It is a lot simpler than you are making it. When a client opts for notional funding, you simply agree with her (in writing) on what the nominal level will be. That level does not change until there is another agreement in writing. It doesn't matter what happens with PnL. The nominal level does not change. This obviously doesn't affect incentive fees at all. You still get your 10-30% of net new profits, depending on your agreement. Re: management fees. Each month you charge 1/12 of your annual management fee as determined by the nominal balance that was specified before hand. Since that nominal amount doesn't increase, your fees also don't increase. That is, until you re-define the nominal balance. As far as defining the performance, you must include something like the following in your DDOC.
Yes, I believe he is wanting to be able to specify the nominal balance so that when a report is generated it will reflect the notional funds. When fees are billed automatically, they would reflect the notional balance as well.
Thanks Eirc. I am just wondering what woud be the risks/cons to the investors using notional funds. In particular, when one of them could not meet his margin call (due to his notional funding % being too high) in a timely matter, that would seriously affect his account's performance as well as the CTA's performance, I'd guess. Any comments or experience?
Notional accounts are an extremely dubious invention in the first place. They allow the client to blow his brains out immediately by overleveraging far beyond the risks justifiable by the parameters of the trading system. Why should the adviser encourage that?. It throws all of the risk calculations of the adviser out the window. Most trading strategies are already risky enough if not too risky. I think that allowing notional accounts exposes the adviser to too much potential liability. It makes it very likely that the account will blow up and then the client will sue the adviser for not warning him sufficiently about the risks. Just having a few lines and tables in the disclosure document about the risks is not going to protect him. If you mention notional accounts in your marketing materials and disclosure document, you are indirectly encouraging them and this is likely to come back to haunt you.
Why in the world would you make such blanket assumptions of ignorance and foolishness, on the part of both manager and client? How do you know an investor isn't simply aiming to make a conservative program slightly less conservative, or has risk capital allocated to trading that he doesn't wish to pull from some other accounts? I really don't understand the mentality that assumes the professional trading and investing world is populated by idiots and fools. I mean, to a large degree it possibly is, but these people can't be saved from themselves anyway. As Yojimbo said, there is no cure for fools. Rules and tool sets should be fully functional and designed for the responsible to use them and drive them. If dummies want to wrap their cars around telephone poles, that's no reason to limit available horsepower for all.
Good points. I'd think your points would be quite valid and useful for retail investors. However, I'd also think notional funding should be equally valid and useful for professional/institutional investors. An example is for a strategy generating net 10% returns with 5% MaxDD, assuming having stable performance year after year. With notional funding, an intitutional investor could choose 2x or 3x leverage aiming at Return_20%/MaxDD_10% or Return_30%/MaxDD_15%, respectively. My guss is these two options would be most common to the majority of institutional investors. (Perhaps the Opposite!) Without notional funding arrangement, probably none of the 3 options standalone would be Optimal/Enough to the institutional investors, imo. Just 2 cents.
Perhaps, here is a reason that notional funding would be used. http://www.futuresmag.com/2012/08/20/pfg-victims-give-trustee-f-in-communication?t=financials Q Commodity Trading Advisor Bouchard Capital LLC will be shutting its doors later this week because nearly 80% of the client and proprietary money it was trading, $3.4 million of $4.4 million, is tied up in the Peregrine Financial Group fraud. UQ
Is it my imagination, or do a lot of folks on ET see trading as a dangerous and foolish activity that should be shut down? Peregrine was a disaster, no doubt. But if you trade futures or run a CTA, what do you do? You fire your mid-tier clearing firm and find a top tier clearing firm, with triple safeguards, excellent financial reporting protocols and decades of reputation. The PFG fraud means more business for the most trustworthy FCMs. It doesn't mean futures trading will stop or should stop. And in fact, in some ways, a potential advantage may have been created for future traders who survive this debacle, as a significant amount of capital dedicated to various futures strategies will be removed from the market. Smaller pool of speculator capital relative to same-sized pool of commercial capital = more potential alpha to extract.