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15 Top Traders Round Table with Jennifer Sunu, Arthur Bell and JP Bruynes – 2of2

“I think the flat fee is market-driven, and the trader is still going to try to do the best they can because they want performance to attract more capital.” - Arthur Bell (Tweet)

Welcome to Top Traders Round Table, a podcast series on managed futures brought to you by CME Group where I continue my conversation with Jennifer Sunu, who is the director of compliance at the NFA, Arthur Bell, CPA and managing member of Bell Tower LLC, and JP Bruynes, who is a partner at the law firm Akin Gump.

Listen in to today's episode as we focus on how regulators are helping and sometimes hurting managers and clients, the importance of cyber security as a CTA, the way that cryptocurrencies have changed the way we trade, some of the best things that have happened to managed futures over the last twenty years, and how the market has been affected.

In This Episode, You'll Learn:

  • The dangers of over-regulation

“There are certain areas where I know we have increased the regulatory burden over the years, but we really try and balance that with the needs of the customer.” - Jennifer Sunu (Tweet)

  • What we can learn from blow-ups at the manager level and how to avoid them in the future
  • Why investors need to do their due diligence to avoid fraud
  • What the NFA considers in reviewing educational and promotional materials
  • How to ensure your promotional material is meeting NFA guidelines

“The CFTC has taken the position that cryptocurrencies are commodities, and that position has been affirmed by the 2nd district court here in New York.” - JP Bruynes (Tweet)

  • Why pundits on news shows are allowed to make predictions on markets that may be just an educated guess
  • The importance of cyber security and how to you can protect yourself
  • What impact cryptocurrencies may have on futures markets
  • How regulators are working to help clients avoid unrealistic expectations in cryptocurrencies

“It's hard to find a CTA today that only trades commodities.” - Arthur Bell (Tweet)

  • The best things that have happened to managed futures in the last twenty years
  • What has changed regarding the Volcker rule in the past few years
  • How flat fee products are changing the industry
  • Why we need to worry about the "race to zero"

This episode was sponsored by CME Group:

Connect with our guests:

 

Learn more about Jennifer Sunu and the National Futures Association

Learn more about Arthur Bell and Bell Tower LLC

Learn more about JP Bruynes and Akin Gump

“The manager doesn't have to sell [investors on cryptocurrency], all they have to do is point them to the newspaper where it shows these very extreme growths in value, and then people want to jump in on it, not realzing what they're really getting into.” - Arthur Bell (Tweet)

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Full Transcript

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Niels

Welcome back to Top Traders Round Table, a podcast series on managed futures brought to you by CME group where I continue my conversation with Jennifer Sunu who is the director of compliance at the NFA; Arthur Bell, CPA and managing member of Bell Tower LLC; and JP Bruynes who is a partner at the law firm Akin Gump. 

Jennifer, I might want to hear your perspective on something that is very related but very slightly different and that is, I have interviewed many of the largest managers in the CTA space in the past four years and what’s interesting to me, actually, regardless of size, is that a lot of them, when I asked them about what’s the opportunities or the dangers you see for the industry as a whole, dare I say they mention the word regulation very often. Probably it’s the number one answer. 

Jennifer

That would probably be my number one answer too. 

Niels

So, I just wanted to ask you whether you recognize... we all think that it’s fair and it’s good and it is, but is there a danger that regulation becomes overregulation do you think? 

Jennifer

Absolutely, and one of the things that NFA tries to do is really pay attention to what our members are saying. So, we have advisory committees for each of the different registration categories, so there is a CPO, CTA advisory committee. We have CPO and CTA members on our board and on our executive committee.  

We really try and do get a lot of feedback from the industry any time that we’re considering a new rule or a rule change, or maybe a new interpretive notice to give more guidance. There are certain areas that I know we have increased the regulatory burden over the years, but we really try and balance that with the needs of the customer. For example, when there were several large bankruptcies over the past several years with some FCMs, we really took a look and said how can we get a better handle on Seg [Segregated] Funds and not just rely on what the firms are reporting to us every day and what we are seeing, in our examinations, but also to really have more comfort in the balances that they’re reporting.  

It was a lot of work for the firms and a lot of work for the depositories that they put their funds with, but we were able to get feeds directly from the banks and the clearing firms and the FCMs (that our other FCMs deposit the funds with) so that we know on a daily basis. We can compare what the firms are reporting to us versus what they’re actually holding at those depositories. While I agree that that’s a large regulatory burden, the comfort that the industry can have then about Seg Funds that they didn’t have before, I think, outweighs that tremendously. So, we do try and do things like that in other areas as well.  

We recently created a new rule for CPOs and CTAs where, at the firm level, they’re required to report a couple of different financial ratios to us on a quarterly basis. We did get some pushback from the members about this additional regulatory reporting. At the end of the day we decided that we didn’t want to be in a situation where there were firms that were out there, where maybe the firm itself wasn’t financially viable, and we wanted to be able to know would they try and (for example) commit fraud if they had significant expenses that were outside any revenue that they were reporting. We worked with the CPOs and CTAs and came up with something that we thought was good for them, good for the industry, and I think it’s something that has benefited the industry overall. 

Niels

Sure, sure. You’re almost psychic in the way you lead into my next question because that’s exactly the area I wanted to ask everyone about your views and experience, and that is the whole thing about what are the real risks we’re trying to manage? When I think about the industry, of course, we hear about the occasional “blow-up” at a manager level.  We’re in 2018, and February, of this year, was such a period where there were a couple of managers that lost (essentially) all the clients assets in a very short space of time.  

However, the big headlines, over the years, that I’ve come across, are actually from the FCM side because they’re the ones holding the money. That’s where investors can get hurt if some of these rules (as you refer to, Jennifer) the Seg rules, and so on and so forth. So, I’m just trying to find out here what the three of you think about what are the real dangers, what are the real risks that we should try and look for, and what have we learned from these situations? You’ve already touched upon this, Jennifer, so maybe Art and JP, you want to start out on some of this? 

JP

Well, you are right that there have been some very major headline cases involving FCMs, but there have also been (and I ask for Jennifer’s opinion on this as well) a lot of small managers that have gone under or have been guilty of fraud. Many times they involve a particular group of investors that are somehow associated. So, they may all belong to some organization. They may all be of some ethnic group. There was a problem several years ago involving Asian people that trusted someone of their own background, and it was a fraud.  

So, I do see more than a few frauds involving small managers that are looking to a particular associated connection or some affinity group that they can build on their confidence in them and money is lost that way. They’re typically not big numbers, usually in the single-digit millions, but there is that risk out there. So, investors should be very careful if that is the type of trader that is seeking to get their money. 

Niels

Yeah, and of course, I know that has nothing to do with, or at least I think it has nothing to do with our industry in terms of regulations, etc. etc. But I think we can all remember the Maddoff issue and how a lot of money was... 

Art

These do involve futures managers. 

Jennifer

I think one of the things (and we touch on due diligence a little bit earlier) that I see with those types of frauds (and I think you can even see it with Maddoff to some extent as well) is that even in just looking at the performance... So, we talked about hypothetical performance and the pitfalls of looking at that and making sure that you’re aware that it's hypothetical and all of the implications that go along with it. Even some of the affinity fraud that I’ve seen (and again this is usually a very small population of the entire managed futures industry, so I’m not by any means saying that this is across the board), I think the times that we see it, where the fraud starts, is that they’re telling the customers the types of returns that they could be getting, or that they supposedly have been getting. All I can say is, the old adage, “if it looks too good to be true it probably is.”  

If people really paid attention to what type of performance they were listing. Is it always positive? Are there ever times that you would have negative performance? Is it always consistently very, very high performance? Do they ever have anything that is even remotely in accordance with what the rest of the market is doing or to look again at maybe to programs that both sound similar but yet they have completely different returns. What would be the reason for that? So, really to do due diligence in that type of area is something I would recommend that customers do. 

Niels

Yeah, that’s a great point. JP, do you have anything to add or do you want me to kind of move on to the next topic? 

JP

Yeah, just to add to Jennifer’s point of view, I think existing managers who are registered with the CFTC and are members of the NFA now have to report on their CTA, PR, CPR, PQR, their rates of return. I assume that the NFA (based on feedback I get from clients) fairly actively reviews those filings because many of our clients receive phone calls from the NFA with follow-up questions. It appears that managers who are reporting smooth or too good performance may, in fact, move themselves up the chain of being a candidate for an NFA audit. 

Niels

It’s so interesting coming from the manager’s side to hear these things because, of course, we all know, that’s exactly what investors want. They want managers to magically take volatile markets and put them through some kind of system, and then it will come out as a smooth track record. Now, of course, coming from the trend following industry we’ve never been accused of having smooth returns anyway. It is interesting, and I think it’s a good thing that there are these things in place. 

Now, I want to go on to something a little bit different but kind of related as well, and it’s a little bit closer to home, for me at least, because it relates to how the industry communicates with the outside world, which we’ve already touched upon in terms of attracting investors and showing performance. I think that we can all agree that education is really important in order to see the industry continue to grow. Of course, our conversation today is meant to be educational, but I feel that from a manager’s point of view, at least, that we can at times feel restricted when it comes to educating investors. So, perhaps I could ask you, Jennifer, if you want to elaborate on NFAs view on educational initiatives undertaken by managers when it comes to managed futures as a whole (just sort of the overall feel about these things). 

Jennifer

I think from our perspective, where we see the educational aspects of it with our members, is in terms of what types of promotional material they put out. Even if it is more of an educational based thing, if it also seems to be promoting the firm itself and its managed futures program, we would consider that promotion material. That’s something that we would look at.  

We take a different view if it’s clear that it’s being used to try and educate people about the industry as opposed to this, “How I trade,” or things along those lines. So, we do look at it mainly just to make sure that it’s balanced and it’s not painting an overly rosy picture of how futures work - that it’s not consistently giving nothing but positive returns or examples. That’s really where we see it mostly, from our end, is just to make sure that whatever materials you’re putting out, even if they’re educational, are balanced in what they’re trying to tell the investor. 

Niels

Sure, sure. Now, just to continue on a little bit on this, and of course, there’s a risk that I’m completely wrong here, so I hope you can help me out when it comes to the understanding of what managers can do and can’t do. Trying to summarize where I’m trying to go with this because as you say, my understanding is that almost anything a manager puts out into the world is viewed as promotion. My understanding is that the NFA kind of warns against providing statements of opinion in promotional material. This is where I find it difficult to balance, right? Usually, people do want to hear the opinion of a manager. So maybe, Jennifer, just staying with you for a little bit, is there some examples where you can show the difference between what is and what isn’t a statement of opinion if I could put it like that? 

Jennifer

Sure, our rules talk about allowing for statements of opinion, and we certainly have no problem with that, as long as it’s clear that it is an opinion and that it has a reasonable basis in fact. So, that’s really, I think, where most of the members that have problems in this area, where the sticking point is, that they may put out something that is an opinion but is it really a reasonable opinion to have? As long as the answer is, “Yes, that seems like something that would be reasonable,” we aren’t going to have any problems with that. So, that’s typically how we tend to look at opinions in promotional material or other pieces. 

Niels

OK, yeah, because one of the things that we come across a lot, on the manager’s side, is the key selling point of managed futures, [pretty much since 1983 when Dr. Lynn published his research about adding managed futures to a bond and stock portfolio that would essentially provide the investors with a higher return as well as a lower risk due to the low correlation. As far as I’m aware, at least, there has never been a white paper to prove otherwise so to speak. Of course, managers sometimes would like to use the same approach but using their own performance data. Because saying, “If you add us to a portfolio of bonds and stocks, this is what’s going to happen.” So, just for me to be sure I understood what you said, is that kind of OK if you use that because it’s based on a fact, it’s based on a track record, even if it is a little bit self-promoting? 

Jennifer

Sure, that type of thing is perfectly acceptable I think if you’re going to say things like, “This will happen,” to make it so that it’s, “I believe this would happen,” or to have some kind of couching there. So that it’s not put in there as a fact but more clearly so that it is clear that this is what our opinion is. You don’t necessarily need to use those words but to just have something along the lines of that it’s not painted as a hard fact. 

Niels

Yeah, and of course we have risk disclosures that we should add as well when we do things like that, of course.  

It’s very interesting, it’s very helpful; also it’s interesting, in some ways (just to go a little bit off topic here), it is so different to see what promotions we do in the managed futures side. Then there’s what is allowed to do in other things where there are financial newsletters, people who go on CNBC, Bloomberg, whatever, where they talk about (as you say), “This will happen,” or “Buy this stock it’s going to be up three hundred percent next year.” It’s so different compared to what they are allowed to do. I don’t know whether it’s just SCC or where the difference is but there seems to be a lot more control, if I can put it that way, on our side of the fence. Is that a fair statement? 

Jennifer

You know, in terms of what’s on CNBC and things like that, I think, compared to the promotion material that we look at, I would say it probably is more controlled from our standpoint. Obviously, if we had members that were going on TV and talking about their opinions about the markets, again we would expect, in order for it to not be misleading, that they would make it clear that it’s their opinion. So, we would have the same approach if we saw a TV ad or an interview on television, or something like that, if it was our member, we would take that same approach that we would with written materials. 

Niels

Are CTAs, just out of curiosity, are CTAs actually allowed to advertise? I thought it was just the 40 Act funds which are SCC type stuff. Are CTAs allowed to advertise as long as they...? 

Jennifer

From our perspective, there’s nothing that prohibits them from advertising on television or radio. We do have a requirement that if the TV or radio ad is going to mention profit projections, that they send that to us ahead of time to review, but otherwise that type of medium is allowed. 

Niels

But is a profit projection anything that relates to what the historical returns have been of the manager, or is it if someone came out and said, “You are going to make... Is there a distinction there or is it anything that touches on your own actual performance? 

Jennifer

You are perfectly fine talking about past performance and not submitting that to NFA ahead of time. I think most firms (if they do talk about past) also end up talking about how it can affect future performance. So, very rarely would we see something that mentions one type of performance without also talking about profit projection. It’s not something that we see very often, frankly, but it does come up sometimes. 

Niels

That’s right, I’m just thinking out loud here because obviously the world has changed and is digital today. Maybe people don’t put an ad in the newspaper, but social media, YouTube videos, and whatever you have nowadays, there is a lot of information out there. That’s why I thought, for our audience, it probably is a very relevant and useful discussion to hear someone like yourself, Jennifer, to clarify some of these points. I think everyone is, obviously, afraid of doing something wrong, which they should be. We also need to educate (and that’s the balance) and promote, in a positive way, all of the good things that the managed futures industry does represent I guess. 

Art

Yeah, Niels, I would just jump in on one point that there is a significant distinction in the U.S. between advertising for a managed account program (which, if the manager is properly registered with the CFTC and a member of the NFA, they can do) versus advertising for a collective investment vehicle or a fund which, again, raises concerns with the SCC under the Securities Act because these shares of limited partnerships and funds are securities.  

So, if a manager desires to engage in advertising for a fund, it can now do that under the FCC’s Job Act Rule as well as corresponding rule amendments from the CFTC for 4.7 funds. However, at the FCC level you then have to make a check with the FCC to let them know that you are engaged in general solicitation or advertising for your fund. Not many fund managers are willing to do that, right or wrong, because there was a least some perception, initially, that the FCC didn’t like this rule; that it was forced upon them by Congress and was really meant to enable small mom and pop businesses to raise some money, not be used by hedge funds or commodity pools. However, the rule still exists, and some managers do rely on that.  

Typically there is a rule of thumb that if a manager, a client of ours, is going to be interviewed by the press or is going to be on a radio or TV show, we typically would recommend that they do not mention any funds at all and that they stay away from assessing past specific performance of their strategy. Managers do appear on shows all the time and the media. 

Niels

Yeah, absolutely. I appreciate that. Now, in general, thanks for spending a little bit of time on this because this space has long been a misunderstood and, in my opinion, underappreciated asset class, so education is really the best way to overcome these obstacles.  

Let’s move on to some other topics that have been floating around in the news and that I have picked up lately. I think Jennifer already touched upon it just a little bit, but I want to go back and see what else comes up.  

Cyber Security, you mentioned that, and it does bring to my mind that we’ve seen firms and we’ve seen elections being hacked, so it’s definitely something that can keep people up at night. How do the three of you think about this issue and what can we do to help members and participants avoid this? 

Jennifer

I think, from our perspective, and again, touching on the importance of having qualified consultants, depending on the size of the firm, you may want to consider hiring some type of cybersecurity consultant to help you with, not just putting together your written cybersecurity program but actually making sure that it’s implemented properly. I know that there was recently an enforcement action that the CFTC took against a firm who had a significant security breach. They had hired a third-party consultant to do their cyber security, and unfortunately, that third party consultant had missed a big hole in the security with the servers. The CFTC took the opinion that it was the firms failure to supervise that third-party consultant that resulted in the breach and they actually ended up fining the firm, I believe it was a hundred thousand dollars. So, to really make sure that you have qualified people that are helping you. 

From our perspective, we know that nothing is going to be perfect. We know that things can happen. The programs should be developed in such a way that you understand the risks involved in how you develop the program and are doing something to assess the risks and determine what’s acceptable for your firm. We do feel that it’s important that you are at least consulting with people that are qualified in this area and not just relying on someone who may not be qualified to assess your cybersecurity risks.  

It is still a very new area for NFA. The rule just came out a little over a year ago that required firms to have their cybersecurity programs in writing and in place. We have spent that last year on our exams really looking at it more from an educational aspect. So we have not, for example, taken any actions against firms for not having an adequate cybersecurity program. We’ve also, recently, hired a person for our compliance department that is a cybersecurity expert so that we can learn more about that. Now that we’ve seen these written programs, [how do we go about helping firms and giving more guidance to them to make these programs, themselves, more robust? 

Niels

Yeah, yeah, that’s great to hear. Do you want to add anything to this JP or Art, or are you fine with the very detailed answer? 

Art

I think Jennifer’s position is best to know what’s going on and I can’t add anything to that. 

Niels

Maybe you can add something to this. I don’t know, we’ll see. Staying in cyberspace for a moment, there’s something called cryptocurrencies nowadays. Some of them have even made it onto the world of futures as our exclusive sponsor will know. So, how does the world of crypto come into the world from your different angles, so to speak? Maybe we should let Jennifer rest her voice a little bit and hear from you Art and JP about that first, and then see what Jennifer thinks about it. 

JP

Well I think that clearly, with approval by the CFTC in December of last year of the CME bitcoin futures contract and then also, secondarily, the CBOE bitcoin futures contract, there is interest in the CTA space, clearly, in cryptocurrency futures. I think many managers are also looking at the spot assets and there certainly has been a wave of mostly smaller fund managers launching digital asset funds, but some of the larger managers and institutions have gotten into the space as well.  

It’s an area where there has been volatility. There have been rapid price swings, so it’s an appealing asset class for many managers. Now, the NFA has sort of already started saying to its members, “Hey, before you trade a cryptocurrency derivative or spot transaction you have to notify us.”  

I think there is also a requirement on the annual financial statements for registered commodity pool operators that they have to tell the NFA if they’ve traded any derivatives or spot cryptocurrencies in the previous period. So, the NFA, I think, is getting in on making sure that it knows what its members are doing, which I think is good.  

The CFTC has taken the position for several years now that cryptocurrencies are commodities and that position has been affirmed by the U.S. Federal District Court for the Second District here, in New York, earlier this year. So, there’s a lot of regulatory interest in it.  

The FCC is very interested in regulating initial coin offerings. So, I think we’re going to see a lot more regulation as this is an area of innovation where there isn’t a lot of regulation, and it may be regulation by enforcement action initially. 

Niels

Sure, anything you want to add here, Art? 

Art

My successor firm has a lot of cryptocurrency, bitcoin, those kinds of funds that are start-ups, and some of those we are a little bit concerned with. First off, some of those we’ve totally refused to get involved with, not because we saw anything that clearly was a violation, but we just thought that the people didn’t have the background or the depth or didn’t have the right advisors involved. So, we just did not get involved with them. Others we did get involved with because we felt that they were sincere and honest and all of those Boy Scout attributes, but none the less, they are a bit naive. The rules are a bit vague in some areas, and we are concerned about this industry.  

We expect that there will be some serious blowups and people will lose money, not just on the trading, although they are very volatile, more so than generally what you see in commodity funds. Commodity funds do lose money. They do have streaks of losing money, but you normally don’t get the thirty percent down day that you can very much have with currency.  

So, we’re cautiously nervous about these funds and what happens; how the regulation and enforcement really play out; what’s to be expected and furthermore we’re concerned that some of the investors really have no idea what they’re getting into. They read the headlines; they see the... The manager doesn’t have to sell it, all they have to do is point them to the newspaper where it shows these very, very extreme growths in the value of some of them and then people want to jump in on it not realizing what they’re really getting into and why that particular fund may be totally unrelated to where the money was made in some other fund or some other measurement of bitcoin profitability. So, yeah, there’s a lot to be nervous about here.  

Niels

Are you nervous, Jennifer? 

Jennifer

I think we’re all a little nervous about it. What JP was mentioning: reporting out to NFA whether or not you have firms that are trading in these products and we do both the spot and the futures contracts for cryptocurrencies. The reason why, as you can imagine, we were so interested in that is to try and just, again, learn more about it. We will have a new interpretative notice coming out soon that will require more disclosures from firms about whether they’re trading the cryptocurrency futures or whether they’re actually doing the spot, or allowing customers to do spots. From the futures standpoint, it really is just more, in terms of some of these (like the extreme volatile swings that Art was mentioning) making sure that that type of information is disclosed to clients.  

From a spot standpoint, our big aspect is that we want to make sure that they understand the NFA does not regulate those products. That they’re not going to be thinking, “Oh, they’re an NFA member. I don’t have to worry about the fact that I’m opening up bitcoin accounts with them.” That’s not something the NFA regulates, and we just want to make sure that that’s clear to the clients. 

Niels

Sure, that’s a great point. Now, we are going to slowly start to wind our conversation down. We’ve talked quite a lot about some of the burdens and dangers that our industry is exposed to. So, I want to turn to a more of an upbeat finish to our conversation, hopefully.  

You’ve all been involved in the industry for a very long time. So, I’m interested in finding out what you feel are some of the best things that have happened to the industry and how do you see this having a positive effect on the growth of managed futures? For example, we have perhaps more institutional participation. We have now 40 Act Funds allowing smaller investors to take part. What are the highlights in your opinion? 

JP

As Art said, back in the seventies, there were very few futures contracts out there, mostly agricultural, so the innovation with which the markets have evolved, the types of products that people can now trade, whether it’s electricity, emissions; the opportunities and available products have expanded geometrically, creating all kinds of opportunity sets, whether it’s freight shipping. It’s been a very exciting time with new product and innovation, and I think the bitcoin and the bitcoin derivatives just is one more step in that direction of an ever-expanding universe of tradable products. 

Niels

Yeah, true, what about you, Art, what excites you when you look into the future? 

Art

What I’m seeing, as perhaps the most exciting, is that the CTAs... It’s hard to find a CTA today that only trades commodities. More and more they’re working in some equity element into what they’re doing trying to transfer their experience with commodities into equities with varying degrees of success, I might add. So, that’s one thing.  

As JP said, the expansion of what’s traded is phenomenal compared to as recently as five to ten years ago. So, there’s much more out there to trade. There are more weather contracts, catastrophe contracts. There are all sorts of things that are now available that were not.  

I think the industry has grown up to be fully matured, at this point in terms of people that have been in it. People have been in it ten, fifteen, twenty years. They have experience. They’ve built real organizations. So, you can find, today, a CTA that is structured like a business, run like a business. We also see CTAs that now are into their second generation.  

There was a time, twenty years ago, perhaps even fifteen years ago, where the typical CTA was some individual who was a star trader. The whole organization was built around one individual who had the trading ability, knowledge, and skill, and those around him were worker bees rather than equally skilled traders. The systems were not really well documented or systematized so that a successor could come in.  

Today we’re seeing firms successfully transferred to new ownership, new people involved and able to survive even after the founder is no longer in the picture. So, those are big developments. Now, some of those have not been successful. 

Niels

Sure, that is very true. Those are good points. Jennifer, what excites you from where you sit when you look at the future of the managed futures industry? 

Jennifer

I think to build on what Art was saying, the fact that there are so many well established, reputable firms out there, from a regulatory perspective, really lends a lot of reputational integrity to the industry which I think benefits all of them. So, that’s the exciting thing that we see in our end just as it has continued to grow and expand. 

Niels

Sure, sure. I’ve just got a couple of small points left that I just wanted to touch on because I do think that they are of interest and I would love to hear your opinion about it. Maybe one thing that could make the future of managed futures, or alternative investments interesting in some respect and that is my understanding is that the Volcker rule is changing. Maybe you, JP, have some view or insights, or maybe Art, as to what that might mean in terms of the industry and how certain organizations now may participate again in this industry? 

JP

This is probably an area where the Trump administration wishes to loosen on certain provisions of the Dodd-Frank Act by limiting the restrictions on banks to engage in certain financial activities. So, to the extent that large banks could, again, be engaged in sponsorship of commodity pools or ownership of firms engaged in those businesses in excess of diminished thresholds, I think, would be useful to the industry to bring a greater asset base to the markets. 

Niels

Right, sure, sure.  

Art

Following up on what JP said, the relief now, on the Volcker Rule, is allowing banks, large institutions, to take an equity interest in a manager. We are seeing that. We’re seeing interest in that. It has happened with some, and this facilitates further growth and research of that manager beyond the capital it has, and it also helps with the transition.  

I was just talking about second generation ownership. Having the depth of capital, as an investment in the manager, or to partially pay to take out the founder, are all positive steps. I’m very pleased to see that because it does illustrate that there is stability, that the funds that have been around that have been successful, the managers that have been around and successful, can continue, albeit, with new personnel. 

Niels

Yeah, true. The final point that I wanted to touch on and that is something that I think is interesting because it has attracted a lot of assets. However, I think that there are people on both sides of the fence here in terms of opinions. I’d like to hear your opinion about it, and that’s really the issue about flat fee funds versus funds that charge, like the old days, a management fee and a performance fee. I wonder whether you have any opinion, whether you’re worried or not, or you think it’s a good thing that we have these flat fee products.  

Certainly, they are predominantly happening in the 40 Act space which attracts money from a very broad range, not just from institutional investors. I think one side of the coin, in terms of concerns, is that these products are often focusing on raising as much money as possible because there’s a flat fee, instead of focusing on producing the best possible performance.  

There’s no incentive for actually producing the best possible performance because you get paid the same. Therefore some managers tend to use a lower quality version of their strategy and then they can raise more money and mainly trade financial futures rather than the commodities which for other ones provide real diversification. So, I don’t know whom to start out with here, but I just want to hear your opinion whether you think this is a good development for our industry or something to be concerned about? So, Jennifer, why don’t I start with you, ladies first on this one. 

Jennifer

Thanks. I think you raise an excellent point that would be NFA’s concern is not so much the change in structure but just how they are then applying that to their trading program, and again, how they’re disclosing, for example, the conflict of interest that is inherent in having a flat fee versus a performance-based fee where, are they going to be trading less, or are they going to not pay as close attention to how the performance is actually doing for a CTA program as opposed to really trying to do what’s best for the customer’s account. 

Niels

Yeah, yeah, absolutely. 

Jennifer

That’s exactly right. 

Niels

What about you, Art, what do you see in this field? Do you have any opinion about it? 

Art

Yes, a lot has changed, a lot has changed. Back in the days when a manager would be lucky and excited to get a ten or twenty million dollar allocation, now the large traders are looking for significantly more. A large trader will get a three hundred million dollar allocation or more. What comes with that is a much more sophisticated investor, an investor who is going to insist and negotiate on fees, and what we’ve seen in the industry is that it is becoming even more competitive where they force the fees down.  

There’s a phenomenon going on now that’s called the Race to Zero, and that is where there is no management fee. So the manager is pretty much forced to say, “OK, I’ll take your four hundred million dollars with no management fee but with a twenty-five or thirty percent incentive fee,” and that’s what they’re trading off on that. We’re seeing that for the very large investors.  

We’ve seen investments of five hundred million dollars, for example, but zero and something incentive fee. That is going on and even apart from that, getting the fees which were at one point were a four and twenty, then for a long time were two and twenty, now we’re seeing one and twenty, one and fifteen fees, again, based on size.  

So yes, we wanted to see the larger size accounts, but the larger size accounts are demanding lower fees. As far as flat fees, I don’t see the merit in that. I don’t know that a trader would necessarily try to be safer and less performance-based because, after all, performance is what drives investment. I think the flat fee is market driven and the trader is still going to try to do the best that they can because they want performance to attract more capital. 

Niels

Sure, now I want to hear your opinion as well JP, but I just want to inject one thing here just as a personal contribution to this, and that is that the zero percent management fee is not new as such. There are firms, including firms that I know very well, that have had that fee structure for the last forty-four years where essentially they want to be on the same side as the investor and only make money when the investor does.  

So, on one side you can say that’s perfectly fair, and if you, as a business, are willing to do that that’s fine, and you can charge a performance fee. My concern is more, and I’m not concerned about the institutional investors driving down fees. They are perfectly allowed to do so. They should be sophisticated enough to see through to what’s good for them in terms of what the net return is rather than just looking at the total expense ratio, which is, unfortunately, what I think drives a lot of these fee negotiations.  

I was concerned more for the 40 Act space where it is less sophisticated investors that often times fold. That’s why I think, maybe as Jennifer was saying, we do need to be concerned because we need to protect those investors so that they get a good product and not a subversion of a product just to raise more assets but at a cheap price. That’s just to clarify my point on that. 

Anyway JP, you get the last word on this debate. 

JP

Yes so I think two things. One, on the flat fee products, managers are going to be compelled to put markets into those products that are not capacity constrained. So, you’re going to end up with a lot of financial futures where there aren’t really capacity constraints, as opposed to smaller markets and agricultural or metals or energies. The investor may not be getting the diversification that it thinks it is  getting from putting money into a commodity pool or managed futures product. I think these management fee-based mutual funds are the corollaries ETFs where people can just buy a sector at a fraction of the cost of buying more diversified mutual funds.  

In terms of the fees in the industry as a whole, clearly, fees have come down a lot over the years. One fee structure that we have seen, that has increased in popularity, is the one that’s being advocated by certain of the consultants, being like the one or thirty structure, so that during periods when a manager isn’t making money in a year it still gets paid a management fee so they can pay its rent and pay its employees, so that they don’t leave, and that that management fee is later netted out against a future incentive fee so that the manager is never getting more than one or thirty in a given year. I think that’s a nice hybrid for some managers to get a balance of a steady management fee and come to pay for expenses while still having the potential for a good payday if they make a lot of money. 

Niels

Yeah, absolutely, thank you for that. Now, we’ve been going on for a long time, so I do want to wrap this up, but I just want to make sure, is there anything that you feel that I missed asking you? Is there anything that you are burning to voice, at this stage, before we wrap up our conversation? 

Art

I think we’ve covered a lot of ground. 

JP

Yes. 

Niels

OK, good, good. On that note let’s wrap up this awesome conversation about managed futures and what goes on behind the scenes of this fascinating industry. Jennifer, Art and JP, thank you ever so much for sharing your thoughts and opinions on today’s topic. I really appreciate your openness during our conversation. It is so important to have practitioners, like you share these ideas because when ideas become conversations that lead to action, that's when real change happens.  

To our listeners around the world, let me finish by saying I hope you were able to take something from today's conversation onto your own investment journey. If you did, please share these episodes with your friends and colleagues, and send us a comment to let us know what topics you want us to bring up in the upcoming conversations with industry leaders in managed futures. From me, Niels Kaastrup-Larsen and our exclusive sponsors, CME group, thanks for listening and I look forward to being back with you on the next episode of Top Traders Round Table. 

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