3. Managed Futures Risk Management - How to Improve it with SafeMoneyMetrics CTA Rankings and Indexes

Topic:  How To Use SafeMoneyMetrics ; Client Education; Professional Education; Risk Management

How You Benefit
Conscious application of SafeMoneyMetrics® CTA rankings and indexes can improve the advisor selection process. Investment profitability relative to time can also be semi-analyzed. How to not use SafeMoneyMetrics® is pertinent so its’ inherent weaknesses are included.  The SafeMoneyMetrics® CTA rankings are sorted by the Net and Funding Level Ratio from best to worst over 6, 12, 24 and 36 month time frames.  Rankings are useful during the initial advisor selection process.  Read the Ranking Definition document  

SMM® Indexes are created from the Net and Funding Level Ratios calculated using traditional CTA track record data. People can learn to constructively use SMM® Indexes relative to a single or multi advisor investment and Advisor Analysis .

Share Content

Content below was basically taken from the SafeMoneyMetrics® CTA Index Definitions at http://www.safemoneymetrics.com/?page=indexes

SMM® CTA Indexes were built from traditional cta data licensed from Barclay Research Group. SafeMoneyMetrics® can be licensed for application to any data base. People can also use SMM® indexes and CTA Rankings as site or media content. They are updated and online with the advisor rankings the first week of each month. For details contact: MJ 212-777-3862.

**************************
A Few Benefits of SafeMoneyMetrics® CTA Indexes:

• Indexes can be useful as timing indicators for entering or exiting specific types of managed futures investments.
• They can be useful for determining risk and cost of an investment relative to ‘an index or industry average.’
• Investors can watch indexes over time frames, if an investment is not performing better than the ‘middle ground created by averages’, find another investment.   
• Indexes can establish acceptable downside boundaries. Data provided by an index can be used to semi-determine the worst you should expect for an investment related to that index over specific time frames and market conditions.

We use the word ‘semi’ because nothing on earth should ever be blindly accepted as ‘Divine Intervention of Superiority” except God!  Specifically I would employ a trader with volatile returns. They would need capital at risk to reward of at least 5 to 1, fair costs and the ability to use high leverage! That description does not fit into an industry average created by indexes!

How to Understand the Index Data

The master table above lists each index with its current Net and Funding Level Ratio. The number of traders in each index, assets managed and percent of assets represented by each index relative to total assets reported to the data base being used.

In the table above, look at the first Agricultural index. The 0.08% NR for October 2010 simply means that advisors in that index averaged a profit of 0.08% on capital at risk. Not the account size, or notional assets, but capital at risk. The 0.01% FLR is the profit on minimum funding levels for the index.  The capital at risk and funding level formulas are described below.

SMM® indexes may appear to not represent enough of total assets reported to Barclay. This is because our index rules include the following.

1. Only advisors with a three year track record or more are listed.
2. Only one program from each company is listed, the program having the oldest track record.  Many management companies offer several different programs. That same program may be listed in the sector and account size indexes.
3. If one company offers two different programs with different account sizes both programs are included in the account size categories. For example, Company A offers 25,000 and 250,000 investments using different programs.  Each program is included in their respective account size index.   
4. We add new advisors to all indexes annually. For example. Every month Barclay publishes an additions and deletions list. We delete advisors used in any index monthly and we add new advisors only in January.   

When people download the index data excel file, they see raw monthly data and charts for each index. You can select a time frame to display the relationship between a net and funding level ratio for the most recent 36 months for any index.  Graphically, the green line represents a net ratio and blue is the funding level ratio. Assume in April 2012 there were 12 advisors in the agricultural index. The graph represents an average Net and FLR ratios for all 12 advisors. The graph always shows the most recent 36 months.  Each index allows you to select 3, 6, 12, 24 or 36 month time frames for any index.

Net to Funding Level Ratio Applications:
Investment stability is indicated when the Net Ratio (NR) is consistently above the Funding Level Ratio (FLR), especially when the difference is wide. The two ratios evaluate a net return (NR) earned on capital at risk relative to net return (FLR) earned on minimum capital required to fund an account. If and when the net ratio (NR) moves into and below the funding level (FLR), leverage is too high at the minimum funding level under current market conditions. Look at the agricultural graph below.

Data is not compounded. The chart is intended to show profitability trends relative to actual risk taken to achieve that profitability. Return on capital at risk is defined by the green line. When it stays above “0” and the blue line, all is well because actual capital used for trading (at risk) is showing a positive return. When the green is below “0” and moves into the blue line, risk is increased. The blue line represents return on capital used to fund the account.

If risk remains high, clients can be asked to increase their capital contribution to the account, a situation we want to avoid. High risk = NR ( green line) moving into and under
the FLR ( blue line ).

Selecting low risk traders is paramount to optimizing peace of mind and positive returns. Low risk traders are easy to find using SafeMoneyMetrics®. Spend time with definitions analytical relationships defined below and analysis becomes easier to understand. SafeMoneyMetrics® analysis reveals potential risk of an investment when funded at the minimum funding level over variable market conditions. When applied to indexes, the analysis reveals potential average risk of the sector represented by the index being evaluated.

Because nothing in the Universe lives in isolation, SafeMoneyMetrics® always monitors ratios in relationship to each other.

Formulas, Definitions and Applications

1. Capital at Risk (CAR): 
A formula that represents actual capital used to produce a return; NOT the account size an advisor asks for, or minimum funding level. CAR is the foundation for all ratios. The CAR formula is adapted for different situations. Two examples are actual margin requirements for each trade, or when evaluating monthly data, we use the maximum margin.

Because monthly data is used to create all indexes, the maximum margin requirement for advisors in the index becomes the foundation for determining Capital at Risk. The exception would be foreign exchange traders, and a foreign exchange index.

Since accurate evaluation of capital at risk relative to return is only determined by tracking all trades in the sequence that they are taken, please remember the inherent limitations of using a maximum margin formula.  

Capital at Risk Applications:
CAR is also used to evaluate capital waste built into the investment.  For example; assume we're evaluating two advisors each having a $1M required account size. The advisor using the least amount of capital at risk to produce the highest realized return relative to the lowest volatility would probably be a better choice. (Highest RVR and Lowest CV- see below).

Net Ratio (NR): 
Is the composite value of realized and open trade equity on capital at risk. (Realized Ratio + or - Volatility Ratio/ Capital at Risk Formula).

Funding Level Ratios (FLR):
Is the composite value of realized and unrealized open trade equity based on the minimum funding level account size.

A Few Limitations of SafeMoneyMetrics® Indexes:
Based on benchmark definitions taken from

• William Sharpe/ Gordon Alexander - Investments Fourth Edition Pages 733-734.
• Sharpe and Alexander - Investments 4th Edition  Page 737 23.2

  With one exception, we do not believe that any managed futures index is a useful investment benchmark. Mr. Sharpe is quoted below.

“In order to infer whether the manager's performance is superior or inferior, returns of similar portfolios that are either actively or passively managed are needed for comparison. Such comparison portfolios are often referred to as benchmark portfolios. Selecting benchmark portfolios should prove relevant and feasible, meaning they should represent alternative portfolios that could have been chosen for investment rather than the portfolio being evaluated”.

A few of our own reasons are as follows:

• The nature of numbers is that averages create a middle ground. The best, worst and those next to the extremes are leveled off. Comparing an investment to an index or average establishes erroneous performance expectations. Any erroneous expectation is cause for ill-fated loss.

• Indexes are compiled with advisor data having different account sizes, investment strategies, margin to equity and minimum funding levels. Past performance calculations also vary. Although parameters for identifying and monitoring risk are easily identified on individual accounts, they would not realistically be comparable to an index, unless the index was specifically built to mirror an investment.

• There is no direct ‘benchmark’ relationship between an investment and an index. The text below was taken from an article that we wrote earlier on indexes and relevance.

“Stock and bond market indexes are comprised of closing stock or bond prices at the end of each day. Indexes directly mirror prices of the stocks or bonds in it.  If someone developed a grain index and daily prices for all the grain markets were included, then that futures index mirrors the equity indexes and has useful relevance.

If people bought the grain markets reflecting the exact proportions used in the index, then the index serves a useful purpose. If people invested in grain traders based on values of the grain index, they are increasing their risk because there is no relevance between the grain index and the performance of any grain trader!

CTA and hedge fund indexes reflect the returns of trading talent applied to markets, whereas debt and equity indexes reflect the market prices of stocks or bonds in each index. 

I perceive that the industry wide applications of using CTA and Hedge Fund indexes for benchmark and investment evaluation purposes are ‘erroneous.’  The ‘belief’ underlying the application unknowingly increases risk for many investors.”

In conclusion SafeMoneyMetrics® Indexes, when used as ‘industry wide indicators’ are only as useful as the data base they are applied to. Data-base services can track assets reported. Although not factual, I have reason ‘to believe’ that data-base services have no indication of total industry assets managed relative to assets reported to their specific data base. 

Useful SafeMoneyMetrics® Ratios:

Definitions below are included because, no matter what, people insist on using indexes external to their investment to judge the performance of their investment. The ratios below can be calculated and applied to any investment under consideration.

Cost Ratio (CR): Defined by a relationship between account costs relative to the Net or Funding Level Ratio. Traditionally costs are evaluated as a percent of the fully funded account value annualized. Cost analysis is improved when evaluated relative to return and capital at risk. For example - one of the industry's greatest traders had a 20% cost factor. People “perpetuate the illusion” that he needed to exceed a 20% return before clients benefited.

This industry wide thinking is 100% inaccurate. The trader earned over 100% annually on the fully funded account using 25% margin (Capital at risk). Now we “see” that he earned 400% on capital at risk and his costs were 20% relative to the 400% or Net Ratio.

Traditional Rate of Return (TR): SafeMoneyMetrics®ä uses the TR relative to the Net and Funding Level Ratios for evaluating account stability at variable degrees of leverage. The TR is also used to evaluate costs relative to account size, capital at risk and return.

***A Primary Benchmark: Reward to Variability Ratio (RVR): When used with SafeMoney risk and investment management services the RVR estimates the capability to produce realized profits with respect to managing the risk of open trades. Traditionally the RVR is calculated by dividing the Risk Premium (RP is a return above the risk free ROR) by the Standard Deviation (SD) of returns. Since SD measures volatility and RP risk premium the result is a risk/reward ratio. For this advisor selection analysis we divide the average Net and Funding Level Ratios by their Standard Deviation (NR/StD and FLR/StD). A high RVR indicates a higher return relative to the amount of risk taken. For example Assume the NR= 23%, a SD of the NR for the same time frame is 30%, then 40% and 55%. 23/30=0.76%, 23/40=0.575% and 23/55=0.418% - As the SD increases or NR decreases the RVR decreases.  This ratio is expressed as one number and is applied to every aspect of analysis, including comparison of investments.

***Secondary Benchmarks: Coefficient of Variation (CV): From statistics the CV measures absolute and relative dispersion. If the absolute dispersion is a standard deviation (S) and the average (A) is the mean, then the relative dispersion is called the coefficient. When a mean or average is close to zero, the CV is not useful CV=S/A – When applied to composite SafeMoney analysis the CV is a Benchmark, used to monitor the average of each ratio over time frames relative to the last for that time frame. The CV is also used to compare advisors. Assume two trading advisors, one returns 55% with a StD of 35% and the other returns 35% with a StD of 15%. 35/55=63.63% and 15/35=42.85%. The second advisor is more efficient.   

Minimum Acct Size (MAS): Also called a fully funded or notional account size accepted by the advisor (Management fees are calculated on this account size).
Minimum Funding Level (FL): Cash used to fund an account expressed as a percentage of the Minimum Account Size.
Margin Minimum%: Margin used expressed as a percent of the minimum account size.
Margin Funding%: Margin used expressed as a percent of the minimum funding level. 
Cost/MA: Annual cost relative to the Minimum Account Size (MA) accepted by the advisor. 
Cost/FL: Annual cost relative to the Minimum Funding Level (FL). See # 4 Cost Ratio.
MA and FL Total Return: Based on the hypothetical account size for time frame being analyzed.

Max: The best value of a ratio within the time frame specified.
Min: The worst value of a ratio.

Time Frames: Ratios and benchmarks calculated over a specific time frames, rather than calculating annual return data. We perceive constructive evaluation of time frames to be superior to evaluating annual return data.

Follow Us