As investors look to diversify their investment portfolio, one option is trading of derivative contracts, including futures and options on futures. However, as the normal investor may not have much knowledge or experience trading derivatives, many investors choose the route of managed futures. Traditionally, there are three ways in which an investor can pursue this opportunity: a broker assisted account, an individual managed account, or a pooled investment vehicle. To gain a better understanding of a particular firm, a customer can research a firm via NFA’s BASIC system found on NFA’s website, www.nfa.futures.org. This system allows a potential customer to research many aspects of the firm: what type of business they can conduct, their location, any disciplinary actions taken against a firm, and owners and directors of the firm. Once a firm is selected and the investor determines that they do not want a self-directed account, they must decide on one of the three options previously discussed for a managed futures account. This article will discuss the compliance perspective of each option.
The first option is a broker assisted account. Traditionally, this is an account that is opened via an Introducing Broker with a futures commission merchant and an Associated Person (“AP”) is assigned to the account. Ultimately, management is responsible for properly supervising all APs and this can sometimes be a sensitive issue as the APs are the driving force behind the firm’s profits. While the AP will not have Power of Attorney (“POA”) over the account, they will recommend trades to the account holder and place trades once an acknowledgement is made. Relative to the three options described above, this has a higher risk of conflict, as the AP has an incentive to trade, as for every trade placed, the AP earns a commission. Firms must ensure that their APs are well educated on futures trading and understand customer needs and experience. Suitability of these types of accounts and products must be assessed, and understanding how they fit in an investment portfolio is imperative. This includes how the products attribute to risk related returns, liquidity needs of a customer, and product specific information like calculating proper break-even analysis prior to recommending and placing trades. Another issue that may arise is a trade not performing as expected and a customer making a complaint that they did not give prior authorization for the trade. The most common ways that firms protect themselves from this is by tape recording all conversations with clients or maintaining email chains if discussions are electronic. Another compliance issue for firms is proper supervision. This begins with the solicitation process of obtaining customers and ends with the AP offering trading recommendations. In recent years, regulators have hired former traders with a wealth of knowledge that have assisted examination teams with greater scrutiny of trading analysis and have brought disciplinary cases against firms, and individual APs for these items. As such, management needs to be cognizant of their AP’s activities, monitor the activity closely and take appropriate action when necessary.
Another option is having an individual account managed by a Commodity Trading Advisor (“CTA”). In this instance, the CTA has POA over the account. Potential conflicts and compliance concerns begin with the CTA’s disclosure document (“CTADD”). The CTADD is used as part of the marketing efforts of a CTA. Included in the CTADD is a comprehensive description of the CTA, including the trading principals, the details of the trading strategy, all fees related to the trading program, past performance history of the program, and any program the CTA offers or offered in the past. By far the greatest risk to a customer is hiring a CTA based purely on performance found in a CTADD as these documents need only be submitted to the regulators once every nine months for review. However, the regulatory review process is not all inclusive, as it does not test the performance. They will however detail test these on regulatory examinations, so having proper records and performing the calculations correctly is one of the biggest compliance concerns to CTAs. This is a high risk area as there are a few options to calculate performance. Firms should ensure that they have sufficient understanding of the rules and regulations and if not comfortable with them, should consider outsourcing the performance calculations to a third party. Another issue is fees. Traditionally, firm’s charge a monthly management fee and a quarterly incentive fee. If the firm is not calculating fees correctly, they may be under or over charging their clients, which in both cases is an issue.
The final option is similar to a managed account with a CTA; however, it is a pooled investment vehicle with other investors and managed collectively via a Commodity Pool Operator (“CPO”). Along with the issues identified above related to CTAs, the main compliance concern related to CPOs is the fact that CPOs collect funds from participants and have complete access to all funds. This is a high area of risk as a CPO can withdraw the funds improperly, making it an easy target for fraud. This must be an area of greater scrutiny with a small firm that may lack sufficient supervisory personnel. As such, proper checks and balances must be in place to ensure proper cash management. One way that firm’s mitigate this is by outsourcing fund management to a fund administrator. While this doesn’t remove the CPO from having full access to the bank account, it does provide an additional layer of protection, as the administrators receive bank statements and can monitor activity.
Diversification is an important part of investing for customer accounts. The options for investing in derivative contracts, including futures and options on futures create extensive opportunities to spread risk over investment portfolios. As with any investment recommendation or investment, an understanding of how the product affects a customer’s portfolio risk is important. Equally important is the understanding the intricacies of the compliance and operational aspects of the products themselves. Proper due diligence, and a considerate approach to all aspects of a product is an essential part of investing in futures and commodities.
Article Written By:
Matthew Reynolds, Director of Financial Services Consulting, McGladrey
Jason Gonzalez, Supervisor, Risk Advisory Services, McGladrey
