Bottom Line
Your ability to quantify the consciousness, perception, motive and analytical skill of a practitioner (trader, analyst or advisor or investment sponsor) is THE ONLY VITAL ELEMENT for success in any endeavor – Would you buy investments sponsored by MF Global? How can you identify an MF Global before getting involved? ( added 3/29/2012)
For an in-depth foundation of the principles supporting SafeMoneyMetrics®ä we recommend reading Standards for Advisor Evaluation and Universal Principals for Investment Selection
SafeMoneyMetrics® has multiple applications. It can be designed to incorporate any time frame including intra-day data. For in-depth information on the benefits of SafeMoneyMetrics® targeted to specific audiences including hedge funds we recommend going to www.safemoneymetrics.com
Definitions –
Realized Ratio measures realized profits relative to actual capital at risk. The percentage value used in the formula 20%, 34% or - 15% etc., represents a “relative” scenario. A consumer understands that either 20%, 34% or – 15% was earned or lost relative to a specific capital allocation. Formulas produce exact when applied to daily trade data because we have access to the margin requirements, cost and profitability.
Volatility Ratio represents unrealized profits or losses (open trade equity) relative to a specific capital allocation.
Net Ratio represents the difference between a realized and volatility ratio also relative to a specific capital allocation.
Funding Level Ratio represents realized and unrealized returns relative to actual cash used to fund an account. For example: An advisor may have a minimum account size of $250,000, however their funding level is 30%. Investors can use $75,000 to trade the $250,000 account size.
A Brief Overview -
Simply stated – we perceive that true value of any managed futures/options investment is measured by capital at risk relative to return over variable time frames and market conditions. An advisor’s ability to translate unrealized profits or losses into realized profits minimizing capital at risk is quantified by a constant relationship between the SafeMoneyMetrics® Realized and Volatility ratios. Remember Einstein and relativity. Equally important is your awareness of time frames relative to perception and decisions. Specifically look at the 3 and 24 month charts below and on the next page.
Three graphs above represent relationships between a realized and volatility ratio on a mix of two advisors over three time frames. Fifty percent (50%) of the assets were allocated equally to each advisor. Because of space limitations, only three time frames, 3, 9, and 24 months are graphically illustrated. I originally calculated 3, 6, 9, 12, and 24 months using four different splits – 50%-50, 55%-45, 60%-40, 65%-35. Tables will be presented later. Capital allocations and time frames are always user defined. We can contract time, or use shorter term time frames to increase risk management.
Realized Ratio is represented by the green lines. Although any capital at risk formula can be applied, we chose the maximum margin used for trading defined by the advisors disclosure document, relative to realized trading profits at the end of each month.
Weaknesses
- The capital at risk was NOT all at risk at any one time during the month.
- Profits and losses were also not all realized at any one time during the same time frame.
- Maximum margin is probably conservative. Many advisors do NOT use anywhere near the maximum margin requirement.
Advisors chosen for this demonstration have two different account size and maximum margin requirements. One can argue that we are evaluating apples and oranges therefore the work has little validity. As time passes we’ll learn how to effectively equalize differences. For now, bringing your attention to weakness is the best we can offer.
Any SafeMoneyMetrics® ratio is meticulous when applied to every trade using the margin requirement or percent of capital allocated, translated into a dollar denomination. Trades can then be sorted by market and totaled by month. Sorting presents the ability to analyze how each market adds or detracts profits to or from the composite. Sorting also gives us information to correlate the trading results of each market within the portfolio to prove that diversification is prudently applied.
Nothing is hidden when SafeMoneyMetrics®ä is applied to individual trade data.
When possible we analyze one account relative to the advisors composite 13 column track record. When client accounts start trading with any particular advisor, we easily track every trade then sort by any time frame needed for a particular analysis. Client accounts are monitored relative to the advisors composite past performance used as the benchmark and the advisors monthly performance moving forward. (Take time with the Client Risk Management PDF demo).
With esteem and affection for my favorite industry colleagues Stark and Barclay, yet contrary to their viewpoints – I do NOT believe in using benchmarks - indexes external to the investment unless someone can prove that the benchmark has any relative comparative value to the investment being considered. Then I would need awareness of weaknesses and differences between the benchmark and investment.
I am 150% convinced that applications of benchmarks and indexes are frequently abused when applied to investment evaluation and marketing process causing more harm than good.
Volatility Ratio is represented by the orange lines. Again the Volatility ratio is defined by capital at risk relative to open trade equity for the same time frame that the realized ratio is calculated. Open trade equity is useless until translated into realized trading profits. We’ve witnessed hundreds of thousands of dollars jiggle around before they were translated into realized nothing.
The volatility ratio applied to intra-day data quantifying each trade and then the composite portfolio can effectively manage risk in current reality as well as past performance.
A relationship between the realized and volatility ratio fluctuates between a few possible scenarios. Each investor can create their own decision rules relative to different positions between the ratios. For example -
- Low realized and Low volatility over a specific time frame and market condition can be used to add capital only if reasons for using the advisor remain stable – If there are solid reasons to change the advisor then capital can be removed from the account –
- High Realized and Low Volatility can be used to take profits –
- High Realized and High volatility can be used as early warning to de-leverage assets.
Again the analysis applied to time frames is a major factor for allowing its usefulness to evolve. Time frames are partially defined by the trading strategy and current market conditions. Possibilities are only limited by the creativity of the analyst. The most important factor for optimizing the strength of SafeMoneyMetrics® is to be aware of time and relationships between the ratios. Ratios do NOT serve any useful purpose when seen in isolation. As a matter of fact nothing in the universe can accurately be perceived in isolation.
Partially Funded Accounts and Risk Management
An advisors ability to maintain account stability at their accepted funding levels is quantified by a relationship between the SafeMoneyMetrics® Net Ratio and the Funding Level Ratio.
Most trading advisors ask for large accounts (Over $1M) – Rather than fund an account with $1M – they may accept 25% or $250K as actual funding. (Or other variations of the total account size.) If account assets are drawn-down to or below the $250K clients are responsible for bringing the account back up its minimum funding value. These same advisors may only use 5% of the $1M for margin at any one time. Simply stated:
- 5% of a $1M account = $50,000
- $50,000 represents 20% of the $250,000 acceptable funding level.
Net Ratio – Since our net ratio is the difference between the realized and volatility ratio, we can comfortably claim that it works as a perfect “internal” benchmark to monitor an account’s funding level ratio and traditional rate of return. For complete details on internal benchmarks read Article #32 Benchmarks and SafeMoneyMetrics®.
Funding Level Ratio – is represented by the advisors accepted funding levels relative to realized and unrealized returns. It has two basic purposes:
- To determine efficient use of capital relative to return and cost –
- To determine and monitor effective use of leverage over variable time frames and market conditions.
When an investments net ratio drops below the funding level ratio we have early warning of impending “unwanted” losses – and should carefully reassess the investment. WHY?
A net ratio represents the maximum percentage return (or loss when below the 0 baseline) because the capital used to calculate the return is the lowest possible value for that advisor. The funding level ratio is always a lower percentage than the net ratio because the capital it uses is greater than what is used for the net ratio. Finally traditional rate of return calculations are ALWAYS much lower than both the net and funding level ratios because they are calculated using the notional or fully funded account value.
Please see the chart to understand the previous and following explanation.
Below are the 3 month average returns for the Billing Account ( Traditional ROR), Funding Level and Net Ratio (Margin Account). The Net Ratio should be well above the funding level and further above the billing account return. Wide differences between net and funding level ratios indicate exceptional risk control at the maximum leverage allowed. Narrow differences between the funding level and billing account indicate an efficient strategy and probably "fair" billing of management fees.
Data tables below represent the average minimum and maximum of all four ratios for a 3,6,9, 12 and 24month time frames when assets were equally split between two advisors. Look at the NR and FLR columns in all five tables. Over any 3,6 and 24 month time frames the net ratio fell BELOW the funding level ratio which tells us that leverage being used in this investment was too risky. The best possible scenarios are when the Net is well above the funding level ratio. Find that and you are in managed futures heaven!
50-50 3Mo |
RR |
VR |
NR |
FLR |
Average |
5.7% |
0.3% |
5.4% |
4.8% |
Minimum |
-28.7% |
-1.3% |
-28.7% |
-15.2% |
Maximum |
48.1% |
3.8% |
48.1% |
28.5% |
50-50 6Mo |
RR |
VR |
NR |
FLR |
Average |
4.7% |
0.3% |
4.4% |
4.5% |
Minimum |
-28.1% |
-1.5% |
-28.1% |
-6.5% |
Maximum |
2.1% |
35.6% |
20.7% |
8.7% |
50-50 9Mo |
RR |
VR |
NR |
FLR |
Average |
16.3% |
0.1% |
16.4% |
8.9% |
Minimum |
3.5% |
0.0% |
3.5% |
0.5% |
Maximum |
23.9% |
0.4% |
23.9% |
14.2% |
50-50 12Mo |
RR |
VR |
NR |
FLR |
Average |
12.3% |
0.0% |
12.3% |
6.4% |
Minimum |
4.4% |
-0.1% |
4.4% |
1.6% |
Maximum |
19.6% |
0.3% |
19.6% |
11.3% |
50-50 24Mo |
RR |
VR |
NR |
FLR |
Average |
4.6% |
0.4% |
4.2% |
4.0% |
Minimum |
-0.4% |
0.0% |
-1.0% |
1.1% |
Maximum |
13.8% |
0.6% |
13.8% |
8.2% |
When applying the net and funding level ratios we always want a wide gap between them. Before they narrow or cross we would suggest that the investment be de-leveraged. If the realized ratio is really high while the net and funding level are positive, profit taking would be a wise decision. In reference to profit taking – if clients remove 50% of their profits annually – or 25% every time the advisor is paid an incentive fee they are “building an automated risk management system” into their managed futures account. Leave instructions when the account is opened and you’ll have more free time to enjoy life.
Three graphs below represent the 3, 9 and 24 month time frames for the Net and Funding level Ratios. Although an account can be funded at $250K, clients pay management fees on the entire $1M so the ratio serves two purposes.
- We ONLY want advisors that optimize realized returns with minimum volatility on the least amount of capital over variable time frames and market conditions.
- When we monitor the difference or gap between both ratios it becomes a remarkable early warning signal that excessive leverage is causing unwanted risk.
To be continued in subsequent articles. Look at the advisor analysis pdf demo. Analysis is used for the advisor selection process. Then look at Client Risk Management pdf demo, used after an account starts trading.
“There is never a conflict with person or condition, but rather a false concept mentally entertained about person, thing, circumstance or condition. Therefore, make the correction within yourself, rather than attempting to change anyone or anything in the without.”
Joel Goldsmith“ The Infinite Way” Pg 149