Over the years we have done blog posts that discuss common mistakes investors make when investing in managed futures. This time around, we decided we would do a similar blog but instead focus on commodity trading advisors (CTAs), specifically emerging CTAs. Since our inception, we have dealt with over two hundred different CTAs, most of whom were emerging when we first started dialogue with them. Through this experience, we have learned common pitfalls that some emerging managers make during their first few years of operation. They are outlined below:
Raise the Minimum Investment too Soon
When most CTAs come to market, they set their minimum investment based on the smallest “trading level” unit they can trade based on their trading strategy. As their track record matures (and with good performance), they attract more assets, and start to build a strong foundation. In some cases, we have seen CTAs increase their minimum investment size as their assets increase. The reasons for doing so would be to limit the number of clients they have to deal with or to ease their operational burden by having less accounts to do accounting/compliance for. While we can understand the reasoning behind increasing the minimum, we do not always agree with the timing. If done too prematurely, it can end up “shooting the CTA in the foot” and limit the flow of new assets. There may be investors out there that are willing to invest at the lower amount, but if they see a “higher” advertised minimum, they might avoid the CTA for consideration. Our recommendation is to keep the minimum investment as low as possible for as long as possible. Dealing with investors is part of the job when it comes to being a CTA, so if there are more to deal with, its better to streamline the process within your operations than to limit the flow of assets.
Flexible Fee Structures (for Early Investors)
CTAs are compensated through both a management and incentive fees for managing client assets. While the management fee helps cover overhead and other expenses, CTAs may opt to take a 0% management fee in return for a higher incentive. Investors that allocate in the early rounds of a CTA’s asset raising cycle generally want a 0% management fee structure. It is in these cases where a CTA has to be flexible if they want to raise assets more quickly. Generally, the trade-off is fair: investor John Doe is willing to invest if he can get a 0/25 structure (instead of 2/20 or 1/20) as he feels he is taking some additional risk being one of the first investors in the strategy. Meanwhile, the CTA is happy to take on John Doe, as it helps the CTA build up a base of assets and legitimize their trading strategy. If an emerging manager decides they do not want to bypass a management fee, they have every right to make that decision. However, they must realize that by doing so, they will have an uphill battle reaching their AUM benchmarks and goals. Our recommendation is to be as flexible as possible early on, especially as you try to raise your first 10% of your expected capacity.
Setting up Trading Execution at the Wrong FCM
Most emerging CTAs’ initial assets are usually proprietary (assets of the CTA) or assets of close friends and family. As a result, the CTA tries to find an FCM that can offer the lowest commission to setup the accounts. The FCM that offers the lowest commissions sometimes is not the best place for a CTA to setup their block execution. One common example of this conundrum is Interactive Brokers (IB). IB is a great place for professional and speculative traders to house their account as they offer low rates and great technology. The issue for CTAs comes when they want to be able to take on outside capital. FCMs like IB are usually unable to facilitate give-up agreements, and give-up allocations, and generally most managed futures investors are “housed” outside of IB. This creates a real issue when CTAs are ready to come to market and raise outside capital; they have to re-establish their execution at a new FCM. In addition, the CTA must think of scalability. As your CTA grows and more accounts are onboarded you will need a hands-on FCM to assist with potential issues (trust us there will be issues). Our recommendation is to do your homework prior to selecting the FCM you want to work with. aiSource can be an asset in the FCM selection process. We work with seven different FCMs, which allows us to recommend the best place to house your execution based on your trading strategy and business operation.
The above three mistakes are the most common mistakes we see from emerging managers. Although there are many other smaller overlooked items from emerging managers, these tend to be the most common. If you can learn how to navigate the above mistakes when first starting your CTA journey, you will be far ahead of yours. We try to pass on the knowledge we’ve gained by dealing with CTAs through our history, so please do not hesitate to reach out to us with questions and advice!