Hello everyone,
I just wanted to get some opinions from the group about notional funding, either as a way to trade your own account or as a means of making a managed investment
A little background. Notional funding, for those that don't know, is the ability to fund your account below its nominal value (fully funded value), but to still trade that account as if it was at its nominal value. This is becoming increasingly common in the institutional investment world, with an increasing number of CTAs offering this too. In the last few years, with the backing of the NFA and the CFTA, managers are now even allowed to quote their performance on this basis (as a percentage return on a fully funded basis, even if it is partially funded).
If, for instance, you wanted to invest with a money manager that had a minimum investment of $100K, you could either fully fund your account with the $100K, or, if notional funding was offered, you could partially fund your account - say, with only 50K - but still have that account traded as if it was $100K. If the manager made 20% in that year, you would have made 20K (a 20% gain on a nominal basis), but a 40% gain on a notionally funded basis. Obviously, the same is true on the downside, in terms of the proportionally increased volatility. In this case, your account would be considered 50% funded.
Institutional investors have increasingly been favorable to this, since it allows them to have a limited amount of capital at any one manager, limiting business risk with the manager in addition to FCM/custodial risk, since the remaining portion of your capital would be held elsewhere. If manager A accepted notional funding of 20% on a 500K minimum, the investor would only actually invest 100K with manager A, and would be free to use the remaining $400K to diversify with other presumably uncorrelated managers or simply allocate it to principal protected investments. They would still have the upside of a $500K account with that manager, while the downside on that account would strictly be limited to 100K, which in this case is the equivalent of a 20% drawdown.
Obviously the viability of such a strategy presupposes having a clear understanding of the investment program's return/drawdown expectations. It would be insane to fund an account at 20% of the fully funded level (as with the above example) if there was a significant potential for a 20% drawdown, since that would result in a margin call. Therefore, the percentage of the fully funded level allowed by managers is a a function of their drawdown expectations, in addition to margin requirements. Many will offer different levels of funding (20%, 30%, 50%, etc); as a rule, though, the lower the level of funding, the higher potential gains on a cash-on-cash basis, but with a higher risk of margin call.
This is surely not a new concept; and, really, it is somewhat of a strange concept that I think doesn't always intuitively sit well with people. Chris, I hear you thinking, isn't all of this partial funding the same as increased position risk on a cash basis. Yes, it is. That is exactly right, at least in terms of execution, although conceptually it is very different. I believe that Tdion was one of the few to address this in one of his threads - having the money in your account actually being risk capital, rather than not truly being risk capital for you on an emotional/financial level.
For example, if an investor was to invest in a fund that had a maximum drawdown expectation of 20%, he should be prepared to lose 20% (and realistically some more) since that is within expectation. However, if the fund was to drawdown to 40% on the same investment, would he really be prepared to loss that much? Most people, I would venture, probably wouldn't be, especially if they have specific investment expectations ahead of time. They would likely pull their account at some point below 20%, since any risk significantly below that wouldn't be palatable; that is to say, they really aren't treating the vast majority of their account as risk capital at all. If asked, they would likely justify this large cash portion as being there for margin purposes - but, of course, you don't need nearly that much for margin purposes in forex (or commodities), which is what makes all of possible for such instruments.
Now for the negatives. If you were to invest on a notional basis with a manager, your account would experience significant volatility on a cash basis, significantly magnifying both your cash losses and gains. Would you be able to deal with this? Well, that is probably going to be a question of whether you are actually treating the investment from a fully funded perspective. For instance, if someone invests 20% of the nominal level (say 100K again, for a 500K minimum), you must actually have 500K, and must actually be following one of the aforementioned strategies with that money. If you have done such things - and that money is truly diversified in uncorrelated/principal protected investments - it would be much easier to perceive the process in the desired way, and potentially be quite profitable with limited risk. On the other hand, if you only actually had 100K to invest, put it all with the same manager on a 20% funded basis, the volatility might well get to you, and ultimately cause you to prematurely pull the investment, or feel that you lost everything (rather than simply 20%) if that account was to go bust on a cash basis.
Further, even if one was treating the process sensibly, and diversified among various managers, you are still banking on correlation between the managers remaining constant (or, if you are doing this as a private investor, the different trading strategies that you diversify with). If, for example, you were with 5 different managers, 20% funding with all of them - if all of the simultaneously went into drawdown (even if the nominal drawdowns were perfectly acceptable), there could be considerable total portfolio volatility.
There is certainly no right answer to this, as it is all a matter of preference. I am very interested to see what others think about this. Would you potentially trade your own money in this way, or entertain it as a way to invest in a fund? Finally, for those that will undoubtedly misconstrue what I am saying, and think that I am advocating some kind of ridiculous gunslinging risk management style, please don't comment. This should only be entertained if you have a firm understanding of the specific strategy that you are trading (or will be traded for you). Without the appropriate margin and drawdown expectations, deciding on the appropriate percentage to fund with would be a shot in the dark.
I look forward to your comments.
All the best,
Chris
I just wanted to get some opinions from the group about notional funding, either as a way to trade your own account or as a means of making a managed investment
A little background. Notional funding, for those that don't know, is the ability to fund your account below its nominal value (fully funded value), but to still trade that account as if it was at its nominal value. This is becoming increasingly common in the institutional investment world, with an increasing number of CTAs offering this too. In the last few years, with the backing of the NFA and the CFTA, managers are now even allowed to quote their performance on this basis (as a percentage return on a fully funded basis, even if it is partially funded).
If, for instance, you wanted to invest with a money manager that had a minimum investment of $100K, you could either fully fund your account with the $100K, or, if notional funding was offered, you could partially fund your account - say, with only 50K - but still have that account traded as if it was $100K. If the manager made 20% in that year, you would have made 20K (a 20% gain on a nominal basis), but a 40% gain on a notionally funded basis. Obviously, the same is true on the downside, in terms of the proportionally increased volatility. In this case, your account would be considered 50% funded.
Institutional investors have increasingly been favorable to this, since it allows them to have a limited amount of capital at any one manager, limiting business risk with the manager in addition to FCM/custodial risk, since the remaining portion of your capital would be held elsewhere. If manager A accepted notional funding of 20% on a 500K minimum, the investor would only actually invest 100K with manager A, and would be free to use the remaining $400K to diversify with other presumably uncorrelated managers or simply allocate it to principal protected investments. They would still have the upside of a $500K account with that manager, while the downside on that account would strictly be limited to 100K, which in this case is the equivalent of a 20% drawdown.
Obviously the viability of such a strategy presupposes having a clear understanding of the investment program's return/drawdown expectations. It would be insane to fund an account at 20% of the fully funded level (as with the above example) if there was a significant potential for a 20% drawdown, since that would result in a margin call. Therefore, the percentage of the fully funded level allowed by managers is a a function of their drawdown expectations, in addition to margin requirements. Many will offer different levels of funding (20%, 30%, 50%, etc); as a rule, though, the lower the level of funding, the higher potential gains on a cash-on-cash basis, but with a higher risk of margin call.
This is surely not a new concept; and, really, it is somewhat of a strange concept that I think doesn't always intuitively sit well with people. Chris, I hear you thinking, isn't all of this partial funding the same as increased position risk on a cash basis. Yes, it is. That is exactly right, at least in terms of execution, although conceptually it is very different. I believe that Tdion was one of the few to address this in one of his threads - having the money in your account actually being risk capital, rather than not truly being risk capital for you on an emotional/financial level.
For example, if an investor was to invest in a fund that had a maximum drawdown expectation of 20%, he should be prepared to lose 20% (and realistically some more) since that is within expectation. However, if the fund was to drawdown to 40% on the same investment, would he really be prepared to loss that much? Most people, I would venture, probably wouldn't be, especially if they have specific investment expectations ahead of time. They would likely pull their account at some point below 20%, since any risk significantly below that wouldn't be palatable; that is to say, they really aren't treating the vast majority of their account as risk capital at all. If asked, they would likely justify this large cash portion as being there for margin purposes - but, of course, you don't need nearly that much for margin purposes in forex (or commodities), which is what makes all of possible for such instruments.
Now for the negatives. If you were to invest on a notional basis with a manager, your account would experience significant volatility on a cash basis, significantly magnifying both your cash losses and gains. Would you be able to deal with this? Well, that is probably going to be a question of whether you are actually treating the investment from a fully funded perspective. For instance, if someone invests 20% of the nominal level (say 100K again, for a 500K minimum), you must actually have 500K, and must actually be following one of the aforementioned strategies with that money. If you have done such things - and that money is truly diversified in uncorrelated/principal protected investments - it would be much easier to perceive the process in the desired way, and potentially be quite profitable with limited risk. On the other hand, if you only actually had 100K to invest, put it all with the same manager on a 20% funded basis, the volatility might well get to you, and ultimately cause you to prematurely pull the investment, or feel that you lost everything (rather than simply 20%) if that account was to go bust on a cash basis.
Further, even if one was treating the process sensibly, and diversified among various managers, you are still banking on correlation between the managers remaining constant (or, if you are doing this as a private investor, the different trading strategies that you diversify with). If, for example, you were with 5 different managers, 20% funding with all of them - if all of the simultaneously went into drawdown (even if the nominal drawdowns were perfectly acceptable), there could be considerable total portfolio volatility.
There is certainly no right answer to this, as it is all a matter of preference. I am very interested to see what others think about this. Would you potentially trade your own money in this way, or entertain it as a way to invest in a fund? Finally, for those that will undoubtedly misconstrue what I am saying, and think that I am advocating some kind of ridiculous gunslinging risk management style, please don't comment. This should only be entertained if you have a firm understanding of the specific strategy that you are trading (or will be traded for you). Without the appropriate margin and drawdown expectations, deciding on the appropriate percentage to fund with would be a shot in the dark.
I look forward to your comments.
All the best,
Chris