Gaining Leverage with Notional Funding in Managed Futures

Notional funding is simply an agreement a client has with a Commodity Trading Advisor (CTA) to trade his or her managed futures account at a level beyond the amount of cash deposited. The amount above the cash deposited to the adjusted trading level is called notional funds.  For example, an investor could open a managed futures account with $200,000 in cash on deposit and request that a CTA trade it like a $300,000 account. The $100,000 difference is the notional funding. That is a simple summary, but it requires greater explanation so investors can understand the benefits and dangers of using notional funding. 

Why is Notional Funding Available?

CTAs will typically only use a small percentage of the investor’s account for margin requirements at any given time. All CTAs are unique, but 10-20 percent of the cash in the account is about average for margin usage. Someone new to futures trading might think it makes sense to be fully invested at all times, but most experienced traders know all too well that the leverage in these markets can be very dangerous. That means a trader has to balance the amount of risk with the potential increase in returns.

Here is a good way to look at this.  A CTA might average 10 percent annual gains with 5 percent average annual drawdowns.  Assume the CTA uses 10 percent of funds for margin on average.  If the CTA were to move margin up to 50 percent, the average gains could be about 50 percent and the average drawdowns could be about 25 percent.  The 50 percent gains look great, but what if an investor got in just before the 25 percent drawdown? 

Most investors don’t want to see a 25 percent drawdown and institutional investors certainly don’t like to see it. The problem with this is twofold. The first issue is that most investors tend to shy away from CTAs that have 25 percent drawdowns. The second is that the investors who are currently with the CTA program will question the volatility and maybe the validity of the program if they see large drawdowns. A rule of thumb is that institutional investors don’t like large drawdowns and individual investors will typically have a hard time stomaching 25+ percent drawdowns. This is the reason why CTAs dial back the amount of leverage they use on the trading accounts, as it makes a track record more marketable.

For these reasons, CTAs will try to find the optimal mix between trying to achieve above average returns and keep drawdowns as small as possible. This is the recipe CTAs use to attract and retain investors. They also set minimum investment levels for investors and structure their trades based on a certain level of equity in an account. Notional funding allows investors to make the decision to increase the level of risk based on their risk tolerance levels.  However, CTAs have parameters on how much notional funding they allow for their investors, as it could ultimately be detrimental to their program if they allow too much leverage. It’s important to note that notional funding can’t be used to stretch an investor into a program they couldn’t afford to invest in outright.

How Much Notional Funding To Use?

This is up to each individual investor when it comes to managed futures. A CTA must first decide to either allow for notional funding or not. If the CTA allows then, if appropriate for the investor and the account type, the investor can set any percent up to the maximum allowed by the CTA.

It is a matter of doing the math and figuring out the appropriate comfort level of risk and drawdowns from an individual investor perspective.  Commodity brokers can lend some great expertise here.

Pros and Cons of Notional Funding

Pros: The main benefit of notional funding is that it can increase returns for investors without the requirement of adding funds to the account and there are no additional loan or interest charges.

Gaining leverage on the account is fairly simple, as it is a matter of just sending written authorization to the CTA to add or increase the amount of notional funding. Of course, the CTA will have to approve the request and it will have to be within program parameters.   

It can also be easier to qualify for a minimum account level if the CTA allows notional funding. For example, an investor may be able to fund a $100,000 minimum investment with $75,000 for example. Some might be more or less.

Cons: The biggest negative to consider is that the losses on the account will be magnified by using notional funds. For example, if an investor takes advantage of 50 percent notional funding and the CTA has a drawdown in the account of $10,000 on a $100,000 account that would now result in a 20 percent drawdown, since only $50,000 was originally invested. Investors need to realize and accept that leverage works both ways – profits and losses.

A CTA will likely charge a management fee based on the trading level, which includes the notional funds.  There may also be more trades with notional funding and that can increase the commissions and fees on the account.

How Does a CTA Make Changes in Trading with Notional Funding?

The CTAs have criteria for position sizing based on the minimum account levels.  They usually have risk criteria on each trade and will place orders based on the amount of funds in each account. For example, A CTA might place a trade for 1 crude oil futures contract for every $50,000 in an account. If a client has $100,000 in the account, the CTA would place an order for 2 crude oil futures contracts. Now, if the client is using an additional $50,000 in notional funding (now traded as if it is a $150,000 account), the CTA would place an order for 3 contracts.

That is mainly the changes the CTA makes to a trading account when notional funding is used. Each CTA is unique and may have slight variations in trading based on different levels of account sizes.

Bottom Line

Notional funding can be a great tool for managed futures investors if used properly.  It is great to think about increasing returns without adding more cash to the account and not have to pay interest changes. However, the impact can often be more painful on the downside when investors see their drawdowns increased.

Investors would benefit from researching the typical returns and drawdowns of the CTAs in which they might want to invest. If they want to add notional funding to the program, then the percentages should be revised to reflect the new rate of leverage. This will give investors clearer picture of the expected returns and risks. Also remember that past performance is not necessarily indicative of future results. Drawdowns can also be larger in the future than they have been in the past as well, which should be taken into consideration.  Notional funding is not appropriate for all investors.