FOCUSING ON RISK MANAGEMENT & INVESTMENT OPPORTUNITIES IN FX
In the past two decades, Managed FX has emerged as the stellar class of alternative managed investments (see Fig 1.).
As seen from Fig. 2, the size of the estimated current Managed FX industry (under $20B) is less than 1,000th of the Mutual Fund industry ($26T), less than 100th of the Hedge Fund industry ($2.2T) and less than a 10th of the CTA industry ($200B). Due to recent overwhelming interest in Retail FX, the Managed FX sector is poised to grow dramatically in the next few decades.
There are numerous advantages in utilizing the Managed FX structure (see Table 1 on the last page of this article).
Fig. 3 shows a typical Managed FX workflow.
PAMM (Percentage Allocation Management Module) is a trading account that consists of multiple investor accounts which form one whole trading structure, where the trading is carried out by the advisor. The principle of PAMM functioning is sharing the profits and losses in proportion.
There are many schools of thought on this concept, but a 10%-20% range is the most accepted. Managed FX allocations seem to increase in times of worldwide financial hardship, as stock markets don't generate sufficient returns or create losses for investors. Investors should start with a small portion of their portfolio (10%-15%) and increase their allocations once they get comfortable with the process (assuming good performance).
Starting from October 18, 2010, the CFTC (Commodity Futures Trading Commission) requires all FX managers in the US to register with the NFA (National Futures Association) as a CTA (Commodity Trading Advisor). FX managers must now comply with the same strict set of guidelines as the CTA have been doing for many years.
In today's world of outright fraud by many hedge fund "managers", funds safety (part of operational risk) is a major concern. When dealing with a Managed FX advisor, there are three inherent areas of concern:
a) FX Broker Security - A reputable broker with a good pedigree is a must. Preferably, it should be regulated by local authorities and well capitalized. This should be researched by the advisor. The advisor should also constantly monitor the broker for any red flags, as seemingly even the most reputable brokers are prone to serious fraud (e.g. Refco).
b) Custodian Stability - Generally the bank where the funds are physically held. This research should be performed by both the advisor and broker. This aspect should also be constantly monitored, as even the largest financial institutions could fall in times of extreme crisis (e.g. Lehman Brothers).
c) Advisor Competency - This due diligence should be performed by the client. The most crucial potential issues are volatility of returns and depth and length of program's drawdowns. Investors should keep an eye on program performance and consider reducing their allocations in case of high volatility of returns or drawdowns outside their comfort zone. Most investors seem to be comfortable with short drawdowns under 15%.
Both technical and fundamental approaches, as well as a combination of two, work equally well in Managed FX. Various trading principles, style and methods could be successful, as long as they produce steady and smooth returns, while managing risk over a long period of time.
Long-term trading offers reduced turnover expense (spreads/interest), while short-term offers greater flexibility and control. Trading in ultra-short timeframe (scalping) does not produce good results due to liquidity, spreads and slippage issues. A lot of system developers create scalping bots (automated programs) that produce great results on paper. However, in a real environment with a sizeable fund, these systems are useless.
Proper automation of Managed FX trading is a good idea. It eliminates trader's emotions and errors and allows for activity 24 hours a day without human intervention. The advisor should utilize the latest technologies (e.g. redundant power and internet feed, co-location, etc.) in order to keep an automated program running smoothly.
There are many important aspects of performance, such as history length, ROR, maximum drawdown, positive/negative months ratio, amount of pairs traded (more is better), various risk-reward ratios. The Sharpe ratio is a good indicator of consistency of returns. Investors want to see Sharpe of .75 and higher over a significant period of time (one year or more).
Sharpe over 1.00 over a year or longer is exceptional. Managed FX performance is typically benchmarked against major market indices (e.g. S&P 500), as well as managed futures (CTA) indices (e.g. NewEdge) as the closest alternative investment class. This allows the investor to determine how well the advisor is performing against the overall market and its group of peers.
Investors can always log into their brokerage account and check their P/L, closed/open trades and other basic information. Some advisors, however, provide their clients with additional performance reports with features like trade stats, equity charts, drawdown analysis, won/lost pip breakdowns, pair analysis, risk-reward ratios, etc. This could be very beneficial in gauging performance.
There are three important aspects regarding a program's drawdowns (largest peak-to-valley drops in equity):
a) Frequency of significant drawdowns (per annum)
b) Average time to recover (in days)
c) Size of the largest drawdown (monthly basis)
Drawdown frequency and time to recover largely depends on the program's frequency of trading and style. There is no specific metric, but generally the program should not experience frequent drawdowns over 10% and should recover from drawdowns quickly.
The largest acceptable drawdown depends on the programs' ROR (Rate Of Return) and investor's profile. Most investors are comfortable with drawdowns under 15% on closed trades, assuming good returns. The majority of investors also accept an occasional drop slightly over 15%. Drawdowns upwards of 30% should only be acceptable in extraordinary circumstances.
Popular currencies perfectly suitable for Managed FX are: USD (US Dollar), CAD (Canadian Dollar), EUR (Euro), GBP (British Pound), CHF (Swiss Franc), JPY (Japanese Yen), AUD (Australian Dollar) and NZD (New Zealand Dollar). Most FX brokers offer dozens of pairs (e.g. USD/CAD) and crosses (e.g. CAD/JPY), based on these currencies. These pairs and crosses offer great liquidity with good spreads and fit almost any trading style.
Other currencies, called "exotics" (e.g. RUB - Russian Rubble), are typically acceptable only to specific programs due to their lower liquidity and more importantly wider spreads. Some exceptions to that rule might be HKK (Hong Kong Dollar), SGD (Singapore Dollar) and DKK (Danish Kroner), as they offer good spreads and liquidity when paired with US Dollar.
Spreads are a crucial part of the Managed FX business. Most non-ECN (Electronic Communication Network) FX brokers earn their revenues exclusively via the difference in spreads they offer to the advisor and Interbank spreads. Working with tight spreads is even more crucial to advisors with high-volume of trading (short-term). ECN FX brokers charge commissions instead and do not pad the interbank rates. In that case the advisor should try to negotiate the best possible commission rates with its broker. Every trading night, during a rollover, the portfolio would either gain or lose interest on every open position. While an important aspect, the interest typically does not play a large role in Managed FX, unless the program holds positions for a long time with minimal leverage, but constant negative interest. In that case the interest could add up quickly.
Minimum starting balances vary greatly from one advisor to another. For most advisors it ranges between $10K and $1M Investors should always inquire about a program's theoretical capacity and current AUM (Assets Under Management). For any successful program there must be plenty room to grow, as new investors, contributions and profits keep rolling in.
Investors should also do due diligence on the advisor's broker. Here are some key aspects of a good FX broker in order of greatest significance:
a) Solid Reputation - must be in business for a long time and have a good reputation and positive client reviews
b) Tight Spreads - either fixed or variable, the spreads must be tight for all major pairs and crosses
c) Good Customer Service - any issues must be resolved quickly to keep downtime low
d) Powerful Trading Software - to allow for quick execution, minimize slippage and downtime
e) Flexible Manager/Client Software - must be easy to use for clients to allocate, contribute and withdraw funds
f) Low Minimum Trading Size - some FX brokers require the advisor to trade full-size currency lots (100,000 units). Some offer mini-lots (10,000 units). Few offer no minimum at all.
It is often beneficial to deal with mini-lots or no minimum, as the advisor can trade precisely the amount necessary, which could smooth out the equity curve and improve compounding.
There is another potential revenue stream for the advisor that could be completely hidden to the investor. This revenue comes from so-called "rebates" or "kick-backs" that the advisor might collect from the portion of the spread from the broker. This is accomplished by utilizing a third party called "Introducing Broker" or IB. An IB introduces the clients to the broker and collects a portion of the spreads for its efforts. That revenue is then split between the IB and the advisor. In some cases, the advisor is also the IB, and it realizes all of that additional revenue.
This practice should only be acceptable to investors if rebates come directly from the broker spreads, and not "padded" on top of it. If an advisor "pads" every trade with as little as half of pip, with sufficient volume of trading, it becomes equal to the advisor charging its clients a 5%, 10% or even 20% management fee, which is highly unethical. This also diminishes the performance, but guarantees a higher income for the advisor. Investors should always inquire if the advisor utilizes any such practices. Recent regulations made IB - broker relationship more structured better protecting investors.
Most Managed FX advisors have their own funds allocated to their program. This is due to all the benefits Managed FX has to offer, plus the full control over the trading. This adds additional benefits to the investors, as the advisor generally works extra hard, as his or her net worth is directly affected.
Managed FX offers a significant potential leverage to the advisor. Some FX brokers used to offer leverage up to 400:1 or higher, but with the recent Dodd-Frank Act, the maximum leverage available to the US FX brokers is now limited to 50:1. In practice, 50:1 leverage is sufficient for any style of trading. The sweet spot for the majority of trading programs is 3X-10X. Anything above 20X only works on short-term strategies, and should be used only for specific programs. Some advisors offer "Notional Funds" option. An account is notionally funded when the advisor trades the client's account, as if the funding amount was higher than the actual funds on deposit for that client. This frees up capital for the client, but that capital should always be available upon advisor's request. It's up to the client whether or not to use this feature.
Most Managed FX advisors allow for client's contributions and withdrawals at any given time and with minimal notice. To add/delete funds from the program, the advisor would run a process called "Re-Proportion", that adjusts current balances and positions accordingly, using broker's PAMM software. Contributions often require a minimum proportionate to the initial minimum (e.g. $100K initial minimum, $25K minimum addition). When withdrawing, clients are often required to keep at least their initial balance to stay in the program. Ideally, clients should not withdraw any funds for a long period, so profits get reinvested for maximum gains.
The fee structure for Managed FX is identical to ones for hedge funds and CTAs. There are two types of fees: incentive and management. The incentive fee is based on percentage of performance profits and typically ranges between 20% and 25%. The incentive fee is typically charged monthly or quarterly. The management fee is fixed and charged monthly, quarterly or annually and typically ranges between 1% and 2% of client's allocation per annum. Some advisors charge 30%, 35% or even 50% incentive fee and/or 3+% management fee. This should only be acceptable when the advisor's performance is truly extraordinary. The sweet spot in today's world is 20-25% incentive fee with 0-1% management fee for an advisor with solid performance.
With most advisors it only takes a few days to open an account. This typically consists of the following steps:
1) Opening and funding an FX brokerage account
2) Executing client agreement and LPOA (Limited Power Of Attorney) with the advisor
3) Following an invitation hyperlink to be added to the advisor's portfolio of accounts
By following guidelines which this article has tried to outline and conducting proper due diligence, investors stand a good chance of achieving long-term success with Managed FX.
