CTA Selection: Apply Qualitative Analysis

Utilizing the CTA Disclosure Document

Registered CTAs not operating under a Commodity Futures Trading Commission (CFTC) exemption must supply prospective investors with a current disclosure document. Minimum disclosure requirements have been set by the CFTC and compliance is overseen by the National Futures Association (NFA). A disclosure document summarizes the CTA′s background, performance history and advisory fees. It also includes primary risk factors that apply to the CTA′s trading program as well as a description of the trading program and fee schedule. Additional information includes potential conflicts of interest, additions and withdrawal guidelines and the CTA′s privacy policy. A CTA is also required to disclose any material administrative, civil or criminal action within five years preceding the date of the disclosure document. This requirement also applies to the Futures Commission Merchant (FCM) and/or the Introducing Broker (IB) if designated. These regulations enable investors to compare performance information in a standardized form. A disclosure document is good for nine months from its effective date.

Highly Regulated Industry

Most registered CTAs either have been or will be audited by the NFA. During an audit, the NFA will review things such as sales practices, order entry, marketing materials, record keeping and performance history. Material issues and customer complaints relevant to each CTA and the CTA′s principals are noted on the NFA′s site.

Registration history and regulatory actions can be confirmed at the NFA website: www.nfa.futures.org.

Additional Factors

Additional CTA due diligence includes discerning whether performance numbers were compiled internally by the CTA or an independent firm and whether the CTA has been audited by the NFA. Additional factors to be considered include:

• Is the CTA′s track record comprised primarily from proprietary trading (i.e. has the CTA previously only been trading his/her own money) and will the trading strategy remain the same as the CTA raises outside funds?
• Is the CTA′s fee schedule in line with industry averages and does the CTA participate in brokerage commissions that could be seen as a potential conflict of interest?
• What is the CTA′s trade allocation system and does it ensure that all customers are treated fairly?
• Does the CTA use protective stops to limit losses?
• Does the CTA have a maximum risk limit per trade? Depending upon market conditions there is no guarantee that losses will not exceed this limit and every CTA experiences this problem on occasion. However, consistently exceeding this limit could be an indication of lax internal risk controls.
• Does the CTA have a non-guaranteed account stopping point, i.e., a level at which they will suspend trading?
• Does the CTA have a monthly trading suspension level where they will suspend trading for the rest of the month if this level is reached?
• What is the margin to equity level? This is important to determine how much leverage the CTA is using. CTAs generally will notify clients if there has been a material change to their trading system. These accounts should be monitored more carefully until the effects of these changes become apparent.
• Has there been a change in CTA personnel, i.e. the departure of a key trader or research analyst?

Step 4: Portfolio Construction