Real Estate

What is notional funding?

Theoretical financing, for those of you who don’t know, is the ability to fund your account below its face value (fully funded value), but still trade that account as if it were at face value. This is becoming increasingly common in the world of institutional investing, with a growing number of CTAs offering it as well. In recent years, with the backing of the NFA and CFTA, managers can now even quote their performance on this basis (as a percentage of performance on a fully funded basis, even if partially funded).

If, for example, you wanted to invest with a money manager who had a minimum investment of $ 100K, you could fully fund your account with the $ 100K or, if notional financing was offered, you could partially fund your account with, say, only 50K , but you still have that account traded like it’s $ 100K. If the manager earned 20% in that year, you would have earned 20K (a 20% profit on a nominal basis), but a 40% profit on a theoretically funded basis. Obviously, the same is true on the downside, in terms of proportionally increased volatility. In this case, your account would be considered 50% funded.

Institutional investors have been increasingly favorable to this as it allows them to have a limited amount of capital in any manager, limiting business risk with the manager in addition to FCM / custody risk, as the remaining portion of its capital would be kept elsewhere. . If manager A accepted 20% notional funding on a minimum of 500,000, the investor would only invest 100,000 in manager A and would be free to use the remaining $ 400,000 to diversify with other presumably uncorrelated managers or simply allocate it to protected primary investments . . They would still have the advantage of a $ 500K account with that manager, while the disadvantage of that account would be strictly limited to 100K, which in this case is the equivalent of a 20% reduction.

Obviously, the feasibility of such a strategy presupposes having a clear understanding of the return / reduction expectations of the investment program. It would be crazy to fund an account at 20% of the full capitalization level (as in the example above) if there was significant potential for a 20% drawdown, as that would lead to a margin call. Therefore, the percentage of the fully funded level allowed by managers is a function of their reduction expectations, in addition to margin requirements. Many will offer different levels of financing (20%, 30%, 50%, etc.); However, as a general rule of thumb, the lower the funding level, the higher the potential cash earnings on a cash basis, but with a higher margin call risk.

This is surely not a new concept; And actually, it’s a somewhat strange concept that I don’t think people always intuitively feel good about. Chris, I hear you thinking, isn’t all this partial funding the same as increased cash position risk? Yes it is. That is exactly correct, at least in terms of execution, although conceptually it is very different. I think Tdion was one of the few to address this in one of his threads: having the money in your account as risk capital, rather than not really being risk capital to you on an emotional / financial level.

For example, if an investor was going to invest in a fund that had a maximum reduction expectation of 20%, they should be prepared to lose 20% (and realistically a little more), as it is within expectations. . However, if the fund were reduced to 40% of the same investment, would you really be willing to lose that much? Most people, dare I say, probably wouldn’t be, especially if they have specific investment expectations ahead of time. They would probably pull their account at some point below 20%, as any risk significantly below that would not be acceptable; that is, they are not really treating the vast majority of their account as venture capital at all. If asked, they are likely to justify that this large chunk of cash is there for margin purposes, but of course you don’t need that much for margin purposes in forex (or commodities), which is what makes the whole thing. possible for such instruments.

Now for the negatives. If you were to theoretically invest with a manager, your account would experience significant volatility in cash terms, significantly magnifying both your losses and your cash gains. Could you deal with this? Well that will probably be a question of whether you are Really Treat the investment from a fully funded perspective. For example, if someone invests 20% of the nominal level (say 100K again, for a minimum of 500K), they should Really have 500K, and must Really be following one of the aforementioned strategies with that money. If you’ve done such things, and that money is really diversified into uncorrelated / principal-protected investments, it would be much easier to perceive the process the way you want and potentially quite profitable with limited risk. On the other hand, if you only had 100K to invest, put it all with the same manager on a 20% funded basis, volatility could hit you and ultimately cause you to withdraw the investment prematurely, or feel like you’ve lost everything (instead of just 20%) if that account was going to go bankrupt in cash.

Also, even if you were treating the process sensibly and diversified across multiple managers, you are still relying on the correlation between managers to remain constant (or, if you’re doing this as a private investor, the different business strategies you diversify with) . If, for example, you were with 5 different managers, 20% financing with all of them, if they all went into reduction simultaneously (even if the nominal reductions were perfectly acceptable), there could be considerable total volatility of the portfolio.

There is certainly no one correct answer to this, as it is all a matter of preference. Regardless, this should only be considered if you have a firm grasp of the specific strategy you are trading (or will trade for you). Without the proper margin and downside expectations, deciding the appropriate percentage to fund with would be a shot in the dark.

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