I am routinely asked about the advantages and disadvantages of starting a Commodity Trading Advisor (CTA) as opposed to a Commodity Pool Operator (CPO). This is a great question and one that all money managers interested in handling forex or commodity managed accounts should consider. If answered incorrectly, this question could literally ruin the chances for success as a CFTC registrant and NFA member. If that statement was not strong enough to peak interest, how about this one: a wrong decision in this space will likely cost thousands of dollars and countless hours of valuable time.
Certainly, there are many considerations that must be accounted for when determining how to begin any trading operation. Among these factors, simple decisions, such as how to raise assets, what products to trade and where to locate the business, will need to be considered. However, it may come as a surprise that sifting through a laundry list of business decisions is actually not the most challenging part of establishing a lasting CTA or CPO business. In my experience, the biggest challenge facing new and emerging money managers comes after many of the so-called 'easy decisions' are made. Specifically, what I have found is that the overall direction and success of the business will likely result from the intricate way that each of the company's individual decisions piece together.
The complexity and sheer number of variables associated with professionally managing commodity and/or forex accounts is nearly incomprehensible. Although this is true, I have put together the following shortlist of important considerations that should be discussed by the business from its inception. Keep in mind, however, that this list is not intended to be inclusive of all necessary factors needed to make an informed decision. A regulatory professional should be consulted with any questions that may arise prior to moving forward with any long-term decisions.
1. How large an investment is required to trade the strategy?
The first and perhaps most obvious consideration should be determining the minimum investment required to participate in the trading program. Will clients be able to access the model with a $10,000, $50,000, $250,000, $5 million-dollar or more deposit? It will be important to determine the minimum amount of funds needed under management to effectively trade the program. Here are a few basic things that should be immediately considered while trying to arrive at this answer:
- How large will anticipated drawdowns be? Can client accounts survive a hypothetical worst-case scenario with the funding level selected?
- Based on the products being traded, will the accounts have enough funds to cover margin? Meet security deposit requirements? Have the resources to invest across several markets with differing margin requirements simultaneously?
- How much leverage does the program require? What will account margin to equity be under normal trading conditions? Under extreme trading conditions? Will notional funding be used or considered – what implications will this have on program volatility?
- How much in assets under management will the company require to remain viable? With standard industry management fees at 2% and incentive fees at 20% a pro-forma estimation of profitability should be performed and taken into consideration.
2. How will the company gain access to investment capital?
After determining the minimum account size needed for the program to function properly, figuring out who will invest should come next. Based on the figures from above, how many investors (realistically) does the company likely have access to? 1, 5, 20, 1,000 or more? Of these people, how many of them are likely to invest within the program? How many of them will be institutional or high-net-worth investors? What will the average deposit size likely be?
After these points have been considered, it should be relatively easy to determine how much capital may be available to the strategy at its inception. This exercise will also help to more readily identify the path that should be pursued – CTA or CPO. In this instance, remember that 1,000 accounts depositing $10,000 each are not equivalent to one account investing $10 million independently. Keep in mind that the administrative costs and operational requirements to manage 1,000 accounts will be substantially higher than those of trading only one.
3. What is the company's overall experience level?
A large majority of the people I speak with have aspirations to start the next big commodity or forex hedge fund. That may turn out to be true, but it is not likely if the members of a company have no prior experience in the financial markets. Entering into any highly regulated industry exposes people to an incredibly sharp learning curve. As with any best in class operation, it probably will not be realistic to assume that the 'next big fund' will be run by a group of individuals with no prior experience managing client money. This, of course, is not to say it is impossible; however, it is highly unlikely. In making a decision to start a CPO or a CTA, it is very important to assess the company's skill set and determine what might be missing for success to be obtained.
Consider who will run operations? Handle potentially complex accounting issues? Knows the company's commodity and/or forex compliance obligations? Can trade with consistent results? Will solicit on behalf of the program and how will they do it?
Making a Decision: CTA vs CPO
Once the strategy's capital requirements have been thought out, after determining how much money may be available and evaluating the company's experience level, it is time to start deciding on whether a CTA or a CPO is the right choice. To make this decision, all of the company's intentions and goals must be considered in aggregate. It simply will not be enough to look at one particular factor and make a final directional decision. At this time, it is in the company's best interest to contact a regulatory professional that specialises in only commodity and forex matters.
If the company is not yet ready to contact a regulatory professional today, then take a moment to carefully think through the questions presented in this article. After doing so, I have put together some general thoughts on the most common advantages and disadvantages of both CTA and CPO businesses for consideration below:
Commodity Trading Advisor
Individually managed client accounts have the following advantages:
- Administration, start-up, and maintenance costs are very low.
- Regulatory requirements and overall learning curve is relatively low.
- In general, overall costs to the investor should be less.
- Accounting and financial requirements are significantly less complex.
- Client funds must be held with an FCM or FDM rather than with the advisor. In a post-Madoff world, this eases client concerns.
Individually managed client accounts have the following disadvantages:
- May require a higher minimum investment as assets will not be pooled.
- Challenging, if not impossible, to diversify into multiple strategies or investment opportunities.
- Client accounts will have to adhere to strict individual margin requirements.
- Trading may become tedious as the number of accounts and clearing firms utilised by the strategy rise.
- CTA clients will utilise FCM/FDM documents to open an individual account; client identities will not remain anonymous.
Commodity Pool Operator
Pooling client assets as a registered fund has the following advantages:
- Can allow for greater strategy diversification and investment opportunity.
- Minimum investment levels may be lower as accounts are pooled.
- May provide investors with a more focused investment advisor.
- Individual investors will not have margin calls made to them.
- May allow for the operator to collect additional fees - profit margins may be higher.
Pooling client assets as a registered fund has the following disadvantages:
- Administration, start-up, and maintenance costs are very high.
- Regulatory requirements and learning curve is significantly steeper; SEC/FINRA, CFTC/NFA, and State Security registration may be required.
- In a post-Madoff world, investors may be wary of depositing funds with new managers.
- Hurdles for clients to profit and/or break even within the strategy are relatively high.
- May require a funding threshold to be hit in order to begin trading.
It is important to remember that making the decision to begin managing client funds is a difficult one, but with proper preparation, can be incredibly rewarding. Over the coming years, I am anticipating and looking forward to seeing more money managers come into the market place; however, few will become the 'next big thing'.
The financial markets are uncertain, but one thing is for sure: those who fail to plan will likely never get off the ground.
James Bibbings is the President and CEO of Turnkey Trading Partners (TTP), a firm that supports all commodity and forex specific regulatory and business needs. Prior to founding TTP, Bibbings worked with the National Futures Association (NFA) as a supervising auditor. During his time with NFA, he was involved in approximately 100 investigative audits and was able to gain a deep working knowledge of FDM, FCM, IB, CTA, and CPO operations. Since departing from NFA, Bibbings has owned and operated an independent introducing brokerage and participated in international forums on proposed CFTC regulatory requirements. He has also provided financial markets content for MSN, Yahoo, Financial Times, FINalternatives, Wiki-Investments, Safe Haven, Financial Sense, The Wall Street Journal’s Market Watch, Forex Journal, FX Street, Forex Factory, Commodity News Center and many other highly acclaimed investment publications. Two highly sought-after informational pamphlets regarding futures and forex registration authored by Bibbings are currently available for free upon request through his company website. If you have any questions or comments for Bibbings, he can be reached directly by email at firstname.lastname@example.org and would love to hear from you.
This article first appeared in www.finalternatives.com on 9 July 2010.