Whenever an investor opens an account with a commodity trading advisor (CTA), they are required to read and sign a disclosure document (except when a CTA is for QEPs only and chooses not to have a disclosure document). A disclosure document is usually fifteen to forty pages long, and outlines many different items, such as, risks, investment strategy description, background about the principals, and fees. There can be as many as fifteen different sections in the disclosure document, each one outlining a different topic. While most investors “skim” through these documents, we stress that they take the time to completely read them with extra emphasis on the following three sections:
The Principal’s Background area of a disclosure document highlights the previous working experience of any of the CTA’s principals. It is essentially a two to three paragraph resume for anyone that holds an equity ownership in the CTA. As an investor, this is a good area to learn about the “people” behind the investment firm that you are going to invest with. This area will clearly outline whether the principals have any previous financial industry experience (either as traders or investment managers) or whether they are inexperienced in finance or fresh out of college.
The Advisor’s Fees section of the disclosure document describes the fees that the CTA charges to its investors. Generally, two types of fees are charged: a management fee and an incentive fee. For the longest time, the industry standard for fees has been a 2% management fee and a 20% incentive fee. However, this has changed a bit over the last two to three years, where some CTAs are charging alternative fee structures. Due to this, it’s important for an investor to carefully read exactly what they are paying in fees to the CTA. Furthermore, this section will also outline how fees are calculated and we highly stress that all investors ensure that management fees are debited first prior to the incentive fee calculation. Lastly, it’s important to also verify that the high watermark is being used when calculating incentive fees.
CTA’s Performance Record
While it’s very likely that you’ve seen a CTA’s performance track record prior to executing a disclosure document, it is still very important to read this section in the disclosure document for one reason: this section shows the performance for any trading program that the CTA’s principals have managed over the last five years. For example, let’s say John Smith had a CTA called XYZ Corporation in 2012 that managed client assets for 2 years and eventually shut down due to poor performance. Then, in 2015, John Smith decided to launch a new CTA called ABC LLC that had a different (or same) trading strategy. Per NFA (National Futures Association) rules, John Smith would be required to disclose the performance of XYZ Corporation from 2012 to 2014 in ABC LLC’s disclosure document. This is very important, because previous trading performance may discredit or add credibility to the principals running a CTA.
While many investors are anxious to get started and end up skimming through disclosure documents, we stress that you take the time to thoroughly read everything and pay close attention to the three sections described above. The above three sections are where most “red flags” could potentially be buried and finding one of them could prevent an investor from making a poor investment.