It is well known that there is increasing pressure on CTA fees (google interviews with David Harding , Cliff Asness, etc.). We see this in the proliferation of smart beta products offered with relatively low fees. Institutions don’t want to pay for beta. Putting aside what beta means in the CTA world, let’s look at what their options are for fees.
I have noticed CTAs taking one of two different routes:
- A slimmed down program with management fees only or low incentive fees (for example, Altis has just launched a 1% management fee only, “Pure Trend” program, or Cantab’s “Core Macro” program offered at 1/2 & 10)
- Incentive fee only programs (for example, Dunn has charged 0 & 25 for a long time, QIM is offering 0 & 30 via Kettera Strategies Hydra Platform).
I suspect there is a temptation for a lot of new CTAs to offer incentive fee only programs too, but I don’t have any data to support this.
The rationale offered for incentive fees in general is the notion that the client is paying for what they want the most: performance. It puts the client and the trader on the same side. Offering an incentive fee only structure takes this argument to its logical extreme: the client only pays for performance. But is this really true?
To make this really simple, let’s assume the client’s key objective is to not lose money, and the fee structure is zero management fee plus some incentive fee between 20% and 30%. There are really only two outcomes we need consider: the CTA makes a gain or the CTA makes a loss.
In the first case, presumably, both the client and the CTA are happy. My belief is that the CTA is much happier than the client. The client gave up anywhere from 1/5 to 1/3 of the gains on his capital. Think about that for a second, that’s like he gave the CTA between 1/5 and 1/3 of invested capital to trade in the CTAs own account in the form of a zero percent non-recourse loan (and that’s being generous). Why are the returns of many CTA programs attractive, aside from low correlation to other asset classes? It’s the skew of the returns which the client just paid back to the CTA in the form of performance fees!
What if the CTA makes a loss? Does the CTA share in the pain? Not really. Ok, so they did not earn an incentive fee, and their management fee is zero, so it’s a tough quarter. Not nearly as tough as for the client who lost part of his capital and has to earn it back just to break even. The CTA didn’t share in the losses with the client. Granted, if the client had been paying a management fee only he would be down even more. At 2% management fee he might be down 5.5% in the quarter vs. 5% with a zero management fee, is that 0.5% difference going to sway his decision to stay or go?
In my opinion, the argument that the incentive fee puts the investor and the CTA in the same boat is a stretch: their risk profiles are asymmetric in favor of the CTA. Do you really want to argue that without the incentive fee you are not going to try that hard? The investor could take his allocation to any one of the other 100 or so of your competitors. And the argument really doesn’t hold water if you are systematic: your model isn’t motivated by incentive fees.
Furthermore, from an investor’s point of view, I think there are some distinct risks to working with an incentive fee only CTA. The CTA may be tempted to over risk in order to make up losses. In a drawdown, they may panic and start rushing new ideas into production or tweaking their system because, without a fixed management fee, they may not be able to keep the lights on. This is particularly true of an emerging CTA who has yet to build the capital to weather a significant drawdown.
Contrast the situation of a Formula 1 driver: a performance incentive really works because the risk to the driver’s life and limb increase exponentially with speed. In that situation (and we can debate the morals of such gladiatorial activities) the incentive will drive the driver closer to his risk limit which is better for the team, which has a comparatively limited downside in the worst-case outcome.
So how do CTAs genuinely put themselves in the same boat as the client? As the manager of a well-known systematic trading firm told me during a conversation we had a couple years ago: “If you want to claim you are taking risk alongside your investor, put your money in your system alongside his or hers”.
I would really welcome feedback on this topic, so if anyone has any comments – don’t be bashful.
An investor puts money with a CTA for high return potential. If he wants sedate returns he can go to real estate, ETF or some bonds.
If investor puts 1M and loses 10% in a year hes 100k out but how much is the CTA out ? 100k is a basic salary for 1 person. Even if the client is the only client the CTA is still out more than the client who has lost potential income and for the time being capital – but it was investment capital that wasnt needed for immediate use or it would not be in managed futures in the first place. So investor sat for a year – zero risk to his time, business reputation and all in a cash investment that can be pulled back anytime – with large upside potential perhaps 3-4 times that of most investments.
CTA should charge flat 50/50 in my opinion – cash is cheap – talent and controlled risk and hard work being done on your behalf while you remain in a liquid cash investment with huge return potential. Its ideal.
Hi Ramesh,
Thanks for your comment – your point is well taken.
I guess it all comes down to what the investor will pay for. How much do they value that diversification, for example? Given that they are not placing money with the expectation of breaking even or worse, and they continue to have confidence in the manager (i.e. positive expectation), they ought to prefer zero incentive fees.
An example that might reflect what you describe above: Let's compare costs over a 3 year drawdown followed by a 30% before fees up year (not outlandish for a trend-follower over a choppy period followed by a market dislocation). 0 / 30 fees would amount to 0 + 0 + 0 – 9 = -9%, while 2% fixed would amount to – 2 – 2 – 2 – 2 = -8%. The total fee amounts are not much different but the timing is. My guess is that return of +28% crisis alpha from the fixed fee arrangement might be very welcome during that 4th year.
I am not a institutional investor, so this is just my perspective on the situation.
A cynical investor, of course, wants a fixed fee in up periods and incentive only in down – heads he wins, tails you lose! I would not be surprised at some point if someone offers 0 management + capped incentive fee.
Best, Ian
Thanks for a thoughtful post. I agree with your general thrust here. However, consider a scenario where
– a strategy space has exhibited mediocre performance across the board for some length of time
– Yet, the strategy offers meaningful diversification, which keeps the investors allocated to it
– The investment manager's performance is roughly in line with his cohorts.
In such a situation (which I think is a fair characterization of recent performance of long-term trend following), eliminating the management fee eliminates a painful source of performance drag for the investor.