Ep. #6: CPO vs. CTA

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At some point, every commodity trading advisor wonders if they should set up a pool. Most CTAs who set up commodity pools live to regret it, because investors overwhelmingly tend to prefer separate accounts. Listen to this episode to find out why, and also the few situations where a pool might make more sense.

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 happy 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 commodity pools. Too many CTAs are messing around with pools and it’s causing giant expenses, distractions, and making it more difficult for them to attract customers. So today we’re going to talk about what a commodity pool is, how it’s different from separate accounts that CTAs manage, and then we’ll discuss why investors overwhelmingly prefer separate accounts to pools, and why CTAs prefer separate accounts to pools, and last we’ll touch on the few rare situations in which a pool might make more sense.

What is a Commodity Pool?

There are basically two options for futures and forex traders who want to trade other people’s money. The first is that you can trade your customers’ money in separate brokerage accounts. When you go the separate account route, each customer has their own brokerage account in their own name, and you trade for them only in their account. This means that their money and their positions never get commingled with the money and positions that belong to you or your other customers.

The second option is that you combine all of the money from your customers, plus your own money if you wish, into one big pile, one big commingled account, and that big commingled pile of money is called a pool or a fund.

Pools are pretty complex critters from a legal and regulatory standpoint, so the exact legal definition of a pool is much more involved than “a big commingled pile of money,” but the legalese sounds like gobbledygook to most people, so to really understand the difference between a pool/fund and separate accounts, I’d like you to visualize your trading program as a party. A pool is a bus that delivers investors to your party in a group. They all come together, and separate accounts are the equivalent of everyone arriving at the party in their own cars. Most people prefer to come and go to social events as they please, rather than carpooling it, and that’s exactly the way it works with managed futures and forex investors. They prefer not to ride the bus with everyone else. They want their own cars, also known as separate accounts, and now I’ll share four reasons why that’s the case.

Four Reasons that Customers Prefer Separate Accounts over Commodity Pools

Before I dive in to the reasons customers overwhelmingly want separate accounts, I’ll tell you that once in a very rare while, you’ll find an investor who swims against the tide and prefers a pool. If this happens you’re looking at a unicorn, and often the reason is they don’t want the debit risk that comes with a separate account. A pool investors’ risk of loss generally (but not always) is limited to the amount invested in the pool, whereas separate account owners can lose more money than the cash that’s in their accounts.

But, on balance, customers prefer separate accounts over pools, for reasons that include the following:

Better Safeguards on Cash

If you choose to go the commingled route and operate a pool (this makes you a commodity pool operator or CPO, by the way) you have access to your customers’ money. You can write checks from the pool’s checking account to cover all manner of things that the pool has no business paying for. Back when I was an NFA auditor, I investigated pools where the money was being used to pay for snow tires, condo payments, vacations, you name it. In the really bad cases, the pool operator absconds with millions or even billions of dollars of the investors’ money.

It’s horrific, and this is a trend that has continued unabated since the first pool was invented, and investors are getting a little sick of it.

There are an ever-increasing number of rules and regulatory processes that are designed to detect improper use of pool funds and prevent theft, but it’s still way too easy for a CPO to dip into the investors’ money, because most of the safeguards are fairly easily circumvented by lying to regulators, filing false reports, and firing custodians, administrators, and auditors who ask too many questions. These unsavory activities are all in a day’s work for CPOs who are inclined to steal money, so the safeguards don’t really prevent problems.

This is a main reason that customers prefer separate accounts over pools. With a separate account, the CTA has no access to cash, so if you trade separate accounts, your customers don’t have to worry about you stealing their money.

Lower Expenses

A second reason customers prefer separate accounts over pools is that pools are more expensive. When the money of multiple investors is commingled into one big pile, and when you have access to the cash, you need lawyers and accountants and auditors and administrators to keep track of it all and divvy up the expenses and revenues and make sure everyone is treated fairly.

With a start-up pool, these costs can run about 6% per year, and the pool investors pay these costs. So if you corral your investors into a commodity pool as opposed to offering them separate accounts, they start out in the hole by several percentage points before you place a single trade for them. That kind of performance handicap really hurts, and investors know they don’t have to suffer it if they have a separate account.

This is another reason that they like separate accounts a lot more than they like pools. They earn a higher return.

Transparency and Independent Reporting

Any customer who has a separate account has a direct line of communication with the brokerage firm that holds their account. This brokerage firm is called a futures commission merchant or FCM. Separate account customers get daily and monthly statements from their FCMs with no involvement or interference from you, so they can see exactly what’s happening in their accounts, often in real-time. They know what you’re trading, how much, and whether their account is up or down.

With a pool, it’s different. They get very little information, and what they do get comes not from an independent source, but from you. If you run a pool, at the end of each month or quarter, you will send your investors a report that lets them know if they made or lost money, and how much. That’s the only report card they get. It’s not very comprehensive, and it’s not very reliable. Given the chance, many people would fudge their own report card, and that’s exactly what happens with pools all too often. One reason the Madoff scandal went on for so long and got so big is that there was no independent reporting. Madoff was issuing his own report card, and he was giving himself As when really his performance deserved a failing grade.

These kinds of reporting shenanigans simply cannot happen with separate accounts where the CTA is independent from the FCM, so this is yet another reason that separate accounts win in investors’ minds.

More Control

For the fourth reason that investors overwhelmingly prefer separate accounts, let’s go back to our carpooling analogy. If a CTA’s trading program is a party, a pool is a bus that delivers the CTA’s customers to the party en masse. Buses can be very useful in getting a crowd from point A to point B, but they’re also a pain. Everyone on a bus must travel at the same speed, and the passengers can only get on and off when the bus stops. It’s the same with a pool. If you invest in a pool, you can only get in at certain times, and you can only get out at certain times—sometimes you have to stay at a party you no longer want to be at until year-end. And you can’t control your exposure to the trading program through notional funding when you’re in a pool, so you can only go as fast or as slow as everyone else on the bus is going. You have no control over your leverage, in other words. So the takeaway here is that investors give up a lot of control when they access a trading program through a pool.

Most people prefer not to be locked in like that. They like to drive their own cars, and separate accounts are the managed futures equivalent of each customer having his own ride. The customers can come and go when they wish, because, unlike pool investors, they need not wait for the end of a month or quarter or year to get in or out of a trading program. And each customer can go as fast or slow as he likes, because the customers control how much (or little) leverage they use in a separate account through their use of notional funding.

Reasons CTAs prefer Separate Accounts Over Pools

We just went over four reasons that customers prefer separate accounts. There are quite a few more, but that’s probably enough for one episode. Now let’s discuss a few reasons that CTAs prefer separate accounts over pools.

It’s easier to raise money through separate accounts

The first reason is obvious. Customers tend to prefer separate accounts, and this is a big reason that CTAs tend to prefer separate accounts. If you give the people what they want, you’ll have more people in your trading program than if you try to corral them into a commodity pool where they don’t want to go.

Fewer regulatory and compliance hassles

The second reason CTAs prefer separate accounts is far fewer regulatory and compliance hassles. When you have access to your customers money and you’re the guy (or gal) writing your own report card and you have lots of opportunities to lie to customers and abscond with their cash, as CPOs have, it stands to reason that regulators are going to look a lot more closely at you than if you were just a CTA who trades separate accounts.

And not only is the scrutiny higher with a pool, there are more regulators. If you trade futures or forex through separate accounts only, you only deal with NFA and the CFTC. If you do it through a pool, that also invites scrutiny from the SEC and the state securities regulators. Why? Because when investors buy into a pool, they buy a share of a profit-seeking enterprise. A share of a profit-seeking enterprise is a security, which means that the operation of a pool necessarily implicates federal and state securities laws. This means that, in addition to NFA and the CFTC, the federal and state securities regulators are going to be interested in what you’re doing if you manage a pool.

More regulators, and more regulatory scrutiny, means more legal liability, more compliance headaches, and less focus on your trading and your business. I caution every client not to underestimate this burden. A pool is like a puppy. It seems like a great idea in the store, but when you get the little bugger home, he keeps you up all night, he messes up your carpets, and he chews on your shoes. In rare instances you may have to put up with this kind of distraction, but it’s almost never the case, so unless you absolutely need a pool, and I can almost promise you that you never will, don’t do this to yourself.

Bottom line on this point: not having a pool is one of those rare instances where doing the easier thing is also the more profitable thing.

Fewer restrictions on advertising and sales

Another reason separate accounts are preferable to CTAs from a business standpoint is that there are no restrictions on a registered CTA’s ability to market its services to separate account customers across the fifty states. In other words, the marketing is a lot easier with separate accounts than with a pool. As long as a CTA’s track record and other promotional materials are prepared in a manner that complies with applicable regulations, a registered CTA can post those materials on the Internet, distribute them at conferences, and advertise them across a wide range of media. There are also no restrictions on who a CTA can accept as a customer, provided that each customer receives risk disclosure that’s sufficient to the customer’s situation.

This is not the case with pools, because you’re not just dealing with CFTC regulations and NFA rules. You’re also dealing with SEC and state regulations, and they impose significant restrictions on where and how you can disseminate promotional material about a pool, and on who is allowed to invest in the pool. The exact restrictions vary by pool, and depend on how the pool has elected to operate, but for purposes of this episode, suffice it to say that the addition of a second regulatory scheme (securities regulators in addition to NFA and the CFTC) always means that there’s more to think about, and more restrictions, when marketing and soliciting for interest in a pool vs. separate accounts.

Situations where a pool might make sense

All this being said, there are times when a pool might make sense for your business.

Your minimum account size is prohibitively high

One legitimate reason to consider a pool is that your managed futures program is very diversified, and the minimum account size is extremely high. Finding customers who can swing a $10 or $20 million separate account on their own can be tough for any manager, but it’s nearly impossible for a new CTA. And in that case a pool might make sense so that you can aggregate the cash of smaller customers so you have enough money in margin to fully execute your diversified trading program.

Your customers are simply more comfortable with a pool

This one’s tricky. Sometimes you will encounter that unicorn who truly does prefer pools over separate accounts. If this unicorn is large enough, you may want to consider launching a pool just to keep him happy, but you have to be careful, because CTAs often are told that they will get money if they launch a pool, so they fork over the cash for the pool’s set-up, on the theory that they will be reimbursed from the cash in the pool once the pool gets investor money and commences operations. But then, often, after they’ve put up their own money and the pool is ready to go, the investors are not, and the CTA eats the set-up costs for the pool. So the lesson here? Sometimes an investor will tell you that what he wants is a pool, when in reality what he wants is to get you out of his office and he has no intention of investing.

You definitely want to avoid this scenario, because you could wind up eating $80,000 or $100,000 in set-up costs for a pool that winds up sitting empty.

The “carried interest loophole”

The last reason that a pool might be preferable for you, that I’m going to discuss today, is all over the news, and it’s called the “carried interest loophole.”

We talked in Episode 3 about CTA compensation. This may include a management fee, which is a percentage of the assets you’re managing, but the big draw in this business is the share of profits. If you manage separate accounts, the profit share is called an incentive fee, and it’s taxed at ordinary income rates. If you manage a pool, your incentive compensation isn’t a fee anymore. It’s called a performance allocation or “carried interest,” and as of 2018, it’s taxed at lower capital gains rates.

So there’s currently a tax advantage to managing money through a pool rather than separate accounts, but it’s a big question how long this will last. Congress isn’t thrilled that Warren Buffet’s hedge fund income is currently taxed at a lower percentage rate than his secretary’s paycheck. But one thing that’s interesting to know is that the so-called carried interest “loophole” for commodity pools and other hedge funds isn’t really a loophole for wealthy Wall-Streeters. Rather, it’s just the way that all partnerships currently are taxed in the U.S., whether the partnership is a hedge fund/commodity pool, or a dental practice or any other kind of business that you could run through an entity (such as an LLC) that elects to be taxed as a partnership rather than a corporation. That may sound really complicated. The point I’m making here is that this carried interest “loophole” that they talk about for hedge funds isn’t really a hedge fund loophole, but it is the reason that Warren Buffett’s income is taxed at a lower percentage rate than his secretary’s salary.

Given the current anti-Wall Street sentiment, and the state of the U.S. budget, this tax benefit could close at any moment. That’s one reason that diving into a pool might not be such a good idea. Another reason is that if a pool is your vehicle of choice because you want to try to avail yourself of this tax benefit, you will have a much harder time attracting customers. They don’t like pools as much as they like separate accounts, and this could make any tax benefit meaningless. If your pool sits empty, the tax treatment of your incentive compensation won’t matter, because there won’t be any.

Should you Set Up a Pool?

Most of my clients who go through the pain of setting up a pool live to regret it. I go over with them all the considerations we discussed today, and more, but they still want to do it, and then later they tell me, “Good grief, why didn’t I listen to you?”

There are a few reasons they don’t listen. Often, they think their investors won’t understand the paperwork associated with opening a separate account, or they want to make it easier for their investors in terms of paperwork. But the paperwork burden of buying into a pool isn’t any lighter than it is for opening a separate account. There may even be more paper.

Sometimes, forex and futures traders want to open a pool just because they just like the cachet of saying, “I’m a hedge fund manager.” Whether all the pain associated with opening and operating a pool is worth it for you so you can say this is entirely up to you, but I know that I’d much rather have big profits and lots of customers than something catchy to say at the country club.

The most important thing I can tell you about pools is that most of them sit empty because the advantages are so overwhelmingly skewed towards separate accounts. I am happy to help you with a pool if you really need one, but I care about your profitability and the success of your business, so that’s why I recorded this episode. The truth is that most CTAs need a pool about as much as they need a hole in the head, and most CTAs who fork over cash to set up a pool live to regret it.

Before I close for today, I’d like to say that if you have questions about any of this, I’m happy to discuss. Email me at kelly@profitablecta.com, or go to my website profitablecta.com where you can access my calendar and set yourself up with an appointment. Also, I’m an attorney so this podcast may constitute attorney advertising, and you shouldn’t take anything I say here as legal advice that’s applicable to your situation unless you actually hire me as your attorney and I know exactly what your situation is. To talk to me about legal services or how I can help you with your business, again, go to profitable CTA.com or send me an email at kelly@profitablecta.com.

Thanks for joining me today. 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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