Commodity trading advisors (CTAs) are asked to sign a variety of contracts on a regular basis: technology agreements, office leases, licensing contracts and third party marketing agreements, just to name a few. However, arguably the most important contracts for CTAs are the managed account agreements, sometimes called “advisory agreements,” with their clients. For those CTAs with an in-house legal staff or enough assets under management to afford experienced outside counsel to review all of the advisory agreements, their interests are being protected by their attorneys. But, for CTAs without a legal staff, this article will alert you to the most critical and often overlooked provisions in a managed account agreement.
Advisory agreements are the contracts that govern the relationship between the CTA and its client. The contract is designed to set forth all of the business terms of the advisory relationship. The substance of each contract is essentially the same, even though the terms may be significantly different. CTAs often want to have a standardized version of an advisory agreement to provide to their clients. However, sophisticated institutional clients may want to use their own contract or make major revisions to the CTA’s contract. Further, if the CTA’s client is a pool operated by a third party commodity pool operator (CPO), that CPO may have its version of an advisory agreement. In that case, it would be the CTA that may have revisions to the CPO’s version of the agreement.
The fee section of an advisory agreement may say 2 and 20 (the relatively standard 2% management fee and 20% incentive fee structure), but it is rarely that simple and there are opportunities to maximize the CTA’s fees and to avoid some unpleasant surprises by paying attention to the details.
Incentive fees are calculated in two ways; based either on trading profits or increase in NAV (net asset value). If the incentive fee is based on trading profits, the CTA doesn’t have to recoup all of the expenses of the account or fund (accounting, audit, legal, CPO fees) to get its incentive. It only has to make back the advisor’s management fees, brokerage commissions and other transaction fees. If instead the incentive fee is based on increase in NAV, the CTA would have to generate additional trading profits to make back all of the expenses of the account or pool, even those unrelated to trading, before an incentive fee is earned.
Incentive fees can include interest income earned on the account’s assets. Interest rates currently are at such low levels that inclusion of interest in the incentive fee would not make a significant difference in revenues to the CTA. However, interest rates may increase significantly in the coming years and could make a big difference in the incentive payments if such income were included in the calculation. Even if interest is not included in the incentive fee, it is included in the performance of the account. If rates were to increase, such increase would boost CTA rates of return.
Asset-based or management fees can be calculated either at the beginning or end of the period. In the long run, the differences in these approaches should be negligible, but initially it may help a CTA’s cash flow if the fee is charged and paid at the beginning of the period. However, if trading is profitable, it is best to calculate the fee in arrears when the NAV of the account is higher.
Clients sometimes make additions to their accounts during drawdowns. The issue here is whether the profits attributable to the new capital are subject to an immediate incentive fee (treated as if it were a separate account for incentive fee calculations) or whether all of the previous losses have to be made back before any incentive fee is earned (treated as if the client had one account). The latter method is more pro-investor and may encourage investors to add to their accounts during drawdowns.
Some clients withdraw capital from their account during drawdowns. Typically, the amount of the carry forward loss (the amount that the CTA has to make back before it is entitled to a new incentive fee) is reduced if there is a capital withdrawal or reduction in the notional level. The idea is that the CTA has a smaller capital base to make back a specific dollar amount and it is therefore appropriate to reduce the carry forward loss in the same proportion that the withdrawal bears to the NAV of the account immediately prior to the withdrawal. If a CTA doesn’t have this language in its agreement, it would have to make back all of the carry forward loss even if the client had withdrawn a significant portion of the capital (see “Details matter,” above).