Two components often drive the evaluation of an investment decision in the futures world—the viability and strength of a program and the capability of a trader to execute that strategy. Recently, a marketing email from a new manager showed incredible returns, an interesting commodity, and over a year of track record. In short, the type of investment that generates a lot of interest on our site. Upon digging further, I found that the commodity trading advisor did not seem to have any characteristics we would normally use as predictive of success. Much like my grad school professor exhorted when evaluating entrepreneurs, the characteristics of a winning business team can be boiled down to a short list of “must-haves.” We use a similar list before recommending an investment to our clients.
Evaluating Intelligence
We once spoke to an aspiring trader who believed he should be managing millions of dollars. When asked why, he responded, “Because I am really smart.” That might be an accurate statement, but being “really smart” is simply the price of admission into our field. Markets can be cruel, and the only way to make money is to be intelligent and make good decisions. This is especially true when participating in a zero-sum game. How do we identify if someone passes this test? Proven academic performance is one way. Elite schools filter well for natural gifts. Professions, including doctors, lawyers, and engineers, often show promise as technicians. Resumes that include work for successful fund managers, sector-specific experience, or with large commodity providers are welcome. Long, verifiable track records showing consistent gains are another way. Often, we find proprietary traders living off their success for many years before launching a CTA. It is important to know that they own unique insights or can come up with ideas that may be novel to create a sustained edge.
Operational Competence
Once they demonstrate a sufficient level of intelligence, we ask whether they can run their firm properly. This may seem minor once someone demonstrates an ability to trade, but a regulated business is another role entirely. Navigating the day-to-day trade reconciliation, position execution, handling client calls, and processing paperwork can distract from their core role. We maintain that hiring support or working with third parties to offset some of these tasks is critical to early-stage CTAs so they can concentrate on returns. Some spend so much effort on the initial setup that they never even get off the ground. Previous experience running a program, good answers for how they manage their duties, and a history of managing businesses go a long way to answering doubts in this area.
Developing Unique Strategies
Trend following is arguably the most popular strategy within the futures space. It is also very crowded, so standing out can be difficult, especially for a new CTA. It is tough to compete with long track records, a staff of PhDs, a marketing budget, and hundreds of millions (billions) in assets. The best ideas take new approaches to the market. This way, they do not compete with everyone but can chart their unique path. This might mean a specific sector strategy, trading fundamentals when everyone else is using systems, or identifying non-traditional patterns, to name a few. A great idea can mean consistent returns or above-average performance by zigging when everyone else is zagging. Limitations can occur with narrower programs, which may only perform when that market is moving. A solid trader will understand these limitations and need patience to succeed.
Realistic Expectations
Continuing the point above, a manager must be able to view their strategy and the markets realistically. Confidence is needed, but humility is a lesson that is best learned before controlling money for other people. Limitations impact every investment. The adage that “markets can remain irrational longer than you can stay solvent” is truer than ever. Black swan events happen more than we anticipate, and they hit unsuspecting and egomaniac traders the hardest because they did not prepare. A 30% drawdown will end most programs. Similarly, a program that aims for very high returns necessarily comes with the possibility of losses. Everything is a trade-off. Happenstance can be dealt with through risk management, uncorrelated positions, or filters to identify sub-optimal environments. Beware the CTA that ignores these techniques.
Exceptions and Consistent Traits
Exceptions exist to every rule. Many talented traders only have a few of these characteristics or one in spades. This might lead them to a successful proprietary trading career or help them manage their own money well. A few might turn into fantastic CTAs. The four characteristics seem consistent, though.
- Smart
- Capable
- Unique idea or approach
- Realistic expectations
We will evaluate the manager with great returns because the profile looks appealing, but warning bells will ring. People can get lucky for a bit, but that does not ensure they will be great traders. Anyone can win a few bets, but ultimately, the market will determine whether someone has the talent to compete long-term.
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