators have developed advanced technologies, making the process by which operators “touch” customer assets more fluid and audit-friendly. Administrator technologies are also striking daily net asset value (“NAV”) for pools and developing investor read-only logins. Open and closed positions, equity, margins, currency data, are readily seen. While we’ve heard consultants dismiss daily NAV as a viable feature, the fact remains that it can be a useful took for both manager and pool investors to gain immediate access to a fund while still maintaining orderly exits with monthly, quarterly or even yearly redemption enforcement. Daily NAV can help reduce the bottlenecks that often develop at the end of month when investors line up to get into a fund.
One of the indirect ways in which a manager has control over the types of investors it can attract is through setting account minimums. The lower the minimum, the more the CTA is considered a retail product. The upshot of creating a lower minimum is that a manager may be able to better diversify her investor base, increasing the number of accounts.
The other side to this coin is that lower minimums tend to attract less sophisticated investors. The exponential increase in these types of accounts could create a commensurate increase in administrative headaches and with regulatory scrutiny, particularly for accounts that are sensitive to draw-downs. In some instances, accredited investors and qualified eligible participants (QEPs) don’t want to be associated with retail products. In the end, there’s a trade off because higher minimum requirements mean there are few investors available to meet those requirements and those that do invest, may not be sticky or may represent a critical leg of a manager’s structure, making it vulnerable to the exit of 1,2 or 3 key investors.
Whether a manager chooses to register as a CTA or a CPO at the inception of a business, they’re likely to register as both after a few years. Alternatives add diversification to investor portfolios and a mix of investor types add diversity for managers. Including myriad investor is a practice that lowers business risk.
We recommend traders begin by offering investors managed accounts. Once the manager reaches a multi-year track record and assets reach critical mass, we recommend increasing the size of managed accounts and start building a fund offering. Opening multiple funds with alternative leverages available for both domestic and offshore investments is a viable part of a business diversification strategy. The key is to surround oneself with best in class services providers. Accountants, lawyers, introducing brokers and FCMs are key partners that will help guide you on the path to growing the business.
Image via flickr