We speak to many new CTAs that are in the early stages of developing their track records and still formulizing how they will market their strategy to outside investors. During this phase of their business, they are in the process of making many decisions that will impact the long-term success of their CTA. One of these decisions is choosing a minimum nominal investment. Deciding on a minimum investment boils down two major factors: investment volatility and margin usage.
Daily, monthly, and yearly volatility of the trading strategy is a big factor in deciding the minimum. Initially, the volatility is measured on a dollar basis on the most basic unit of trading. The daily and monthly dollar volatility is then converted on various nominal investment levels to gauge what the rates of return would be should the minimum investment be adopted. For example, a strategy that has an average daily volatility of $10,000 cannot have a minimum nominal investment of $100,000 because the resulting daily volatility as a percentage would be 10%. All things being equal, a minimum nominal investment of $500,000 or $1,000,000 would likely be recommended for this example.
A similar analysis would then be conducted for monthly $ volatility. Ideally, the % volatility on a daily basis should be no greater than 2% or 3% and should be no greater than 10% on a monthly basis. After comparing the daily and monthly % volatility, the CTA next must consider the margin-to-equity usage.
Similar to how a CTA should monitor their dollar volatility of their trading strategy, they should also monitor their daily margin-usage on a dollar basis. After a few months of data, the CTA will have a better understanding of their margin-usage and be able to obtain an average daily margin usage number. They can then conduct a similar exercise, where they divide the margin usage number by various minimum investment levels to get the margin usage percentage. For example, if the average daily margin usage is $10,000, then that would translate to a 10% margin-to-equity ratio on a minimum investment of $100,000. Ideally, a CTA should maintain a margin-to-equity ratio of less than 20% for their trading strategy. Most of the strategies we allocate to use margin-to-equity of 15% or less to conduct their trading activity.
On a very basic level, a CTA’s minimum investment will be based on their investment volatility and margin-to-equity usage. The higher the volatility and higher the margin usage, the higher the minimum investment will likely be. Even if one of the two components is “high,” it will likely result in a correspondingly high minimum investment. Both have to be assessed to find the “sweet spot” when settling on a minimum investment.