A common question that comes up when we deploy a multi-CTA portfolio for a new client is whether or not profits (and losses) made from a CTA investment are automatically re-invested into the initial nominal account size. While this question has a simple “yes” or “no” response, it can also have a more a thorough response, which will be provided in this blog post.
Simple vs. Compounded Returns
If a CTA does not re-invest profits or losses, then that means that they trade a client’s account at a set nominal account size. For example, if you invest $100,000 nominal with a CTA, and they do no re-invest, then they will continue to treat your account like a $100,000 account unless you either explicitly notify them to increase or decrease the nominal size of the account. Conversely, if a CTA does re-invest profits/losses, then they will automatically re-calculate your nominal account size each month as follows:
As you may have guessed, a CTA that continually re-invests profits/losses each month calculates a new nominal account size for each client each month and compounds their invest month to month to month and year to year. A CTA that does not re-invest profits/losses does not compound a client’s return and generates a simple return at the end of the year.
Most investors like the idea of compounding because it makes your invested dollars grow faster (assuming positive return periods), so why doesn’t every CTA re-invest?
The reason why certain CTAs re-invest, and others don’t, is based on how a CTA manages risk within their investment strategy. For example, let’s assume a CTA has a $100k minimum investment and for each $100k in investment they trade 1 corn contract. This would mean they trade 5 corn contracts for a $500k investment. Now let’s assume you invest a $100k with this CTA and the generate you a 20% return and your account value is now $120k…the additional $20k cannot be re-invested because it does not allow for an additional corn contract to be purchased based on the CTA’s risk control and investment strategy.
CTAs that have similar risk controls to the simple one outlined above generally round up (or down) when an account has grown (or lost) 50%. Going along the same example above, once a client’s $100k investment turns into $150k (50% return), the CTA may automatically increase and start treating that client’s account as a $200k investment client (and start trading 2 corn contracts).
The various nuances of how a CTA manages a client’s profits/losses are outlined within their disclosure document or advisory agreement.
New NFA Reporting Requirements
Until recently the National Futures Association used to require all CTAs to report their performance tables on a compounded basis, however recently added an exception to that rule. The exception to the compounded returns relates to how CTAs treat profits and losses on a monthly basis. The NFA made this change this past February when NFA released the interpretive notice rule 2-34: CTA Performance Reporting and Disclosures. Initially made effective back in May 2004, NFA rule 2-34 outlines the following information when it comes to CTA’s:
- Accounts with Actual Funds that Differ from the Nominal Account Size Written Confirmation for Accounts with Actual Funds that Differ from the Nominal Account Size
- Additional Disclosure for Partially-Funded Accounts
- Other Performance Reporting Guidance
Rule 2-34 goes on to discuss how interest is calculated in CTA performance along with composite performance reporting and the treatment of any additions/withdrawals made to any CTA accounts. Lastly, and most importantly related to this article is the discussion related to the exception to compounded returns.
“CFTC Regulation 4.35 requires that the annual ROR, the peak-to-valley draw-down percentage and the net lifetime ROR be computed on a compounded monthly basis. However, for programs where net performance does not affect the nominal account size, and therefore profits are not reinvested, the CTA must sum the monthly performance returns instead of compounding them when calculating the annual return, the peak-to-valley draw-down percentage and the net lifetime ROR.
All performance information must be presented in a manner that is balanced and is not misleading. CTAs have an obligation to disclose all material information even if it is not specifically required by CFTC or NFA rules. Compliance Rule 2-34 and this Interpretive Notice do not relieve CTAs of that obligation.”
In short, the standard practice is for CTAs to still compound their annual returns assuming they adjust the nominal account size with profits/losses each month. If the nominal account size does not change, based on the new NFA notice, a CTA must now sum their monthly returns to report a simple annual rate of return.