So you have traded successfully as a local or with your retail account and have quantified your methods to the point that you want to manage other people’s money. What do you do next?
Some may say you should get your head examined, but you already knew that if you are making your living through trading. After the initial jokes, most experts would tell you that more of your time will be spent on the numerous aspects of creating and managing a business and less on trading.
The first thing David Matteson, partner at Drinker Biddle and a member of its investment management practice group, asks is, “Are you ready to run a business?” “Trading your own money is not a business,” he says.
The second question he asks is, “Have you thought through whether you have the ability to lose other people’s money?”
For Pete Powers, CEO of Cranwood Capital Management (see “Trader Profile,” October 2008), this was an important consideration when turning his successful bond spread program into a fund. “You trade for yourself, [stuff] happens. Psychologically, when it is other people’s money, it is tougher. You kind of have to live your losses twice,” Powers says.
Leslie McNew, chief investment officer for Maize Asset Management, has spent more than 20 years trading her own money, trading proprietary money for institutions and teaching trading. She says trading for a fund is a new ball game. “When you manage your own money you know how much you have. You know how much you want to put at risk. When you are trading someone else’s money, you can’t take the same risk. When it is my money I know what I can afford to lose,” McNew says.
Most traders, when transitioning from trading for themselves to managing money, have to alter the volatility of their systems. “Traders generally have a high tolerance for drawdowns because they are in control of all of their trades. Outside investors don’t have that same tolerance. So you would definitely need to create a volatility or a drawdown scenario that is in tune to your investors, not to you,” Matteson says.
Powers says traders can risk up to 50% of their capital per day when they start off. “We honed it down to risking 1% of our capital per day once we created the fund.”
TRADING AND BUSINESS
“The number one reason that small CTAs do not succeed is not performance. It is operational mistakes,” Matteson says. “You need to have a business plan. You need to have proper books and records, good accounting. You may need to hire someone from outside of the futures business who is skilled and experienced at running a small business, someone who understands how to use lawyers, accountants and auditors,” he says.
All of these questions need to be answered before you proceed and will be based on your trading strategy. If you have a strategy that is long-term and systematic, entering orders once a week, you can get by without a great deal of help in the set-up period. If it is more of a high frequency day-trading strategy, you need to know who will be entering the orders while you are out getting accounts or who will handle your accounting, marketing and sales while you are trading.
Cranwood trades butterfly spreads within the Treasury complex and trades extremely actively. “I have 12 guys who can run the trading room when I am not there and that has been important in the first five months because I have done a lot of conference calls and a few trips to meet investors and we were averaging two visitors a week,” Powers says. “You have to be able to run your business and have time to talk to investors. And if you are a one-man shop, or even a two-man shop, that can become pretty tough.”
Cranwood set itself up as a hedge fund and exempt commodity trading advisor/commodity pool operator instead of simply offering managed accounts. To execute their strategy and be profitable, they purchased six Chicago Board of Trade memberships so that they could receive member rates. A managed account structure would not allow them to receive the preferred rates. Any potential manager with a high frequency or arbitrage type strategy will need to take that into account.
Things being equal though, the managed account format is the simplest for an emerging manager. “It is definitely cheaper and simpler to go with separately managed accounts because a separately managed account is not a security so you are not burdened by Regulation D,” Matteson says, while adding there are drawbacks. “It creates administration issues because you may have different clearing brokers and order entry execution may be a challenge relative to only having your own private labeled fund as your only account, but it is definitely easier and cheaper.”
WHO WILL INVEST
One of the biggest mistakes a new manager can make is to waste time going after the wrong allocator, says Frank Pusateri, president of Adirondack Portfolio Management. “The [CTA] decides that they should meet the guy with the most money. They spend $5,000 to $10,000 to fly somewhere and beg, borrow and steal a meeting with somebody whose first criteria for hiring a trader is that they have $500 million under management,” Pusateri says. “They make no effort at all trying to decide who they should actually be talking to and how they should deliver their product.”
Pusateri says that many of the decisions an emerging manager must make will become clear once they define who they want to be and what type of customers they will go after. “I want them to define what the client looks like and what they want to look like in five years. Once you do this, it is amazing that a lot of the rest of this falls [into place],” Pusateri says.
“They have to get comfortable with this as a business and a business is everything from A to Z,” Matteson says. “It is talking to the accountants, it is talking to the marketer, it is making sure you have a receptionist out in front every day, it is all those things that have nothing to do with trading and you have to budget your time so you have enough time to run your CTA as a business.”
How much initial business infrastructure you need will be based on your potential investors. While getting all of your ducks in a row is important, you can spend too much money on the trappings of a business, especially if you will not be in position to entertain institutional investors for several years.
“I don’t have a problem if someone operates out of their home or from a desk someplace, but at some point if you want to hold yourself out as a serious money manager to an institutional investor you better have an office and all the trappings of a successful CTA business,” Matteson says. “Otherwise the institution is not going to take you seriously. But in the start-up stage I don’t think trappings matter a bit and your money is better spent elsewhere.”
“You can over engineer and over hire,” Matteson adds. “Like any business, you crawl before you walk. You walk before you run and you shouldn’t build a business model that is out of line with your revenue projections.”
Knowing your target customer is essential in not only how you market your program but in how the system is geared. “The high net worth client asks how much money can I make and an institutional client asks how much can I lose,” Matteson says. “Both are good questions and it is up to the CTA to create a volatility dynamic that matches who they are going to offer their services to.”
Pusateri encourages managers to scope out the competition. “I tell them to look at other people. You have to compete for money. You have to know what other people are going to do and you have to position yourself to compete, so I send them to the databases so that they look at other people’s performances and find out that there are other people in the world with great performance and no money.”
While you may believe you have found the Holy Grail, chances are there is someone out there doing something similar. And if they have been successful and have a longer track record, they will get the allocation. “I can go out there and take a counter trend system that doesn’t make any money and probably raise a quarter of a billion dollars for it basically by saying it improves your rewards to risks characteristics,” Pusateri says.
TIME AND MONEY
Matteson and Pusateri agree that a new CTA must have about two years of operating capital to give itself a chance. “I have no hard and fast rule but I would definitely suggest that CTAs be able to afford their business with no revenue for two years. That is giving the business a fighting chance,” Matteson says.
Pusateri says, “The most common reason for failure — for good traders — is lack of staying power. They can’t survive the next two years.”
Matteson adds, “You need to plan for success and you also need to plan for failure. Since CTA revenues are so driven by the incentive fees, you don’t know whether your trading is going to be profitable or not (initially) so you don’t know whether you are going to get incentive fees.”
He asks, “What would happen if you didn’t make incentive fees for the first year or the first two years? How are you going to keep the business running? You have to ask those questions in advance.”
A NEW BALL GAME
With the recent success of managed futures, Matteson expects to see more emerging managers entering the fray. Managed futures provide better diversification from traditional portfolios than most other alternatives and are more liquid and transparent than most hedge fund strategies. But they have suffered from a poor reputation and many have placed themselves in the hedge fund bucket to avoid being tarnished. That also could be ending. “We are going to see an increase in start-up CTAs, started by people who used to work at a hedge fund or investment bank. One of the great things about a start-up CTA is that you can start up a new business without a substantial amount of capital,” Matteson says. “Today a start-up CTA would call themselves a start-up CTA or a start up commodity pool so as not to be burdened by many of the things that have tarnished the hedge fund community, such as over leverage, [illiquidity and] lack of transparency.”
But they will have to remember that they are no longer just traders. “I have developed and traded this model for a long time. This is my life’s work and this is my trading plan, but putting it into practice with other people’s money is a different ball game,” McNew says.