Nov 26, 2022 By: Scott Kruse Turnkey has worked with Commodity Trading Advisors (“CTAs”) to compile trading track records and customer results for more than 15 years. After working with hundreds of registered firms one area continues to be confusing year after year for emerging managers. This area is how best to communicate trade level to customers, third party accountants, and regulators. This article provides some insights into how trade level should be discussed and presented as it relates to CFTC and NFA based performance result presentations. Trade Level By Agreement All CTA’s are required to have some form of written agreement with their customer. This agreement is required to spell out the terms of the investment with the trading manager and, amongst other things, must include language about how advisory fees will be calculated. When developing such an agreement CTAs must decide whether or not they plan on using a fixed trade level or a cumulative trade level balance. This decision very much will impact how accounting results and fees are developed. Every CTA should be intimately familiar with what their customer advisory agreement says when onboarding a new customer. An area that Turnkey frequently sees incorrectly presented to customers by CTAs is the difference between fixed and cumulative trading levels. Fixed and Cumulative Trade Level With a fixed trade level approach, the value of the customers account will be reset each month to an agreed upon amount. Trading profitability will not impact fixed trade level. The customer will have the same trading balance with the CTA month after month. Management fees will also typically be static month after month and will not fluctuate up and down. Additions and withdrawals of cash or removal of advisory fees from an account when using a fixed trade level approach also will not have an impact all things being equal. With a cumulative account balance approach trade level will change month to month. When applying an accumulative account balance approach a customer’s net monthly performance from trading will impact each subsequent month’s beginning equity balance. Fees, additions, withdraws and all other factors which may bring an accounts balance up or down will impact trade level. Management fees will change month to month. It is also worth noting that CTAs are generally not permitted to alter between methods and customers pursuant to CFTC and NFA best practices. Changes from fixed to cumulative or between customers will impact the overall rate of return outcome of the mandated CFTC 13 Column Table rate of return results. CTA’s should use one method consistently to best ensure ROR calculations accurately and reasonably represent the composite ROR. For more details see NFA Compliance Rule 2-34 and the other various publications NFA has produced on this topic. Ultimately, both the CTA and NFA’s goal is to not have a customer account make the composite ROR misleading based on a variation in accounting approach. Pros and Cons of Trade Level Methods There are pros and cons for each the fixed trade level and the cumulative account balance approach. The ultimate decision of which method to use depends on what the CTA and the client agree to in the customer agreement. Fixed trade levels: Pros: Usually rate of return is more in line with what the program or strategy actually did within the customers account. It should however be noted that results should not materially differ from using the cumulative account balance method. This difference usually is the result of how a CTA must size positions for customers. Using a static trade level better allows a CTA to “unitize” its strategy whereas a cumulative approach the CTA must adjust “one contract up, one contract down” as an account grows or shrinks over time. Having the same fixed trade levels allows a CTA to use a consistent denominator when calculating trade size. This ultimately allows ROR for client accounts to be more uniform. Cons: In order to establish a fixed trade level CTAs are required to have in place a notional funding agreement. This agreement must spell out the terms of the fixed trade level as well as the risks involved in utilizing notional funding with futures and options trading. Notional funding agreements must document what the amount a customer intends to trade will be in writing. These agreements need to be updated if trade level changes. Such changes don’t require a new notional funding agreement but should have the customer confirming trade level adjustments in writing (email is typically fine) each time a trade level changes. Cumulative Account Balance Pros: No Notional Funding agreement needed. Often cumulative account balance is simply referred to as “cash” based trade level. This can be easier or the CTA and the customer to remember what the balance at risk in the account is at all times. Similarly it usually is easier for clients to understand rate of return against a cash balance. When notional funds are involved the return presented for regulatory purposes must be based of the nominal value – that is the trade level not the cash. This shows the customer results which will differ from the actual results generated on cash in the account. Typically less educational support will need to be provided by the CTA to less sophisticated investors when using the cumulative account balance approach. Cons: Turnkey has found that most CTAs have difficulty sizing positions consistently across customer accounts with varying account balances. To properly allocate trades across a block of customer accounts more time must be spent in the back office documenting allocation processes. In addition, Turnkey has also seen over the years that most customers and many CTAs don’t understand compounded rate of returns. When computing return on a fixed trade level the results are based upon the same static amount month after month. These results are then summed to come to an end of year rate of return on trade level. When dealing with cumulative account balance CFTC and NFA obligations require that results be compounded. Compounded returns reflect the cumulative effect of a series of gains or losses on an original amount of capital. Conclusion The type of trade level used for calculating ROR is up the client and the CTA. It is however an area that Turnkey does not see many CTAs pay close attention to when structuring their business. Without properly weighing the impact of fixed and cumulative trade level accounting against trading style, customer type, and intended fee structure challenges likely will emerge down the road. Emerging managers who are considering launching a CTA or adjusting their CTA business before taking on more customer accounts should seek professional advice. A consulting firm like Turnkey Trading Partners has both the experience in accounting and the compliance background to help make the correct long term decision. Do you have specific questions regarding the content of this article? Contact Turnkey Trading Partners for assistance and to speak with someone today.