Ep #10: Q&A for Unregistered CTAs

Many commodity trading advisors would like to forego registration in the early stages of their business. They want to operate as exempt CTAs at first, but they simply don’t know how. Listen to this episode for answers to questions about how to operate an unregistered or exempt CTA.

TRANSCRIPT:

Welcome to The Profitable CTA, the only podcast that helps commodity trading advisors grow their businesses and boost their bottom lines. I’m Kelly Hollingsworth and I’m very glad you’re here because CTA profitability is suffering, and in this show we talk about how to fix that.

In every episode, we discuss a common problem that undermines CTA profitability, and the problem for today is confusion. Since I started the show, listeners have been contacting me about operating an unregistered CTA. They like the idea, but they don’t know quite how to do it, so today I’m going to spend some time answering some of the questions about that.

I give trading advice to my friends and those who are in my company (presence). Would I be considered a CTA or be able to call myself a CTA without facing legal ramifications?

The first part of this question is, by giving this trading advice, am I considered a CTA and can I call myself a CTA? In the U.S., anyone who gives trading advice about trading in futures contracts or forex contracts is a CTA and can call themselves a CTA.

The next question is about the legal ramifications of this. I don’t know exactly what “legal ramifications” means in this listener’s mind, but what it means to me is that it raises legal issues. When something has legal ramifications, it raises legal issues. So in my mind, yes, there are legal ramifications to giving trading advice to your friends and people who are in your presence. Today I’ll discuss three of those.

Legal Ramification 1: If you give trading advice, you might have to register with the CFTC, and become a member of NFA

The first legal ramification is, does the CTA have to register with the CFTC and become a member of NFA? Now here’s where people often get confused. They think, if I’m not registered I’m not really a CTA. So let’s clarify. If you’re giving trading advice, even just to your neighbor and your best friend, you are a CTA. It’s the advice that matters. At this point, what I usually hear is “Okay, great, so I’m a CTA, but do I have to register as a CTA?”

The answer is, it depends. For example, CTAs in the U.S. that advise 15 or fewer people in the previous 12 months, and don’t hold themselves out to the public as CTAs, don’t have to register. They can call themselves CTAs even if they’re not registered as CTAs, but they can’t hold themselves out to the public as CTAs. So maybe they could tell their disapproving uncle at Thanksgiving dinner, “I’m a CTA.” What they couldn’t do is put this on a website and do other things that are considered holding themselves out to the public.

Legal Ramification 2: You might get sued

The second legal ramification of giving trading advice is that you’re dealing with a customer, or maybe more than one customer, and anytime that’s going on, you can get sued.

Legal Ramification 3: Regulatory Problems

The third legal ramification of giving trading advice that I’m going to discuss today is you can run afoul of regulatory requirements and find yourself in a situation with the CFTC. This always raises the question, are legal problems common for CTAs?

Legal Problems are Rare for CTAs who take a few simple protective measures

Many would-be CTAs who would make a lot of money and have fantastic businesses, if they go the CTA route, hold off on actually trading other people’s money because they’re afraid of legal ramifications. They think the risks are high. Too high.

But the truth is that legal problems are very rare for CTAs who do a few simple and inexpensive things to prevent them, and the good news is that doing these things also help the CTA attract customers and increase their profitability. In other words, you lay off risk at the same time you bring in revenue. Part of the reason I started this show is, I wanted to spread the message that it’s just not that complicated (or expensive) to operate a CTA in a manner that minimizes your risk of trouble, and maximizes your profit potential.

I’ve never had a client who got sued or who ran afoul of regulators in any meaningful way, because we set the CTA up to do things in a way that minimizes the risk of these problems. It’s the CTAs who ignore the basic, simple steps that we’re going to talk about today, who struggle with everything. They struggle with legal ramifications, and they struggle with attracting and keeping customers. so as I go through the rest of the questions that I’m answering today I’ll talk about some of these things so you can see what they are.

Many unregistered CTAs resist doing these steps, and that’s a head scratcher because they’re simple to do, they make your business a lot simpler to run, and there are so many potential problems if you skip them that could arise.

The first thing many unregistered CTAs wonder is if they can skip having their customers sign an advisory agreement. This is the next listener question I want to answer for today.

Are you legally required to present an advisory agreement to friends/family or the first 15 clients as an unregistered CTA?

Trading for anyone other than yourself without an advisory agreement is what I call “trading naked.” Is there an explicit law against trading naked for unregistered CTAs? I don’t think so, but that doesn’t end the inquiry.

If you don’t have an advisory agreement, all kinds of bad things can happen in your business, and only some of them are legal problems. Today I’ll tell you about a few of these problems.

Wonky Rates of Return

Your track record can be horribly screwed up if you don’t have an advisory agreement. This is a big deal. Track record problems from not having an advisory agreement happen all the time. It is so common that I devoted an entire episode to why you shouldn’t trade naked and how doing so can screw up your track record.

It’s Episode 4 in case you missed it. If you did miss it, you might want to go back and listen. It’s too much to repeat in this episode, this episode is going to be long enough as it is, but suffice it to say that if you don’t have an agreement, your monthly rates of return can look so wonky based on things your customers do that it can effectively put an end to your career as a CTA. This alone is a sufficient reason in my mind to never trade naked.

Angry customers

The next reason I suggest that every CTA have an advisory agreement with every single customer (meaning, everyone who isn’t themselves) is that CTAs who don’t have advisory agreements often find that their customers get very angry. Why does this happen? Because what CTAs think is clear is not at all clear to their customers. Why does this matter? You want your customers to have clarity about what to expect because confused customers become angry customers. This is a problem for CTAs, because angry customers file complaints. They file lawsuits. And they fire CTAs.

Many CTAs think, this won’t happen to me, so I’m just going to share a couple of points of confusion with you, that commonly arise with customers, when there’s not an advisory agreement. These points of confusion are so common it’s scary.

One big point of confusion is fee calculations. It is not obvious how to calculate CTA fees. As an unregistered CTA, you can tell your customer, “Okay, I get 2% of the account’s value and 30% of the profits,” and he can say, “Yes, that sounds fine,” and you can shake on it, but if you’re like most CTAs, you’ll quickly realize that this kind of handshake deal leaves a lot of room for misinterpretation and misunderstanding.

Is the 30% on just realized trading gains, or does it also include unrealized trading gains that are reflected in the open trade equity in the account? Another common point of confusion: Does the management fee get calculated on the cash in the account, or the trading level of the account?

If you don’t have a written agreement that specifies exactly how these calculations will go, you risk alienating or angering your customers. And as I said earlier, what do angry customers do? They close their accounts, they complain to regulators, they file lawsuits, and they fire CTAs. These aren’t good things in any case, but as an unregistered CTA, they’re especially bad, because who are your customers? They are people you know. Your friends, family, and existing business associates. Why would you want to risk alienating these folks or making them mad, when they’re taking a chance on you and helping you get your business off the ground?

Weird and scary legal problems

The next problem of trading naked isn’t common, but it’s such a big deal I would feel remiss if I didn’t share it with you. One day I was poking around in the law library, and I found a case where a CTA was criminally prosecuted because he was charging incentive fee on unrealized trading gains. This is standard operating procedure in the CTA world, by the way, but those outside of the CTA world often don’t understand how this works. In case you’re unfamiliar, the calculation goes like this: if at the end of the month, or quarter, or year, however frequently you collect your incentive fee, the customer has a position on in his account that’s worth, say, $50,000, and you charge that customer a 30% incentive fee, you would get 30% of the $50,000, even if the market subsequently moves against the customer’s position and he never realizes any of those profits.

The CTA in this criminal case I’m telling you about was doing exactly that calculation, totally standard, but evidently this raised the ire of the prosecutors in his state. How did this fee calculation come to the prosecutor’s attention? The case wasn’t specific, but I imagine it’s because the customer who was paying these incentive fees got angry and complained. The important thing to notice is how serious this case was. It wasn’t a civil action where the customer was merely trying to get money back from the CTA. This was a criminal case where the state was trying to put this CTA in jail. And the only thing that saved the CTA was that the customer had signed an agreement that very clearly spelled out that the incentive fee was calculated on unrealized as well as realized trading gains.

This is an extreme example, but it’s important because it reveals that an agreement that spells things out can often save your hide in ways you never would have seen coming. I certainly never would have predicted a criminal prosecution like this against a CTA. So the bottom line here? No CTA was ever sorry that they were protected by a good advisory agreement. Many CTAs have been sorry that they didn’t have one.

Now I’m going to stop harping on agreements and answer some other questions, but as I go through these questions, you’re going to notice a common theme—all of these seemingly unrelated questions are impacted by the presence or absence of an advisory agreement. So as you listen, I’d like you to consider, why, when there are so many benefits to having an advisory agreement, and such big risks if you don’t use one, would an unregistered CTA ever consider not using an advisory agreement? Here what I’d like to suggest to every CTA is, think about legal requirements as business decisions. Whenever you’re thinking about doing something or not doing something, the question to ask yourself is, is there a consequence to this that I am not willing to live with with? Being a CTA is all about balancing risk and reward. This is as true in your trading life as it is in your business decisions. If you can take an advisory agreement, put it to work in your business and swat big risks to the ground at the same time you bring yourself big benefits, that is a trade you should take every single time.

Are you legally required to present a track record to friends/family or the first 15 clients as an unregistered CTA?

As with agreements, I’m not aware of any current law, regulation, or rule that explicitly says, “Hey, unregistered CTA, you have to show your customers your past performance before you sign them up.”

But that doesn’t end the analysis. What struggling CTAs do is say, “Oh, if there’s no law that requires it, then I’m not going to do it.” Profitable CTAs look further, and they analyze the benefits and risks of providing a track record vs. not providing one. Some of the risks are legal, by the way. I’ll get to those in a second.

Three Reasons Unregistered CTAs don’t provide track records

But first, I’ll say that there are pretty much only three reasons on the planet that unregistered CTAs don’t provide track records to their prospective customers:

  • They’ve never traded an account before, so there is no track record.
  • They have traded an account, either their own account or someone else’s or both, and they’ve performed well, but they just can’t be bothered to have a track record calculated.
  • They’ve traded in accounts in the past and the performance was poor, and they don’t want anyone to see it.

So now I’ll talk about each of these three reasons for not providing a track record and you can get my thoughts on them.

Reason 1: There is no track record

Some unregistered CTAs don’t want to test a trading strategy in their own account. They want to do it in a customer’s account, and this is because they either they don’t have the money to do it in their own account, or they don’t want the risk, and this is a very tough way to proceed in this business, because it raises the obvious question from customers, “If it’s so great, why don’t you try it first?”

These are tough questions for CTAs to answer. “I don’t have any money,” from someone who’s supposed to have invented a goose that lays golden eggs, is hardly satisfying. And it raises questions about the CTA’s cash management practices. If a CTA can’t manage risk and conserve cash in his own personal situation, why should customers expect that the CTA will manage risk and conserve cash in the customer’s account? If it’s a matter of, “I don’t trust this trading strategy well enough to take the risk in my own account first,” that’s obviously going to raise eyebrows as well.

Nonetheless, every once in a while you’ll find a customer who dares to go where the CTA has not yet gone himself, and what winds up happening is basically an experiment. The CTA can consider his trading methodology finalized, it doesn’t feel like an experiment before he begins trading the customer’s account, but when real trading actually commences, at that point it inevitably becomes clear to the CTA, and often to the customer as well, that this is still a testing ground. It’s an experiment, and it’s not one that goes well very often.

This is not a good spot for any CTA to find themselves in, but it’s a particularly bad spot for unregistered CTAs, because that means they’re experimenting in the account of a friend, family member, or business associate. This is a terrific way to burn bridges in more than one area of your life. So I like for every CTA to have at least a proprietary track record from trading the program in their own account before they trade for anyone else.

Reason 2: The CTA can’t be bothered to have a track record prepared

Some CTAs who’ve posted very nice performance in the past are reluctant to show a track record because they just can’t be bothered with calculating one. And I’m not going to mince words here–this is just crazy. This is like getting a law degree and sitting for a bar exam, and passing the bar exam, but not bothering to show up in court to be sworn in as a lawyer so you can actually practice law. To do this just doesn’t make sense.

If you have traded accounts very well in the past, showing the returns to your customers will help you bring them in the door, and help you command higher fees. It’s a no-brainer.

And as I’m going to talk about in a minute, it’s not terribly complicated or expensive to have a track record calculated for you. If you are a CTA in this situation—you’ve traded profitably in the past—get your track record together so you can show it to customers. It’s going to help your business and it’s going to boost your profitability.

Reason 3: Poor Performance

The other, more common scenario, in which an unregistered CTA doesn’t show a track record is that the performance doesn’t look good. In this instance, unregistered CTAs should remember that even though they’re not subject to many of the rules that apply to registered CTAs (one of them is giving your customers a track record, in general) the anti-fraud provisions of the Commodity Exchange Act are always working in the background. This part of the law says that CTAs can’t commit fraud, and this includes unregistered CTAs. So a big question for unregistered CTAs who don’t want to show a poor track record to their prospective customers is, does not showing the poor track record rise to the level of fraud?

It’s pretty easy to see how it could. If a CTA has customers signing up, the reason they’re doing that is because they want to make money. They think there is the possibility of profits. Why would they think this? This idea about the possibility of profits probably didn’t just fall out of the sky and land on their head. If they’re thinking the possibility of profits exists, it’s not a stretch to assume that the CTA said something that led them to believe that or to assume it.

If, in the face of this belief or assumption on the customer’s part, the CTA has lost money for some, most or all of the accounts he’s traded in the past, but he doesn’t show that losing performance, it’s not a stretch for the customers to say that the CTA led them to believe one thing, while deliberately concealing facts that would have shown them otherwise. Saying one thing, while concealing facts that reveal the opposite, is the textbook definition of fraud.

So what happens in a case like this? If there are trading profits, if the CTA goes on to trade for these customers profitably, probably nothing happens, because no one complains when they’re making money. But if there are losses, that’s when everyone lawyers up and looks for any possible reason to sue, and fraud is a great reason to sue.

And this is when CTAs realize that giving customers a track record isn’t just about appeasing regulators. It’s not just about complying with the law. That’s certainly one benefit, but mostly, the reason you want to give your customers a track record is that it serves as an insurance policy against angry customers, and (God forbid) customer lawsuits.

So I’ll put it this way: If you don’t give your customers a track record, you’re basically handing them a free put. If there are profits, they keep the profits. If there are losses, they can cry fraud and try to put the losses on you.

Could this fraud allegation necessarily be proven in a court of law? Who knows? The point is that the moment a fraud allegation arises, you lose. Your business is over, even if you technically win on a fraud claim. Plus, on top of a customer claim for fraud, the CFTC can also come after a CTA for fraud in a case like this.

So the answer to this question is, you don’t give a track record just because the law requires it. You also give one to protect yourself and your business, even if the law might technically give you a free pass.

The Last point on track records for unregistered CTAs: one reason you want an advisory agreement with each customer is because this is where the customer acknowledges, in writing, that they received and understood the track record. It’s not enough to just slide your track record across the table before they invest and have them take a peek at it. What you want is an agreement in your hand where they’ve signed on the dotted line saying in writing, “Yes, I received the track record and I still want to proceed.”

How are unregistered CTAs actually paid management fees and incentive fees? I can’t imagine a CTA is legally able to deduct or withdraw money from a client’s account for compensation.

Here’s another very cool thing about having an advisory agreement with your customer: In the agreement the customer authorizes you, even if you’re an unregistered CTA, to present an invoice to the FCM that’s holding your customer’s account, and the FCM in theory will deduct the money from the account and send it to you. Usually it’s by ACH transfer and the money gets deposited directly into your business account. Sometimes it’s by check.

This is the most efficient way to operate so everyone wants to do this, obviously–registered CTAs and unregistered CTAs.

But, the complicating factor for unregistered CTAs comes in when some FCMs get stinky and they won’t facilitate this transaction for them.

Why do I call this stinky? Because there’s no reason for the FCMs not to do this for you. They’re happy to take the commission dollars that your trading generates as an unregistered CTA, but they won’t do something for you that they’ll do for registered CTAs, and that by itself is stinky because there’s no reason to treat the two of you differently. And often, what’s really stinky about this is that while they’re saying they won’t do it for you, they’re doing it behind the scenes for other CTAs who are also unregistered.

So what can be done about this? The first thing is that you simply don’t have to do business with that FCM. As an unregistered CTA, your customers are likely to look to you for some guidance on where to put their accounts, and you can give them names of FCMs that won’t be stinky in this way. You can give them the names, in other words, of FCMs that will actually facilitate the transaction, deduct the money from the customers’ accounts, and send it to you.

The other thing you can do is just invoice your customer directly. It’s nice if the FCMs are sending your fees to you with no involvement from the customer, but when you look at businesses across the board, meaning, businesses other than CTAs, this kind of thing is actually pretty rare. Pretty much everyone—lawyers, doctors, dentists, contractors—we all have to send our clients an invoice to get paid. That’s just how it works in business most of the time, so if you wind up doing this, too, as an unregistered CTA, it’s not a disaster. I encourage unregistered CTAs to just look upon this as no big deal if an FCM won’t send them their fees directly.

And here, the last thing I’d like to say about this, is to point out that if you don’t have a written advisory agreement with your customer, that specifies the amount of fees he’s going to pay to you and how they’re going to be calculated, it’s very difficult for you to collect your fees.

Lots of talk of what is legal and illegal. When should a CTA have a lawyer? And what type of lawyer?

I love this question, and I promise you I didn’t write it. It was actually sent in by a listener. But I am going to use this question as an opportunity to tell you why I’ve structured my practice the way I have, so you can see how it’s different from most other lawyers who do CTA work.

First, though, I’ll answer the “when” part of this question—when should a CTA have a lawyer? And the answer is probably not going to surprise you. You should have a lawyer before you manage an account for anyone other than yourself. Why? Because, for all of the reasons we’re discussing today, and as we discussed in Episode 4, you should have an advisory agreement with every customer, even when you’re not registered.

The next part of the question is, what type of lawyer? The type of lawyer who knows the CTA business forwards and backwards. The fact is that lawyers who speak fluent CTA are pretty rare. They may speak CTA as a distant second or third language, but it’s not their first love, and I think that matters. There are lots of lawyers who primarily do hedge fund work and who dabble in CTA work on the side when it comes along, and those two areas of law—hedge funds and CTA work—seem related, but when you look closely, it’s easy to see that they’re just two completely different animals.

I also think it helps to have a lawyer who’s actually operated a CTA. A lot of the things I suggest for CTAs that I advise are based on what I learned to do when I was operating my own CTA. I had another full-time gig going on at the time, so I had to do everything I could to make my CTA operate as smoothly and efficiently as I could, and I learned things that other lawyers who haven’t been in this position probably would never know or even think about.

I think it also helps to have a lawyer who understands CTA accounting. On top of being a lawyer, I’m also an accountant and I started out as an NFA compliance auditor, so I’m well-versed in the nuances of CTA performance calculations. This means my clients don’t have to use a separate accountant to calculate their track record and fees if they don’t want to. I think this is important, because what I’ve found is that with CTAs, the two sides of the business (the accounting side and the legal side) are so closely intertwined it seems difficult on so many levels to separate them. I don’t know how other CTA lawyers function if they don’t know a lot about CTA performance calculations. I know that I couldn’t do it very well if this were me.

Another thing I think CTAs should look for is, who is actually doing your work? You can easily find yourself paying hundreds of dollars an hour to educate a fresh-out-of-law school associate who thinks that CTA stands for Chicago Transit Authority. I don’t operate this way. I’ve tried it here and there, but they don’t teach CTA in law school, and the work is always a disaster in scenarios like this, and it has to be redone. It’s just a giant waste of time for everyone involved. So I just do the work for my clients, and this means they aren’t paying out the nose to educate a lawyer who doesn’t know a CTA from a hole in the ground.

The last thing that’s handy is a lawyer who keeps evening and weekend hours. If your trading day is busy, you want a lawyer who can speak to you when you’re not preoccupied.

So here’s how I’ve structured my practice: it incorporates all of these things. Hopefully this will help you make a decision when it’s time for you to hire a lawyer.

Do you recommend a CPA, if so when should I invest in one?

CTAs have two different types of accounting needs. There’s accounting for the performance in the accounts you’re trading—how much money have the accounts earned or lost, calculating the track record, and calculating the fees that are due to you. The other accounting situation is that you may need an accountant to help you calculate your business income and file your taxes, unless of course you want to do this yourself. It’s not that complicated if you want to try this yourself because unregistered CTAs can basically run their business out of a single checking account.

Performance and fee calculations: don’t try this at home

However, no CTA should ever do their own performance calculations. I used to say maybe on this–maybe a CTA can do their own calculations and it won’t turn into a disaster. But now, I just say no. The do-it-yourself track records always have problems, because even though conceptually it seems fairly simple to calculate CTA performance, in reality, it’s not obvious how to calculate CTA performance and fees without errors and without running afoul of the rules. I’ll probably at some point do an episode on the problems with DIY track records, but for now just trust me when I tell you they are always a mess. And hiring this work out is fairly inexpensive, not everywhere but certainly if I do it for you, and I’m sure other places, too. It’s just not enough money to even consider taking on the hassle of learning how to do this yourself.

This type of accounting, your performance and fee calculations, is something you need right away.

Unregistered CTAs should keep their track records current every month

Why do I say this? Because CTAs, whether registered or unregistered, who have a current track record in hand have something to give an interested person the moment they ask about what you’re doing. When they’re interested, if you give them something that shows why they should be interested, i.e. a current track record, they’re very likely to sign up. This is how you get more customers.

How you don’t get customers is when they inquire, you don’t have your track record brought up to date, maybe you don’t have one at all, and then what happens? There’s a lot of hemming and hawing on your part about what’s involved in signing up with you. The customer asks, “Well, how have you done in the past?” and your answer seems terribly vague and not at all clear, and you can’t even show them how great you’ve done for yourself or your other customers, and what are they going to do in that scenario? In all likelihood, they’re going to just turn around and walk away. Why would you want to do that to yourself?

Some CTAs get into a chicken-and egg problem of, well, I’m not registered so I don’t want too many customers. I have this ceiling of 15 customers hanging over my head, and then they act in ways that puts that ceiling over their head permanently. One of the ways they do this to themselves is they ignore track record. They ignore keeping it updated.

The thing that every unregistered CTA has to remember is that operating as an unregistered CTA is probably not a permanent business strategy for you. The goal is to build a business within the confines of your exemption that will make you look more attractive in terms of AUM, and give you some revenues to offset the additional costs of registration, when you do register.

If you keep your track record up-to-date during the entire time that you’re not registered, registration becomes a very seamless process. If you’re my client, you can call me up and say, “I just got my 15th customer, or I’m talking to my 16th customer now. What do we have to do to register, because that time is upon us?” And I will tell you, “We just have to file forms with the NFA, and maybe you have to take the Series 3 exam.” That’s relatively easy. I can even help tutor you to pass the Series 3 with a minimum of study if you want help.

What isn’t easy is when the track record hasn’t been kept current. Then it’s, “Oh, shoot. Now, in order for you to grow your business by one additional customer, by accepting this 16th customer, we also have to slog through years’ worth of trading records for multiple accounts, and create a track record after the fact, because that’s what you have to do when you’re registered.”

Keeping a track record up to date month by month is easy and inexpensive. Creating one out of whole cloth years after the fact is not. It’s a big project and a big expense, and CTAs who put themselves in this position often stay small because the size of that task, doing all these calculations all at once, seems so big and so daunting in exchange for that 16th customer that it just doesn’t seem worth it, and that’s when they get stuck at 15. They’re always going to be a small CTA if it’s too big a task to register because it’s too big a task to bring the track record up to date. So it’s a lot easier to keep your track record up-to-date as you go along. It’s a lot like maintenance on your car or your house. If you keep it up as time goes by, you never get into a situation where you have a huge project in front of you and you just want to scrap the whole thing.

Can I offer different management fees and incentives fees to different clients, or is that a form of discrimination or favoritism/nepotism?

Here the answer is yes, you can offer different fee structures to different clients, and yes, that is a form of discrimination, favoritism, and nepotism, but it’s not a form of prohibited discrimination, favoritism, or nepotism.

In prior episodes I’ve talked about how CTAs tend to charge their mothers the most, and in my mind that simply is the opposite of how it should go. Your mom should get the best deal that you have to offer, not the worst. How you handle that is up to you, but for what it’s worth those are my two cents as far as the moms of the world go, and if you’re going to offer different fee structures of different customers, there are a few other things to think about as well.

One thing is how a bunch, or even a few, different fee structures will affect your business going forward. One thing that unregistered CTAs often don’t think about is, when you give someone a deal, every later customer who comes along is going to want the same deal. Institutional investors who eventually come sniffing around often even insist on getting the same deal as the customer who’s been with you since day one, and who you gave a break to just because he’s a good guy and he took a chance on you. This isn’t fun. It’s not fun to give someone a deal for months and months and months, or maybe years and years and years, only to find out that when you get that twenty-, thirty-, fifty-, or hundred-million-dollar customer, that you’re going to have to give the same deal to that giant customer or you’re not gong to get the account. This is a reason that I suggest, unregistered CTAs, new CTAs, start out at the fee structure that you’re going to be happy with in perpetuity and just charge that to every customer starting at day one.

If you do charge different fee structures to different customers, when you present your track record, I suggest you have it calculated as if every customer is paying the maximum fee structure. This is called a pro-forma track record. Some CTA accountants will tell you to show the track record at the blended rate, and not adjust for the fee deals that some customers get below what your highest rate is, but I think this is a bad idea. One reason that I think this is a bad idea is that when you do this, you have to disclose the various fee structures that go into the track record, all of the various fee structures that you charge that result in the “blended” rate of return, and that invites all of your customers to start asking why they’re not getting the best fee structure that’s represented in that blended rate.

This brings me to another point to think about about, if you accept various fee structures from your customers, and it’s negotiations. If you draw a line in the sand, and everyone pays the same rate, that’s typically the rate that you will. Few if any customers walk away when a CTA has a firm fee structure and that’s just the deal. But if you start out in this business with a mindset of negotiating different fees with different customers, you’ll often lose customers, and you lose revenues. Things just get bogged down in those negotiations, and customers walk away. We talked some of the problems with negotiations and losing customers in the episode on performance hurdles so if you haven’t heard that yet, you might want to go back and listen. I think it’s Episode 9.

My basic recommendation to CTAs on charging different fees structures is, just don’t do it. When you reduce your fees, you’re just reducing your revenues. Just charge the maximum fee rate that you would charge to anyone—that’s your fee structure—and you’ll find that you get it, and your revenues will be a lot higher, and you’ll have more customers.

How to calculate Assets Under Management

This is the last question I’m going to answer for today. Although there are more questions I hope to get to those in another episode.

If all 15 of my friends and family have a notional value of $100k each, that would mean I’m managing $1.5 million although there is less than $200k in actual cash combined in the accounts. How does that work or look for the investors and for me?

The first thing to notice about this question is that it only works that way if you have an advisory agreement with each of these customers that specifies the trading level of each account. If you have advisory agreements that say, each of these 15 accounts has a trading level of $100k each, you do have AUM of $1.5 million. If you don’t have these agreements, and these accounts collectively have only $200 in actual cash, that’s your AUM. $200,000.

This is another good reason to have an agreement—it generally means higher AUM because you get to use the higher trading level that can include notional funding, rather than just the cash in the accounts. Assets under management doesn’t matter a lot for unregistered CTAs. At the unregistered stage, it’s more about monthly returns. Once you’re registered, returns are still the most important thing, but this is the point where AUM starts to matter, too, and it matters more every year that you’re operating your CTA because you’ll start to attract investors who care about AUM more. An institutional investor who comes along in year 6, 7, or 8 obviously is going to care a lot more about your AUM than your mom who comes along in month 1.

In any case, back to the question. In the scenario where you do have an agreement, you are managing $1.5 million, so you calculate your track record—your monthly rates of return—based on $1.5 million, and you also calculate your management fee, if you charge one, based on $1.5 million. If you don’t have an agreement, you’re calculating your return based on whatever cash is in the account, and you’re probably not collecting a management fee at all, because it’s difficult to collect fees if you don’t have a written agreement.

As for your investors, they can consider their account at $100,000 or at the cash level. How they choose to think about this is entirely up to them, it has no impact on your business. For example, if you earn $5,000 for a customer who has a $100k trading level that’s documented in an advisory agreement, you’re going to post a 5% return in your track record for that customer’s account. If the customer only has $5,000 in the account, it’s up to him how he thinks about it. He can think about his return any way he wants. It can be, in his mind, a 5% return because he, like you, is considering the trading level of the account in calculating the return. Or, he can think to himself, I just earned 100% this month, because I had $5,000 in my account, and I earned $5,000, that’s 100% return in my mind.

Conclusion: An unregistered CTA is still a business. Use an advisory agreement and give your customers a track record!!!

Okay so that’s the last question for today. There are some more questions that I hope I’ll have time to get to in an upcoming episode. For now, I hope this gives you a glimpse into what it’s like to operate an unregistered CTA. It’s a business. You still have to have a lawyer and an accountant. You need an agreement. You need to keep your track record up to date. If you do those two things, you’ll find that your business will grow fairly easily, it will be seamless for you to register when the time is right, and you’ll make a lot more money in your CTA.

So once again I want to return to the question of, why would any CTA want to operate even when you’re unregistered, without these things? I can’t imagine. It just doesn’t work, so I really advise you not to even consider it. Treat this like a business, from day one even when you’re not registered, and you will make significant money because you’re building an actual business.

Before I close for today, I just have to clarify that this podcast may constitute attorney advertising, as if that’s not completely obvious already. Also, although we discuss general principles against a legal backdrop, you shouldn’t take anything I say here as legal advice. The way to get legal advice that’s applicable to your situation is to actually hire me as your attorney and tell me exactly what your situation is so I can speak to that. If you want to talk to me about doing that, or if you want to talk to me about questions about your CTA, email me at kelly@profitablecta.com, or go to profitablecta.com where you can access my calendar and schedule a call with me. Thanks and I look forward to speaking with you if you’d like some help with your CTA, and I look forward to connecting with you in the next episode.

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