SafeMoneyMetrics® and Advisor Evaluation
The chart below demonstrates the relationship between a SafeMoneyMetrics® realized and volatility ratio. SMM analyzes simple Percentage values (ratios) that directly reflect an investments return relative to actual capital at risk and account volatility.
Ratios have multiple applications. Use them for individual advisors, markets traded by each advisor or multi-advisor portfolios. The blue line represents a volatility ratio. It measures capital at risk relative to open trade equity on unrealized positions. The advisor's ability to optimize realized returns relative to capital at risk and account volatility is evaluated. The green chart line is a realized ratio. It represents profitability of liquidated trades relative to capital at risk used to generate the profit (or loss).
We perceive that risk, return and misery we can tolerate (volatility) are what really matter!
In the chart above, a green line below the zero base line represents negative returns. SafeMoneyMetrics® quantifies negative returns as a percentage of capital at risk. For example, imagine that we decided to use margin requirements for each market as a foundation for the capital at risk formula. In this instance the advisor’s maximum loss was under 25% of the margin requirement, NOT the entire account value.
Another important relationship is an advisors’ required account size, relative to what they actually use for trading, relative to return.
Evaluating an Illusion of Equal Trading Talent
Assume someone mentions that two advisors meet your risk/return requirements. Rather than blindly accept their conclusion, integrate a SafeMoneyMetrics® risk management filter. The preliminary stages of SafeMoneyMetrics® can add valuable information. Download and review the analysis pdf demo. Now we can almost superficially evaluate the advisor presentations. Nothing else should be decided at this time.
For example: Based on traditional analysis, assume that both advisors have 25% annual returns and both have draw downs under 20%. The advisor using less capital to produce the return relative to their required account size would probably be a better choice. Also the advisor having lower volatility and higher realized ratio would also prove to be a better choice.
Evaluate Appearances of High Risk
Assume an advisor ‘appears’ to have increased risk because their commitment to margin can reach 50% of an initial account size. However, if an advisor takes little overnight risk and is willing to accept small accounts, you may have an indication of exceptional trading talent. Smaller accounts usually appear more volatile (Higher Standard Deviation). Hundreds of advisors want large accounts and use very little of the cash for trading! Many institutional traders require multi-million dollar account sizes and use under 5% for trading! Many funds have minimum account sizes of $100k to $500K and use under 10% of the cash for trading! WHY? The illusion of low volatility (measured by the standard deviation) created by larger accounts is used to comfort poor souls responsible for pension or high net worth investment.
One SafeMoneyMetrics® relationship is volatility relative to account size and realized profits relative to capital at risk, rather than isolated account volatility.
Remember Albert Einstein and Relativity – nothing lives in isolation!
Remember that ‘perceived volatility’ is merely a function of account size and has no relevance to capital at risk relative to return.
Two Perceptions of Risk Management
An advisor can have volatile realized returns and we are comfortable if a relationship between the volatility and realized ratio remains within the advisors self imposed benchmark. (Remember the chart above). If returns produced are erratic but positive, do you care about volatility? Our perception is contrary to traditional methods of evaluating risk. Traditionally if an advisor has a high standard deviation of monthly returns, they are said to be more risky. Downside risk or negative returns are also analyzed for volatility using derivative of the standard deviation.
The managed futures industry uses a standard deviation applied to traditional rate of return data, which has NO relevance to actual capital at risk relative to account volatility and realized returns. The standard deviation, a valuable statistic can be applied to different data.
Using SafeMoneyMetrics® data as a foundation for statistical analysis appears to bring value of managed futures analysis to a higher level.
The data table below represents the average, minimum and maximum of two ratios for any time frame. The advisors maximum capital loss was negative 23.84% of capital at risk. That means capital lost was no more than 24% of cash used for trading purposes. That capital only represents a specific portion of our total account size!
Realized Ratio
Volatility Ratio
Average
18.28%
-0.09%
Minimum
-23.84%
-7.83%
Maximum
200.96%
7.99%
Time Windows and SafeMoneyMetrics®
The managed futures industry uses 3, 6, 9, 12, 24 and maybe 36 month time frames. The value of time windows demonstrates account performance over specified time frames rather than annual. Annual performance data has little relevance to how a managed futures account may perform. For example, January to December could be plus 40%, and March to December could be minus 10%. Time windows partially offset inherent weakness of annual performance presentations. Time windows are developed using a $1000 VAMI Index created from traditional rate of return data, or rate of return calculations. Analytical accuracy is distorted when using either method of calculation.
Time windows below are calculated using SafeMoneyMetrics® Ratios. Always consider the application and data calculations used when determining the validity of any analysis.
This universal truth is germane to any aspect of material reality. By looking beneath the surface to see what drives an application, we can determine its usefulness without getting involved!
Realized
3 Mo.
6 Mo.
9 Mo.
12 Mo.
Average
17.88%
16.99%
15.02%
14.02%
Minimum
-9.05%
-3.93%
-1.15%
-0.47%
Maximum
80.16%
56.27%
37.95%
29.48%
Volatility
3 Mo.
6 Mo.
9 Mo.
12 Mo.
Average
0.06%
0.03%
0.03%
0.03%
Minimum
-2.61%
-1.30%
-0.88%
-0.66%
Maximum
2.66%
1.33%
0.89%
0.67%
Net
3 Mo.
6 Mo.
9 Mo.
12 Mo.
Average
17.94%
17.02%
15.05%
14.05%
Minimum
-9.05%
-3.93%
-1.13%
-0.47%
Maximum
80.16%
57.12%
37.90%
29.45%
Profit Centers for Managed Futures and SafeMoneyMetrics®
Assume you want to build a managed futures profit center. To have greater risk control, you can integrate SafeMoneyMetrics®. Consider the investor value.
Assume SafeMoneyMetrics® is integrated into the advisor selection and monitoring process. One would think that’s enough. To monitor the advisors composite performance, relative to each component within the composite seems to be enough. If anything looks “off” we take an action. Client accounts rarely perform as expected. SafeMoneyMetrics® uses monthly advisor performance as a benchmark. Read the Client Risk Management PDF demo.
Specifically: SafeMoneyMetrics® evaluates only four basic positions as indicators for taking possible action.
- High Realized – Low Volatility = Stay or take profits
- High Realized – High Volatility = Take profits and be careful
- Low Realized – High volatility = Re evaluate maybe change advisors
- Low Realized – Low Volatility = Re evaluate or change advisors
Take time with the Client Risk Management PDF demo and read all the explanations. The four positions are explained and applied in detail. When the four positions are evaluated for a client account relative to advisor performance used to trade that account, we have an internal benchmark. Client account analysis relative to the composite performance becomes a useful indicator for making one of six decisions.
- Adding Capital
- Taking Profits
- Leveraging Up
- Leveraging Down
- Doing Nothing
- Closing the Account
The BIG Weakness of SafeMoneyMetrics®
The principles of SafeMoneyMetrics® are over 100 years old and founded in hedging. When applied to risk evaluation of managed futures and option accounts, the risk management process is new. Common sense told me that direct evaluation of anything, in its simplest form usually brings a greater degree of truth to the surface. Truth is always a never ending search and is only relative to the perceptive abilities of the person seeking it.
It appears that SafeMoneyMetrics® may bring us closer to the direct nature of the futures markets, therefore increase analytical accuracy for managed futures. Think about it!
One weakness of SafeMoneyMetrics® reveals itself when we compile data into different time frames. We lose the quality of direct truth provided by direct trade evaluation. Complied data adds the capital at risk, profits, losses and unrealized equity, so the value of relationship within each aspect of the analysis in its purest form becomes lost. Explanations built into all PDF reports include a list of weaknesses. As I think of more, they are added.
For example, assume we compile daily trade data into weekly data. Over one week, an advisor trades one contract of each commodity, Bonds, Mini S&P and Oil.
Commodity |
Margin |
Profit or Loss |
Bonds |
$2160 |
+ $3500 |
Mini S&P |
$4313 |
- $1500 |
Crude Oil |
$3500 |
+ $4000 |
Total |
$9973 |
$7500 |
Although we GET that 75% was earned on margin, we LOSE the relationship between capital at risk relative to return on individual trades in the order which they were taken. This weakness is inherent with analysis applied to monthly advisor data. Also margin requirements for each trade are not available. Client Risk Management eliminates this weakness. Understand the weaknesses of any analytical function and offset the risk by integrating other procedures.
Many SafeMoneyMetrics® weaknesses are partially offset by a 51% rule.
The 51% Rule for Initial Advisor Acceptance
To accept any advisor and maintain a long-term relationship we ask for and monitor the following over any 12 month time frame. This idea evolved from what my Father taught me. He once said “I need to be right 51% of the time, and only need my piece out of the middle.” That effectively summarizes profitable trading!
- 51% of all markets traded have to be profitable.
- 51% of all trades within each market have to be profitable.
- Profits have to exceed losses by at least 51% for each market traded.
- 51% of the initial margin required for each market is the maximum capital at risk on each trade.
- 51% of all markets traded at any time need to be profitable.
- Profits have to exceed losses of the composite portfolio by at least 51% at any one time.
Acceptable Variables: The above scenario maintains optimum balance and stability. Profitable departures from our optimum, offered by the marketplace may include 35% profitable markets, 45% profitable trades and profits exceeding losses by 65%. Many other combinations are also highly probable. Use your imagination!
To accommodate what the marketplace offers, without compromising our standards we ask that if any one or more of the six variables is under 51% that another or others be over 51% by three times the difference.
In summary: Ask each advisor for a completed due diligence. Read Article #27 Track Records of the Future. Adapt the ideas presented. Create a downloadable document for each investment offered. You can build superior client relationships with a bridge to exceptional risk management and service.