Ep. 15: Pay-to-Play

Almost every CTA will at some point be asked to pay to play. “Paying to play” means paying money for the promise of accounts coming your way, now or at some point in the future. This episode discusses the downsides of pay to play, so you can decide if it makes sense for you.

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 paying to play.

What do I mean by this? Paying to play means forking over money in hopes of getting customers. Today we’re going to talk about one very common scenario in which this occurs, how it can hurt your profitability, and what you can do to avoid it.

Directing accounts and commissions to brokers

Almost every CTA at some point will be told by a broker, “Send some customer accounts my way, or put your own personal accounts with me, so I can “watch” what you’re doing, and eventually, if I like how you trade, I’ll send you an account or two. Maybe my own account, or maybe I’ll raise money for you and send you some customers.”

This is probably the most common form of paying to play in the CTA business, and there are a couple of things to notice here. One is that there’s no other scenario where would-be customers need or even ask to watch your performance in real-time. If someone needs or wants to see your daily returns or individual trades to get a sense of how you trade so that they can allocate to you, they can do that after the fact. This type of request is unusual, by the way. Even an after-the-fact analysis of your daily trading activity is something you’ll generally get only from very sophisticated institutional investors, and these requests only come later on in the business life of a CTA.

So what’s different with brokers? The difference with brokers is that if the “watch” you in real time, they also collect commissions for doing so.

So here’s the challenge: How do you know if they’re really are interested, and if they’re ever going to allocate, or if they just want your commission dollars, and the commission dollars paid by your customers, and they’re never going to bring you any accounts to manage?

You can’t know this, and in the absence of certainty one way or another, most CTAs just wind up sending their accounts, their own and their customers’ accounts, to pay-to-play brokers in hopes that something will come their way, too. They think, there’s really no downside to doing this, so why not?

The downsides of Pay-to-Play

But there actually is a downside to doing this. There are several, actually, and today we’ll discuss a few of them.

Inflated Commissions (and Reduced Performance and Incentive Fees)

One of the problems with pay-to-play is inflated commissions. The brokers who want to “watch” you with a view to potentially allocating to you generally charge a lot more in commissions than brokers who aren’t actually or ostensibly involved in making allocations.

Does this matter? It depends on the amount of the excess commission rate, how frequently you trade, and how this impacts your performance.

Every extra commission dollar that comes out of the accounts you manage hits your track record. How big the hit is varies from CTA to CTA, but some CTAs that have accounts with high-commission charging brokers find that the hit is around half a percent per month. It could be more. But at ½ % per month, that’s 6% per year off your track record, and that 6% can, in certain years, mean the difference between a positive year and a losing year.

So paying to play can wind up costing you a lot. A CTA that’s never had a losing year is on a different level than a CTA that has had a losing year, even if the losing year is only a few percentage points.

Another thing to consider is that every extra commission dollar that goes to the broker is subsidized by you to the extent of your incentive fee. If you charge a 30% incentive fee, you’re paying 30% of every extra commission dollar that the broker is charging to “watch” you. If they’re watching the trading in your own account, of course you’re paying 100% of these excess commissions.

Whether you want to pay this is up to you, but there are some other things to consider.

Customer Poaching

One is customer poaching. This isn’t something anyone likes to talk about, and on balance pretty rare, but I’ve seen it, and it’s not good. If you direct some or all of your customers to a pay-to-play broker in hopes that eventually he’ll reciprocate and send some business your way, there’s always a chance that he’ll sell your customers on a different CTA. Does this happen a lot? I wouldn’t call it a rampant problem, but it does happen to CTAs, and when it does, it’s not fun.

It’s especially a problem for newer CTAs, because they bring what I call “babes in the woods” customers into the industry. Your first customers are very likely to be people you know who’ve never allocated to another CTA. The industry has never heard of these folks before, and if they are introduced to “pay-to-play” brokers, sometimes they wind up investing with other CTAs, too, on the broker’s suggestion, and the broker gets paid for that, in the form of commissions and also in the form of shared management and incentive fees from the other CTA.

Does the CTA who introduced the customer to the broker receive any of this money? No, and it’s interesting to notice that this relationship is a one-way street. Brokers want to get paid every time they introduce a customer to a CTA. I’ve never seen a broker offer to pay a CTA for bringing him a customer.

Am I saying that all brokers are bad? Certainly not. Definitely not. There are so many brokers out there in the industry who are good people and I like them a lot and they do good work for CTAs. I’m just saying that this kind of thing happens, so be careful out there.

Tolerating the Intolerable

It’s tough to have a broker who’s only your broker because he’s potentially going to bring you money, because then what happens? If things go awry on a trade or in some other situation with that broker, where it’s you against the broker, you may find yourself tolerating something or capitulating to something that’s unacceptable because you don’t want to alienate the broker and potentially shut off the hypothetical tap of future clients that are supposedly coming your way at some point.

I’ve seen this happen a lot, and it’s stressful for the CTA to figure out how to handle these situations, which are already stressful enough.

Knowing when to leave

Another thing that happens in pay-to-play situations is the question of when to leave. If you bring your own accounts, or the accounts of customers, to a pay-to-play broker, and the promised reciprocity, the promised accounts coming your way, don’t materialize, then what? Eventually you’re going to want to move the accounts to get lower commissions or different services, or just because you feel misled, but it’s tough to know exactly when to do that because often they’ll keep telling you, “No, just hang on. The money is coming.” And then of course you have the hassle of moving accounts if the money doesn’t materialize as promised, and here I have to say, it almost never does.

The effect on your mojo

Then there’s the effect on your mojo to consider. What does paying to play do inside your brain? It sends a message that you’re not really capable of getting accounts without some kind of side deal going on. Is this the kind of thing you want to tell yourself? Is this the kind of thing you want to tell your brain? My guess is no. I say this because whatever you’re thinking, other people pick up on. A CTA that’s hungry for money, hungry for accounts to the extent he’s willing to pay to get accounts, gives off a scent, and it’s not a scent that attracts customers.

My general sense of pay-to-play arrangements is that if someone has the willingness and ability to bring you accounts, they generally just do that. They sign your advisory agreement and the deal is done—you have an account. They don’t need for you to send commissions dollars their way for months or years before they sign up.

And doesn’t this make sense? Good CTAs make money for their customers. Why, if someone has the willingness and ability to get involved in a money-making enterprise like that, would they sit on the sidelines and expect to be paid before they get involved? It just doesn’t make sense. This is why I suggest, on balance, that it’s best to stay away from pay-to-play situations.

Why do CTAs Pay-to-Play?

This, of course, raises the question, why do CTAs get involved in these arrangements? The answer is because they’re puzzled about how to get clients on their own. So for the next several episodes, we’re going to discuss how to go about doing that. How to get clients on your own, so you’re not tempted to get involved in situations that really don’t work for you or your business. I hope you’ll join me for those episodes, and thank you for joining me today!

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