Managed Forex: Guide

Accountancy Resources

Managed Forex: Guide



Forex (Currency) Author: Admin

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Don’t Want to Manage FOREX Yourself

You may have decided, or will eventually decide, you like the idea of trading FOREX as a complement to your total investment portfolio — but just do not want to do it yourself. The reasons could be many: not enough time, not the right skill set, not to your personal disposition, or too long a learning curve.

If so, the solution may be hiring a professional FOREX money manager. Money managers have long been in equities as SEC-registered investment advisors. In commodity futures, managers are registered as a CTA (commodity trading advisor) if they control individual accounts, or CPO (commodity pool operator) if they control a pooled interest or fund. In the United States, a currency manager now comes under the auspices of the CFTC (Commodity Futures Trading Commission) and the NFA (National Futures Association). They are registered and regulated as CTAs and CPOs at this time.

The matrix of selecting a FOREX money manager is substantial. There are many managers now trading, numerous trading methods used, and alternative investable entities to select besides an individual account.

Tip: Remember that the FOREX manager introduces at least one more link in the chain from you to the FOREX broker. If the manager uses a pooled or funded entity, that will add at least one more.

The first step is to consider your own needs, wants, and propensities. How much do you have to invest? How much are you willing to put at risk? Are your goals and profit expectations in line with those risks? Always keep in mind performance and risk are inextricably linked. The higher level of profit you seek, the higher the level of risk you must be prepared to bear.

A professional, managed participation in FOREX makes good sense for many investors. A managed account may be the best method of participation for those with little time to trade or learn to trade.

Consider your own requirements first. Then gather a list of prospective managers and programs. Do a performance review based on whatever information is available. Finally, conduct a due diligence of those who pass through the first two litmus tests. Always consider performance in light of the risks and costs taken to achieve it.

If the manager’s broker is not CFTC/NFA registered be sure it has a solid and transparent prime broker and custodial arrangement.

Fraud is more likely to occur in — but is not limited to — pooled participation. But do not discount those out of hand. They have multiple advantages, especially to small-cap investors. But be sure to do the additional due diligence required; know where you are sending your hard-earned money.

Why Managed FOREX?

Currency trading as a part of your investment portfolio appeals to you. But you do not have the time, desire, or inclination to trade yourself. Perhaps the effort to learn the necessary skills does not appeal. Or, perhaps you have given it some time and it is just not happening for you.

As mentioned in the Introduction, investing in currencies, if done correctly, maybe the ideal market for the current global economic and financial environment. Currencies are appealing because one has the ability to potentially profit from events in every corner of the globe. Trading is appealing because in today’s economy change occurs frequently and rapidly; your father’s or your grandfather’s buy-and-hold strategy is just not what it used to be. Long-term profits can evaporate in a short time.

But selecting a managed account and FOREX manager takes some real work and due diligence. Things are not always — perhaps not even often — what they seem. It is a fast-paced market with enormous profit appeal. Such a situation attracts both the best and worst types of people.

Beyond reading this, conduct some independent research. When you find a group of managers who seem to be good possibilities, you will want to first analyze their performance and then carefully perform your due diligence on each of them.

Tip: How FOREX managers react to the due diligence effort may tell you a great deal about them. If they are skittish about providing all the information you require or are not accessible, that cannot be a good sign — no matter how inviting their track record and performance looks on paper.

Pros and Cons

The primary pro — a manager is a professional trader. He devotes all of his working time to currency trading. At least, in theory, these pros did not become successful managers by doing a poor job of trading. That said, money managers, like traders, do come and go for a variety of reasons.

The primary con — you lose control of your money. Yes, if things do not go as you expect, you can close your account. But many people, especially those who have traded on their own, have a psychological block against handing over a goodly sum of money to someone else. Especially, someone, they do not know well or personally. A hearty due diligence can at least partially solve this uneasy feeling.

If you learn to trade on your own you can accomplish everything in small steps and bites. When you hire a manager and open a managed account, it is one fell swoop. Sure, you can start small, at the manager’s minimum, and build up as performance meets or exceeds expectations. But you still must write that first check or send the first wire.

Different Types of FOREX Managers

Managers may be classified by a number of categories. I have provided a FOREX Manager Due Diligence checklist here. You may wish to use it when considering each prospective manager and managed program. Managers are either full-time or part-time. Everyone has to start somewhere and there are a few very good FOREX managers who only devote a portion of their time to this endeavor. But unless the manager has some other stellar features, it is best to let someone else aid in building a track record and business. The majority of FOREX managers are full-time. All of their working effort goes to currency markets and currency trading.

Different Types of Managed FOREX Accounts

Most managed accounts are either individual or pools. A third variety, the PAMM account (percent asset management module) has become popular in the past two years. In an individual account, your money should reside at a registered broker, preferably an FCM (futures commission merchant) in the United States or a manager with a prime relationship. When the manager executes a trade, he will place a single order and lots will be allocated in accordance with the size and other parameters accorded to that account by the broker.

In a pooled account, monies reside in a separate entity such as a fund or limited partnership.

The great advantage of an individual account is the transparency; you know exactly where the money is at all times; there is less opportunity for fraud. Your funds are said to be segregated in your name.

The great advantage of a pooled account is you can participate with less money. A pool also has the advantage of being able to take a bigger stake in a position, hold more positions concurrently, and access more pairs and opportunities in the market than a small individual account.

Tip: Do not dismiss a pooled account — it may be your only means of participating with the manager of your choice if capital is limited. But give preference to an individual account. Fraud is usually associated with pooled interests whereby your money winds up in someone other than the broker’s possession.

The organization of a fund or a pool may get very complicated. They introduce third, fourth, and even fifth parties into the chain. Each party is a potential cost, point of failure, and something on which you must conduct a separate due diligence.

A PAMM account is a new hybrid. Funds are combined for the purposes of the inherent advantages, but remain segregated in the name of the specific account holder. A rose by any other name is still a rose. PAMM accounts still introduce third parties into the chain.

Different FOREX Trading Methods

I have mentioned trading methods en passant in the earlier section on types of managers. The primary breakdown: discretionary, computer-assisted, and automated trading methods. The latter dominates the managed FOREX landscape today.

The variety and range of automated systems is huge and complex. Though it is possible to divide them into a few types, the best approach is in studying performance and considering where they fit in the short-term-to-long-term hold continuum and in the risk-reward area that is comfortable for you. This latter information, fortunately, can be divined by analyzing performance if enough information is provided by the FOREX manager.

Trend Following

This was the most common approach for many years. A trend-following system attempts to capture a large percentage of a trend at a specific price level, using various methods to avoid the whipsawing that may occur when the market is in a trading range or moving sideways. This is an important factor contributing to the longer-term success of these programs. Statistically, trends are in force less than 30 percent of the time. But as computer hardware and software grow more powerful, other methods have grown in popularity.

Hedge

These programs have become very common in the past five years. Their modus operandi is to have open buy and sell orders in the market at the same time. They may be long a higher time frame and simultaneously short a lower time frame. This is similar to what equity traders call trading against the box. Running these programs is prohibited in the United States by virtue of the anti-hedging clause of the NFA’s Rule 2-43. This is most unfortunate, as it is a perfectly legitimate trading method.

Grids and Pac Man Systems

Grid programs attempt to capture as much price activity in a defined price-time area by going both long and short as well as scaling in and out of positions. These programs show considerable promise in the event-driven markets of today. They also require a hedge. Pac Man programs refine grid trading by emphasizing trading in some market environments, and avoiding trading in others. These are discussed in more detail in Computer Trading.

Quality of Market

These programs endeavor to measure the quality of the underlying buying and selling in a currency pair. Such factors as volume-to-price measurements and contrary opinion are used. They may also consider how a market reacts to news to determine underlying strength or weakness. Quality of market trading is typically not fully automated, and focuses more on long-term opportunities.

Divergence

Divergence programs may be similar to quality of market programs but are more likely to be fully automated. They seek divergence in various indicators to spot a trend reversal. An example of a divergence indicator is the well-known relative strength index first detailed by Welles Wilder in his New Concepts in Technical Trading Systems (Trend Research, 1978). When the market and the RSI fail to make new highs or new lows together, a trend reversal is forecast.

Divergence tools may be used by trend-following programs to determine when a trend is faltering.

Breakout

These are very popular at the moment. The space and variety of breakout systems is very large. In a breakout system, the program seeks price points when either buying power or selling pressure is pent up and due for release in a sharp price spike. They tend to be short-term trading methods, although trend-following systems may use a breakout tool to determine when a trend has begun.

Artificial Intelligence (AI)

This is making a comeback after a two-decade hiatus. The trading program attempts to learn from its mistakes by making internal adjustments to the program. Neural networks and expert systems are the most common, although others are also in use, such as agents, bots, and genetic algorithms. Non-AI programs may have AI subroutines to perform specific functions.

Nonlinear Algorithms

The most recent attempt. The trail of prices is seen as an evolving process. Prices at Point A use an internal self-organizing rule set to determine prices at Point B and so forth. In theory, find that rule set and you will be able to forecast prices. The author’s trend machine is such a program. It uses cellular automata (CA) to determine the specific rules involved in the price evolution. If there is a Holy Grail to trading—and that is a very big if—it almost certainly will be a nonlinear approach.

Performance is more important than any particular method a manager may use. But it is very useful for the prospective investor to know where in the scheme of things a manager’s trading method fits. Methods sit on different areas of the risk-reward continuum.

Tip: Ask what is the inherent strength and weaknesses of the manager’s trading method. What if anything is done to maximize the former and minimize the latter?

Most programs tend to shine in specific market environments (see Tools for Traders) and do poorly in others. The best programs work to emphasize the former and lie low during the latter. The exception are Pac Man programs, which define in advance the market environment in which they work best, and then trade only when those conditions are met.

How to Evaluate a FOREX Manager’s Performance

Listed here are the parameters used to dissect a FOREX money manager’s performance. How much analysis is possible is determined by how much of the program’s track record is made available to you.

Reward and Risk

Ultimately, a manager’s performance is about six factors:

  1. Reward — How much can he or she make for you?
  2. Risk — How much risk is taken to achieve those results?
  3. Sustainability — How long has the manager been able to support performance?
  4. Volatility — How wide swinging is the performance or equity cycle?
  5. Frequency — How often does the program trade?
  6. Cost — What are the fees for services rendered?

It is important to consider how frequently a manager executes trades for her program. At the very short-term level, multiple trades may be made during a single trading session. At the very long-term level, trades may carry over for days or even weeks. Generally, automated systems tend to be short-term, mixed and fundamental systems, longer-term.

The disadvantage of short-term programs is cost. The pips add up when many trades are made quickly. The disadvantage of long-term programs is exposure to the various news releases, which can shake a currency pair, reversing and even fully negating a long-term trend in hours if not minutes.

The Equity Cycle and Drawdowns

No trader’s performance goes straight up; even the best managers have drawdowns. These are periods — weeks, months, quarters, even years — when performance goes down instead of up. The equity cycle for a FOREX manager — if it is long enough — can also tell you much about where he sits on the risk-to-reward continuum. A relatively gentle cycle with soft drawdowns indicates a conservative approach, all other things being equal. A more violent equity cycle with fast and dramatic drawdowns may indicate an aggressive program. There is no escaping it; risk and reward are forever linked. The more of the latter you want, the more of the former you must be willing to accept. This is certainly a decision you must make before opening a managed account.

Tip: If you believe in the long-term viability of a FOREX manager’s program, examine the equity cycle and invest a small amount to begin with and more after an average-size drawdown.

Equity Exposure

This is about risk. The more of your account allocated to open trades at a given time, the higher your exposure. This value has a wide range based on the type of trading method, but anything over 75 percent exposure is very high.

Assets under Management

To a large degree, the long-term success of a manager is measured by how long he has been in business — denoted by the amount under management. Success is always noted and rewarded. Functionally, there is no difference whether a manager makes a trade for 20,000,000 or 200,000 EUR/USD for his clients.

Track Record

You will want to analyze a manager’s track record for all of these factors before making a decision and committing to an investment. How complete a track record a manager publishes will tell much all by itself. A simple table showing net results on a monthly basis does not allow for a complete analysis. The more information, the better. You certainly want to see the amount under management on a periodic basis as well as the Sharpe Ratio. Few managers release their actual trades, unfortunately. But as you find some who do, refer to some price charts to see how she does in different basic market environments. Then observe if the manager is hitting them hard in the positive environments and lying low in the negative environments.

A track record may either be a real-time or back-test, or both. Newer programs that have a short real-time experience often show the back-test results to give a better view of performance. A back-test may be as adequate a measure of performance as a real-time one — but only if the former is conducted properly, and most are not. If the manager’s information does not state whether performance is real-time or a back-test, ask.

If a track record is a combination of real-time and back-test, ascertain that both are using the exact same program. A long-term real-time performance is considered most reliable. A performance of only a back-test is considered to be the riskiest.

Tip: Be sure the track record you review is for the exact program for which you are considering an investment. A long-term track record may be a tapestry of a half-dozen different systems for which the manager changed gears and retro-fitted or curve-fit the program every time it began losing money. As in trading for yourself, tweaking a system is good — evolutionary change — but frequent revolutionary changes are not good.

Achilles’ Heel

All traders and all programs have weaknesses. Usually, one predominates. A good manager who has been in the FOREX trading business for a long time will have learned how to mitigate and minimize those in his program.

Performance analysis asks this core question: “How much can I make for how much risk?” Basically, this is the risk-and-reward ratio of a money manager, and that is the information you seek from performance and track record analysis.

Two Methods of Performance Analysis

The conventional approach to performance analysis has become extremely complex, involving numerous mathematical and statistical methods and ratios.

The most common is the Sharpe Ratio.

The Sharpe Ratio

This popular performance ratio was developed by Nobel laureate William F. Sharpe. The Sharpe Ratio is typically calculated by subtracting a risk-free investment rate, such as the 10-year U.S. Treasury bond, from the rate of return for an investment or portfolio, and then dividing the result by the standard deviation of the investment or portfolio return. The Sortino Ratio attempts to smooth the occasional spike in the Sharpe Ratio but is otherwise similar.

Market Environments

This author uses market environments (ME) to analyze performance.

ME divides all markets into functions of directional movement (DM) and volatility (V). If each function is rated on a scale of 1 to 10 from very low to very high, it gives a matrix of 100 market environments from (1,1) to (10,10). (See Table below.) Look for money managers who have done well in a broad spectrum of MEs instead of just a scattered few. Performance — good or bad — that occurs in a mostly contiguous area of the matrix (clusters) can tell you much about the manager’s trading methods.

A 10 �- 10 DP/V ME Matrix

Tip: A short track record with a broad ME sample may be better than a long track record with hot and cold ME clusters. See Tools for Traders, for more on ME applications to trading.

Pac-Man programs take a different tack. They do not attempt to work well in all MEs or tweak the program to emphasize naturally strong ones and deemphasize naturally weak ones. Rather, they define MEs with very specific DM and V values in advance. When a currency pair enters one of these price-time areas — they strike. Pac Man programs execute a hedge order and attempt to gobble as much price movement in both directions as long as they are in the defined parameters. Neat!

How to Pick the Right FOREX Manager: The Due Diligence Process

Now that you have defined your own requirements and considered them vis-Ã -vis performance by analyzing the FOREX manager’s track record, it is time to do a due diligence review of the managers who remain on your list. Tip: Unregistered is not always a bad word. Some very reputable U.S. brokers decided to go unregistered after the release of Rule 2-43 and for very legitimate reasons. But a manager regulated and registered by an agency of a nation such as the United States, Canada, or the United Kingdom eliminates much of the due diligence concern. Regulation is only as good as the enforcement. Small agencies in the Caribbean or other exotic locales may not have strong enforcement teeth.

Registration and Regulation

Is the manager registered with the appropriate agency in her country? If not, it has to be a red flag. The only time you should consider an unregistered currency manager is if your money goes directly to a registered broker-dealer. You may search firms registered with the NFA here: www.nfa.futures.org/basicnet/welcome.aspx. Some FOREX broker-dealers in the United States have opted to not retain CFTC or NFA registration for perfectly legitimate reasons. Either they do not have an interest in the U.S. retail FOREX space or they are promoting trading programs that go against the anti-hedging provision of NFA Rule 2-43, or both. They will, in such cases, have a “prime broker” arrangement with an FCM instead of a IB arrangement.

References

Will the manager allow you to speak with or e-mail a few clients? This is an opportunity to learn more about the program and how the manager interacts with his client base. Do not count on this to tell you much about performance; a manager is not going to suggest you speak with an unhappy client.

Website

Sometimes, small clues are meaningful. How sophisticated is the money manager’s website? Does it offer solid and useful information? Or, does it flash how much money she made the past month or year? Many websites require a brief registration themselves, by you. Yes, this collects information but it also sets a start point for your due diligence from the manager’s perspective. For me, it is more a positive than a negative.

Contract

A legitimate contract with the FOREX manager should include a detailed list of fees, how profits and losses are calculated, program details, and fund withdrawal information. Look for clauses that provide the manager with rights at the expense of the client. Tip: the fee calculation should be very precisely defined, especially performance fees. ‘High water mark’ is easily comprehended, but more difficult to accurately define. You will also need to sign a form, typically a limited power of attorney. This gives the manager the right to trade on your behalf without the right of access to the money. Either one or both of the contract and power-of-attorney forms will detail the fees involved and the latter will give the broker the right to send them, as due, to the manager directly. Needless to say, if they are stated on both documents, they must agree. Managers, like brokers, are not likely to modify or amend a contract for you. Nonetheless, seeking a legal opinion of it is a good idea. If you have questions, ask the manager and then ask your counselor and hope the two interpretations agree.

Transparency

Sometimes, letting your stomach do some of the thinking in such matters is a good idea. The biggest alarm is a gut feeling the manager is not being transparent. Simple questions should elicit simple answers. If you get long answers that attempt only to show how brilliant the manager is and confuse you that is a red flag.

Account Access

Most trading platforms allow the client limited access to monitor performance trades made and in progress as well as equity and margin status.

Who Gets the Money?

Writing a large check or sending a large wire to an unknown or relatively unknown party is unsettling to most of us. You may well be prepared for taking the risk of FOREX trading but not for the risk of your money vanishing. If you are opening an individual account, this should be simple. The money will go to a registered broker-dealer. In the United States, if the broker your manager uses is an IB, the funds will still go to the FCM. Although they are not yet required to do so as in futures trading, most larger FOREX FCMs now also segregate client funds. However, even segregating funds may not eliminate systemic risk as the recent MF Global debacle showed. Tip: Check out all parties in the feeding change, including the money manager on the CFTC website. Many foreign brokers and dealers register, even though it is not a necessity. It indicates their willingness to be scrutinized. Brokers and managers may decide not to register for a variety of reasons; some very legitimate, some not so. If your money goes into a pool, that is a different matter. Is the pool operator registered as a CPO with the CFTC and NFA? If not, why not? Most legitimate pools have funds directed to a major bank account and are often controlled by a cash management custodian. If so, a due diligence is required of those parties. Tip: To whom you send the money is a big issue. It is the single step at which most of the outright fraud is involved. Do not be afraid to ask questions! “Possession is nine points of the law” is an old saying in Anglo-Saxon law. Whoever’s account you send the money to is the party that has control over it.

“Danger Will Robinson”

Again, you are willing to take the substantial risks involved in currency trading, but you are not interested in having your money disappear as soon as the funds are cleared. This is not an easy subject and there are no clear-cut answers. I have seen some fishy setups that were perfectly legitimate and some very clean ones that were nothing but money traps. These are the most common red flags.

  • The manager and/or broker are unregistered.
  • An unregistered manager or broker has no prime broker agreement or cash custodian.
  • The fund or pool is unregistered.
  • Account funds go to the manager.
  • The manager does not provide simple answers to simple questions.
  • The manager makes verbal representations that are not in the written contract.
  • Performance is “guaranteed.”
  • Performance is too good to be true.
  • Performance profit is out of line with performance risk. The manager claims to make 50 percent a month and never has a down month. Legitimate managers have equity cycles.
  • Performance is extremely erratic from one period to the next. In such cases, two or three consecutive bad periods will wipe out your account.
  • Extremely strong performance in the short term may indicate the manager is using very high capital exposure.
  • Fees are excessively low or high and out of normal industry ranges.
  • The manager avoids using the U.S. Postal Service and sends material only by e-mail or by courier services. In the United States, mail fraud is a serious crime.
  • The manager accepts funds by something other than check or bank wire.

Tip: The best deal is that your money goes to a CFTC/NFA registered FCM in the United States that segregates client funds and the manager is registered as a CTA or CPO. The second best deal is a money manager and broker with a prime broker agreement and a well-known cash custodian such as a major bank.

FOREX Manager Costs and Fees

Two types of costs are associated with a managed FOREX account: those incurred in the process of the manager making trades on your behalf and those incurred by the manager.

Transaction Costs

Your manager will have selected a broker-dealer with whom to do business. Prima facie, if the manager is happy with them, so should you. Ideally, spreads have been negotiated, most typically pips and lot fees, to the minimum. After all, the more the broker takes, the smaller your profit and the manager’s fees.

FOREX Manager Fees

Managers may charge any one or a combination of three fees:

  1. Performance Fee – This is a percentage of profits. It typically runs from 15.0 percent to 50.0 percent. How large is reasonable depends much on what other fees are involved and how good the manager is at what he does. Managers who have a 5-, 10-, or 20-year track record of success can command much higher fees than someone with several months of real-time performance.

Tip: Be sure new performance fees are always calculated from a previous high-water mark which is precisely defined in the contract. Suppose in the first quarter, the account makes 15 percent, in the second quarter the account loses 5 percent, and in the third quarter it makes 7 percent. The third-quarter performance fee should be for 2 percent, not 7 percent. Management fees should be deducted before profits are calculated. They are costs to you. Does the manager make a fee off any interest uncommitted funds accrue? How are account additions and withdrawals calculated? Wording on such issues may be quite tricky; read carefully.

  1. Management Fee – This is the cost of doing business with the FOREX manager. They range from 0.5 percent to 4.0 percent again depending on the total mix of fees.
  2. Pips – Some managers take one or two pips off every transaction made in your account. There is nothing inherently wrong with this with the caveat: Is it disclosed, how much does it add to costs, and does it encourage over-trading? If the program trades very short term, one or two pips may represent a lot of money to someone. In a period of poor performance, the manager may still make a profit from your account if pips are part of the fee structure. Be wary of your capital becoming someone else’s income.

Tip: This is sometimes the hidden fee in a managed program. If it is not mentioned in the contract, you need to ask the manager if he participates in transaction costs, or pips. It should be in writing, either way.

The debate over management fees or performance fees has raged for decades. At one time, the SEC frowned on performance fees because they might also encourage overtrading. A manager gets near the end of the fee term and has not made any money. How will the yacht payment get made this quarter? On the other hand, the CFTC encouraged performance fees on the logic of why pay someone for failing at the job for which they were hired? The counter to that, of course, is that trading FOREX, whether by you or the manager, is a best efforts affair. There are no guarantees.

Most managers now charge a combination of management fee and performance fee as a concession to this ongoing debate. The management fee covers expenses and puts at least a few gallons of diesel fuel in the yacht so they do not need to overtrade to take a weekend cruise. The performance fee encourages them to perform. That fellow a few slips down the dock just bought a 70-footer!

Mixed fees in the range of 2 percent management fee and 20 percent performance fee to 3 percent management fee and 30 percent performance fee cover the vast majority of the managed account territory in both currencies and commodity futures. A new manager’s fees may be lower to compensate for the risk inherent in a relatively untested trader or trading system.

Performance-only fees are of course higher. They range from 25 to 50 percent of net profits. Some managers offer options of either a mixed fee or performance-only fee. Managers do understand prospective clients have different ideas about costs just like the SEC and CFTC. I have also seen flat pip fees and flat management fee options recently.

If you participate in a fund, the management of the fund will almost certainly entail additional costs: general partner, cash custodian, and so on. Costs ultimately revert to the client and they only diminish your bottom line.

Tip: If you decide on a pooled or fund participation with a FOREX manager, I strongly recommend legal counsel before committing. Unfortunately, this advice is too often not followed. You are attracted to a pool because you can participate for $5,000.00 or less. That positioning makes it difficult to justify $1,500.00 for legal advice. Sadly, the unscrupulous operators know this exactly; that is why small investors are exposed to the most risk in any investment.


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