Ep. #9: Performance Hurdles

CTAs often wonder if they should offer a performance hurdle in their incentive fee calculations, but performance hurdles are illogical given the performance expectations placed on CTAs. Listen to this episode to find out why performance hurdles unnecessarily and unfairly undermine CTA profitability, and what to do instead.

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 performance hurdles. Today I want to explain why performance hurdles unnecessarily undermine CTA profitability, and why I don’t suggest that CTAs use them.

I’m thinking about this today because a listener wrote in with a question, and he gave me permission to talk about it on the podcast. He trades S&P 500 futures, or rather the e-mini on the S&P, and he wanted an opinion on a fee structure that went like this:

  • a 10% gross return above the performance of the S&P would warrant a 20% incentive fee;
  • a 15% gross return above the performance of the S&P would warrant a 22% incentive fee;
  • a 25% gross return above the performance of the S&P would warrant a 25% incentive fee; and
  • a 60% gross return above the S&P would warrant a 50% incentive fee.

So you can glean from this that if the return is less than 10% over the performance of the S&P 500, there’s no incentive fee for that period.

There are two questions embedded in this proposed fee structure. One is, does it make sense for a CTA to get a higher percentage incentive fee when the performance is better? The second question is, does it make sense for the CTA to only receive incentive fee if he outperforms a stock index by a certain amount? In incentive fee parlance, we call this a performance hurdle, and I’ll answer that part first.

The short answer is that I don’t like stock index hurdles for CTAs, even if they are CTAs who trade the futures contract on that stock index. I know a lot of CTAs use performance hurdles in their incentive fee calculations, and you can certainly use one if you want to, but after 25 years in this business, I’ve never seen anything good come from a performance hurdle such as this, and now I’ll share a few reasons why that’s the case.

The first reason is that if you’re paid based on relative performance, as is the case if your incentive fee is based on your performance relative to a stock index, that implies that you’re offering a relative return strategy. In the proposed fee structure this listener submitted, the fee structure implies that that the CTA is offering a strategy that’s based on outperforming the S&P.

This is how we evaluate mutual fund managers, right? The theory is that if the S&P is down 10% but a mutual fund is only down 5%, the manager of that mutual fund is a rock star. Why is this the case? Because mutual fund managers generally can’t short anything, so if the market is down, they can’t make money as it plummets.

Is this true for a CTA? Will anyone be impressed with a CTA who’s only down 5% when the S&P is down 10%? No. Why not? Because CTAs should make money no matter what. This is what your customers expect. Why do they expect it? Because CTAs have every shorting capability in the world. That the market is down is simply not an excuse if you have a down year.

If the S&P is down 10% and you’re down 5%, your customers aren’t going to care that even though you lost money, you didn’t lose as much as the index. Rather, they’re very reasonably going to wonder, why didn’t you ride the market all the way down and grab a huge profit for them? And they’re not going to want to pay you an incentive fee in that instance.

This reveals the trouble with performance hurdles for CTAs that are based on stock indices. CTAs are expected to make money all the time. They don’t get a break, and they certainly don’t receive compensation, if they are down but the stock market is down more. So a big question to ask yourself, if you’re contemplating a performance hurdle that’s based on a stock index, is, if you don’t get a break on performance during the down years, why should you insert a hurdle in your incentive fee calculation that gives your customer a break on incentive fees during the positive years? It just doesn’t make sense.

And here’s something else to think about: Why do we compare CTA performance to the performance of a stock index in the first place? It happens all the time, but we don’t make this comparison because CTAs offer relative-return strategies and should be paid as if they are relative-return managers. We make this comparison only because investors want to know where they should put their money—in the stock market or with a CTA.

If I think a CTA is going to perform better than the S&P this year, maybe I’ll put more of my money with the CTA. But if I choose to allocate more to the CTA, and less to the stock market, and I was wrong—the S&P performs better than I expected, is that the CTA’s fault? If my CTA makes me 20% and the stock market also gives me 20%, I’ve had a great year. Good for me. Should my CTA get nothing in incentive fee? I don’t think so, and I’m willing to bet that you don’t, either.

So my bottom line on stock-index performance hurdles is that applying a relative-return compensation scheme to an absolute return trading strategy gets you wonky, illogical results. If the hurdle has no bearing on your ability to generate profits, why should it have any bearing on your incentive fee? Inserting the hurdle into an incentive fee calculation hurts you in your good years, and it doesn’t help you at all in your bad years, and it can result in weird scenarios where you performed like a rock star in a given year, but you don’t get paid because the index in that year just so happened to fly high as well.

So that’s a big reason I don’t like stock index hurdles for CTAs, even for CTAs who trade futures contracts on that stock index. And I especially don’t like them when they’re combined with graduated incentive fees where the amount of the outperformance, in other words, the excess performance over the index, results in a higher percentage incentive fee. This kind of thing adds a layer of complexity to a CTA business that kills its profitability.

Complex fee structures add costs and reduce your focus

Operationally this layer of complexity runs up your costs, because your accountant has to do things like always keep track of many more factors than if it’s just a straight incentive fee calculation. Legally, this kind of thing costs more,  because papering this stuff into an agreement adds a layer of complexity that takes time and focus from your attorney. More importantly, this kind of complexity eats up your mental bandwidth, because instead of focusing on your trading day, you’re talking to a customer about what the deal is going to be, and then you’re communicating it to your lawyer, and your lawyer’s trying to document whatever the deal is second-hand, and then you get the agreement back and you have to look at it to make sure what your lawyer has written is correct–it actually matches what the deal is, and then you have to explain it to the customer and make sure the customer agrees that what is written into the agreement actually matches what the two of you have discussed. It’s very complicated. In practice, this kind of thing eats up a huge amount of time, money, and attention.

Fee complexity drives customers away

But these are small considerations relative to the elephant in the room. The big consideration with complex fee structures like this is that fee complexity drives customers away. Customers are just like everyone else. They’re tired, they have a lot of things to think about, they want something—anything–in their life to be easy, just as we all do, and they don’t have a lot of time or patience for details like this. What struggling CTAs do is make everything super complicated, and what happens is that their customers are far more likely to walk away than to buy. If I could promise you only one thing about this business, I would probably promise you this: the managers who make the fee structures really complex invite their customers to get bogged down in fee negotiations. The customers look at all of those variables and they start pushing on them– why is the formula this way? Why can’t it be that way? And then the CTA must explain and defend and justify the formula, the fee structure, when it’s really indefensible. Where does this formula about 20% incentive if the profits are 10% more than the index, and 50% if it’s 60% more than the index, where does all that come from? It’s just made up, and this is when customers want to start making up their own formulas, and this is when protracted fee negotiations commence, and it’s when customers get tired and eventually just walk away.

One of my largest clients didn’t become large until they stopped with all the complex fee structures, and they just offered a single, very simple fee structure that was very easy to understand. When they did this, their customers stopped negotiating everything to the nth degree, they stopped walking away in exhaustion, and they started signing documents and investing.

This isn’t an anomaly. What always works better is a simple fee structure that is based on the manager’s particular situation, and his capacity for AUM, and the demand for his services.

In 25 years, I’ve never seen a CTA offer a complex fee structure like this and go on to have a successful business. I’m not saying it’s never happened, but if it has, my guess is that the CTA succeeded in spite of the complex fee structure. Definitely not because of it.

So in my mind, the best thing CTAs can do with their incentive fee structures is stop apologizing if the S&P happens to perform as well as they do in any given year. If you’re up, and the S&P is also up, that doesn’t mean you did a poor job, and your compensation shouldn’t suffer for that. I hope this helps all of you who are listening and perhaps contemplating a complex fee structure with performance hurdles, and also that if you need any help with your CTA, you’ll let me know.

I’m an attorney, but you shouldn’t take anything I say in this podcast 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. If you want to talk to me about doing that, please email me. kelly@profitablecta.com, or go to profitablecta.com where you can access my calendar and schedule a call with me. And one more thing: I’m an attorney so in case it’s not completely obvious, this podcast may constitute attorney advertising. 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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