“Fee Compression” is the idea that CTAs should earn less, not more. But it’s just an idea, and it’s one that doesn’t serve CTAs. Listen to this episode to find out why the reasons behind fee compression aren’t valid, so you can prevent fee compression for undermining your profitability as a CTA.
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 fee compression. The first thing we’ll discuss today is the “standard” CTA compensation of Two and Twenty, and exactly what that means. Then we’ll hit on fee compression, which is basically the rumor that CTAs no longer deserve Two and Twenty—they should be paid something less than that. I’ll also explain why fee compression is a mythical mental construct that applies only to struggling CTAs who buy into this myth, and why, in reality, Two and Twenty is just a starting point. Profitable CTAs often charge more than that. Some charge a lot more than that.
Two and Twenty: The “Standard” Compensation Rate for Commodity Trading Advisors
To start off, let’s define our terms. When we talk about “Two and Twenty,” what we’re talking about is a 2% management fee and a 20% incentive fee. The management fee of 2% is annual—every year you get 2% of the account you’re managing–but the fee is paid out monthly. In other words, if you manage a $100,000 account that pays a 2% management fee, you get $2,000 per year, but it’s paid to you monthly in chunks of $166.67. And you get this amount each month even if the account isn’t profitable, but of course, accounts that aren’t profitable close at some point, so no one gets a management fee in perpetuity.
The 20% incentive fee is profit-based. It means that the CTA gets 20% of profits on a periodic basis. Sometimes it’s monthly, sometimes quarterly. In certain cases, usually with institutional customers, it’s annually. But whatever the period is, on the last day–of the month, quarter, or year (whatever frequency applies)–you look at the account you’re managing, and if it’s up from the last time you charged an incentive fee, you get 20% of those profits.
Now, by the way, one thing I want to clarify here is that the incentive compensation is called an incentive fee only when you’re managing separate accounts. Separate accounts are when each of your customers has his or her own brokerage account, and the money of your various customers isn’t commingled with the other customers’ money (or your money, for that matter). The incentive compensation has a different name, and as of 2018, a different tax treatment, if you’re talking about a pooled investment vehicle in which the money of all of your customers is mixed together into one big pile. These pooled vehicles are called commodity pools/hedge funds, and with a pooled structure, the incentive compensation is not called a “fee” anymore. It’s referred to as “carried interest” or a “performance allocation.” We’re going to cover pools and the different tax treatment for incentive compensation in an upcoming episode. For now, this episode today is just about the percentages. Whether you’re managing a fund or separate accounts, the question is should you charge a 2% management fee, or more or less than that? Should you charge 20% of the profits, or more or less than that?
Debunking the Reasons that CTAs Undercharge
If you follow CTA compensation, you’ve undoubtedly heard that Two and Twenty is too high. Some people will assure you that Two and Twenty is dead. They’ll tell you that no new CTA is going to get Two and Twenty, and they’ll point to fee compression as the reason.
The first thing I want you to know is that “fee compression” isn’t a single reason. It’s a catch-all term for lots of different justifications that CTAs should earn less rather than more. Some of these justifications come from investors. Many of them are lurking in the brains of struggling CTAs. But none of these justifications stand up to scrutiny terribly well, so today I want to debunk some of the more common “reasons” behind fee compression so you can see why they’re not valid, and you can avoid unnecessarily discounting your fees based on them.
Reason #1: A “Fixed-Pricing” Mindset
The first reason that I want to talk about that CTAs underearn is a fixed pricing mindset. One reason many CTAs undercharge is that somewhere along the line, they developed the impression that “standard” pricing is actually “fixed” pricing. In other words, if you’re a CTA, you charge Two and Twenty. That’s just the way it is. Two and Twenty is what CTAs charge, so if you’re a CTA, that’s what you charge.
The theory underlying this fixed-pricing mindset is that CTAs are essentially commodities. They’re all the same. They are fungible. You can swap one out and replace it with another, and it doesn’t make any difference.
And of course we know that nothing could be further from the truth. Certainly there are some CTAs that are similar to others, but to say that any CTA offers a trading program that’s identical to any other CTA is a bit of a stretch. It’s even a bigger stretch to assume that they’re all the same in terms of performance potential. We readily accept the idea that some lawyers are better than others. This is why some lawyers make $1500 an hour and some lawyers make $50 an hour. We make the same qualitative assessments with almost every type of service provider we deal with. Accountants. Dentists. Plastic surgeons. Even dog sitters make differing amounts of money depending on the value that they bring to the transaction.
Yet too many CTAs, no matter how qualified they are, no matter what kind of trading history they have, how profitable it is, go on auto-pilot when it comes time to setting their fees. They readily accept Two and Twenty without even thinking about it, when their customers would pay more, sometimes far more, and the result is that they’re under-charging and they’re less profitable than they could be.
So the takeaway on this point is that you are not a commodity. Your trading program isn’t a commodity. There’s no reason to price it like one. When you’re pricing your trading program, the only consideration that matters is the value you bring to your customers. The market is what a willing buyer would pay to a willing seller in an arm’s-length transaction. If your customers would pay more, but you’re not charging it, you’re underearning. You’re subsidizing their wealth at the expense of your own with every trading day that goes by.
Why would any CTA do this? Because they don’t feel good about charging more.
Reason #2: Emotional Mismanagement
CTAs who charge less than their customers are willing to pay do so for emotional reasons. They don’t want to feel guilty. They don’t want to feel selfish. They don’t want to feel anxious about what others are thinking of the fees that they charge.
The thinking here is that the fee structure causes the emotion. CTAs who undercharge think, erroneously, “If I charge more, I’m going to feel bad in some way, so I’ll charge less and then I won’t have to feel that negative emotion.”
The important thing to notice here is that the fee structure is not what causes the negative emotion that the CTAs are trying to avoid. What causes the negative emotion is the CTA’s thoughts about the fee structure. How do we know this?
Because some CTAs charge a 50% incentive fee, and they feel fine about it. Other CTAs charge a 20% incentive fee and they feel horrible. So it’s not the percentage that matters. It’s the meaning that you attach to the percentage.
Our brains are meaning-making machines. They will attach meaning to anything– even random events that have no inherent meaning at all. Why does this matter to your compensation? Because if you’re not supervising your brain around your compensation decisions, who knows what it’s doing? You could easily have a whole bunch of faulty programming in there that attaches erroneous meaning to your fee structure that will make you feel guilt or other emotions we typically experience as unpleasant, and then that will cause you to undercharge for reasons that you don’t even agree with.
Coaching CTAs through their compensation decisions is one of my favorite parts of what I do, because it’s probably the quickest way that CTAs can dramatically grow their earnings in a few hours’ time by making a few simple shifts in mindset.
And this process basically involves looking at the sentences that are running through your brain and how they are affecting your emotions and thereby the decisions you make about what to charge. And what inevitably happens in these sessions is that the CTA’s thoughts come out into the light of day and the CTA realizes that they are causing poor decisions about fees–what the CTA is thinking in their subconscious is causing the CTA to make detrimental fee decisions.
Here are some common examples:
Some CTAs want to undercharge because they think that they don’t trade frequently enough. They have this sentence running through their brain: If I traded more, I could charge more in fees. This thought has no basis in reality. Any quote-wielding maniac can sit and pull the trigger on trades all day long. The real discipline is in sitting on the sidelines and waiting for the set-up. Few people can do this, and that’s worth a premium. Definitely not a discount.
Some CTAs charge too little because the markets have gotten more difficult lately. To this, my response is, that’s when you charge more. When it’s more difficult. No one charges less when a job is easier.
Another common thought that commonly leads to under earning is, I won’t charge a lot now. As I get more customers, then I will charge more. This thought starts your business off on the wrong foot, and very predictably creates an under-earning snowball in your business. If you start out charging your customers say, a 10% incentive fee and no management fee, as many new CTAs are inclined to do in the age of fake news about fee compression, that becomes a pattern when future customers, particularly knowledgeable industry customers, ask you, “What’s everyone else paying?” If you start out discounting your fees, that tends to become your market price, and everyone wants a discount. Some institutions even insist on a most-favored-nations clause, in which the institution automatically gets the lowest fee structure enjoyed by any customer at any time.
What happens if you go in the other direction? When I was running my CTA, every customer paid a 50% incentive fee. The first customer, and every customer after that. And eventually, once we started getting accounts from seasoned industry professionals and the occasional institution, they would ask, “Wait a minute. Why am I paying a 50% incentive fee?”
And to this my answer was always the same. “Because that’s what our mothers pay. You’re getting the friends and family discount.”
And here I’m not saying that every CTA should charge 50%. Our CTA could charge that because the profits were there, and they were very consistent profits. What I am suggesting is that what you are thinking about your fee structure, even subconsciously, will affect what you charge, and if you don’t know what you’re thinking, or if you’re thinking something that’s not accurate, you could wind up unnecessarily discounting your fees for reasons that have no validity and that you don’t even agree with. Our brains do that kind of thing to us, so I strongly suggest that CTAs go through an analysis about fees that extends beyond, “This is what I’m charging, because this is what I feel good about.” If your fee decision is based on what feels good, I can almost promise you that you are leaving money on the table and starting your business off on the wrong foot.
It is very possible to charge what your customers are willing to pay, and feel very good about that decision. These two things aren’t mutually exclusive, so if you want some help analyzing your fee decision in terms of its impact on your performance, as well as looking at how your thoughts are driving you to make unproductive emotional decisions about what you’re charging, let me know because I can definitely help you with that.
Reason #3: A Misunderstanding of What CTAs Do
Another big reason CTAs undercharge is that they just don’t see where they fit into the commercial marketplace. CTAs are often called the investment advisors of the futures/forex industry. And what do we know about investment advisers? Largely, what they do is they help their clients select a portfolio of underlying companies, publicly-traded companies, to own. And what do they get paid for this? The max is about 2% of assets. Fidelity just launched two index funds with total compensation of zero. So fee compression in the investment advisory space is a real thing.
But take a look at the underlying assets in those portfolios that investment advisers help their clients to build. Look at Google. Are Larry and Sergey operating their company for a mere 2% or less? Of course not. The sky is the limit in terms of their compensation, as it should be, because they are creating real value and real wealth.
So the question is: is a CTA a portfolio manager who deserves a paltry 2% or less, or is a CTA the underlying company that creates the wealth and therefore deserves much more than that?
Academics who have studied this say that the CTA is the underlying portfolio company, not the portfolio manager. And this makes sense, doesn’t it? What do great companies do? They take skill and knowledge and the ability to process information, and they combine it with some capital, and they generate a return for their investors.
This is exactly what CTAs do, so the idea that they should be paid a paltry 2% or less is simply ridiculous. A great CTA is a money-generating machine, and that is a valuable function that’s worth more than 2%, every day, all day long.
Reason #4: Too Much Competition
A fourth reason CTAs underearn—this is a big one–is the perception that there’s too much competition. The thinking here is that this is a “mature” industry in which the only way to get a customer is to take a customer from another CTA. Those who buy into this theory believe that there are too many CTAs chasing too few customers, and the only way to entice someone to switch over to your CTA is to charge less.
Where does this perception come from? In large part, it comes from the hot pursuit of institutional investors. A common story that you will hear in this industry is that for every five hundred managers who approach an institution, ten will get meetings, and two will get money.
This is probably anecdotal–I’m not sure anyone’s actually conducted a study on this, but it certainly jibes with what I see. CTAs who chase institutional money rarely get it, and then they very reasonably begin to think that the competition is too intense, and that lower fees are the only way to distinguish themselves.
Is there a lot of competition in the CTA industry? Yes, but only in the bad neighborhoods. A bad neighborhood for CTAs is anywhere you have too many CTAs chasing too few customers, and one great example of a bad neighborhood is the conference circuit. If you put five hundred, a thousand managers, or more, in a room, all chasing a relative handful of institutional investors, at least some of whom are there only for the free trip to Newport and nothing else, what do you get? You get CTAs, and you get investors, who think that CTAs are a dime a dozen. That is a recipe for fee compression, but it’s based on a fiction.
What’s the reality? As of August 25, 2018, there are 1,615 CTAs listed in NFA’s registration database. Is this a lot of CTAs? If you line them up in a hotel conference room and sic them all on a handful of jaded institutional investors, it seems like a lot.
But what happens when you consider the number of CTAs relative to the population as a whole? Suddenly the world is your oyster.
Everyone wants to make more money. Institutions definitely don’t own a patent on that desire. So the idea that there’s too much competition in the CTA industry, and that CTAs must reduce fees to get customers, is just that: an idea.
And it’s an idea that doesn’t serve CTAs. Where does this idea come from? As I said earlier, it comes from CTAs lining up in the streets and chasing institutions like they’re bulls in Pamplona. Why are they doing this? Many CTAs have the idea that individuals are not appropriate investors for managed futures or managed Forex programs. Where does this notion come from? Too many places to count, and we’ll deal with them in an upcoming episode. But for now, I would just like you to know that there is no real competition once you get out of those overcrowded hotel conference rooms and out into the real world.
My most profitable CTA clients have no interest in institutions. They trade exclusively for civilians– people who have no connection to the industry but who have a taste for the kinds of profits that CTAs generate, and money to invest—and doing so is a game-changer for CTAs at every stage of their businesses. It’s a game-changer early on, because civilians pay the highest fees. This sets a baseline for when the CTAs begin talking to institutions. They don’t have to say, “Oh, all my customers are paying zero and ten,” and charge that. They can say, “My customers, including my mother, pay 50% of the profits.” And then the institutions have a market price for the services and are much more likely to pay that. One thought on this: no one should charge a stranger or an institution, less than what their mother pays. That’s just not right. I see that all the time, but it’s just not right.
So it’s a game changer early on, to deal only with civilians because it sets a baseline for when you begin talking to institutions, and it’s a huge game-changer later on, because while all the other CTAs have been getting gored in the streets of the institutional rat-race, these CTAs quietly amass the AUM and track records that institutions need to actually make an allocation.
In short, the CTAs who focus on civilians and ignore institutions ironically are those who eventually get the institutions. So here’s a tip you can take to the bank: hard-to-get works in the CTA world as well as it does in the dating world. If you want to capture someone’s attention, truly don’t care about what they think. Ignore them entirely, pay attention to someone else, and eventually they’ll come running after you.
Takeaway for this Episode: Good CTAs can earn a lot more than they’re currently earning.
I could go on and on and on about the reasons that CTAs undercharge, and why they could charge more, but today we’ve covered four:
- They undercharge because they’re thinking of themselves as commodities, and they start thinking that “standard” pricing means “fixed” pricing. Then they don’t base their pricing decisions on what the market would actually pay and what their track record would warrant. They just blindly make a decision and go with it, and they undercut their incomes as a result.
- The second reason we discussed: They undercharge because they have unexamined, perhaps even subconscious thoughts, that are leading them to undercharge, often in ways that hurt their businesses not just now, but in perpetuity.
- They also undercharge because they’re thinking of themselves as portfolio managers, rather than the underlying portfolio company. CTAs create enormous value. I encourage them to think of their relationship with their clients as not in terms of “I’m one of your portfolio managers, one of your investment advisers,” but as “I’m partnering with you in a business.” Of course, no CTA should enter into a partnership with a customer, that’s a legal distinction that isn’t helpful, but the partnership scenario is helpful in terms of fee structure. If your next door neighbor came to you and said, “Listen. I’ll put up some money and you do all the work,” would you split the profits with them 80% to the customer and 20% to you? Probably not. If they were going to put up some money and you were going to do all the work in any other kind of business, You’d probably start somewhere at a 50/50 split. And I think good CTAs should start there in terms of their own compensation. Look at what your track record will support, but I’m guessing it’s more than 20%.
- The last reason we discussed today that CTAs undercharge because they’re all chasing the same customers, and they don’t recognize that there’s a huge untapped market for what they do. This is huge. If you can do what good CTAs do, which is take a little bit of money and turn it into a lot of money, everyone wants that. To think that there is a limited customer base for that service is insane. And that’s why I think the notion of fee compression is a collective insanity that CTAs have bought into, and they can let themselves out of it by just stopping the institutional rat race. Stop chasing people who everyone else is chasing, and turn your attention to the civilians who are hungry for what you do, and who don’t know anyone else who does that.
So to wrap up today here’s what I suggest for every CTA: Don’t set your fee structure until you’ve done an analysis of what your track record will warrant, and you’ve taken a look at your thoughts about your compensation scheme. You want to make sure that you’re making a decision that’s based on the math of the situation, and the actual market for your services, rather than faulty drama that may be swirling around in your subconscious.
If you need some help with this, I’m here for you. Email me. email@example.com, and definitely don’t hesitate to do this because your fee decision is one of the most important things you’ll ever do in terms of whether your CTA will make money or lose money. I’d love to work with you on this if you want some help. And with that, I’m going to close for today. I want to say thank you for joining me, and I look forward to connecting with you next time.