Real Estate

What is Notional Financing?

Notional funding, for those who don’t know, is the ability to fund your account below face value (fully funded value), but still trade that account as if it were at face value. This is becoming more and more common in the world of institutional investing, with an increasing number of CTAs also offering it. In recent years, with the backing of the NFA and CFTA, even managers are now allowed to quote their performance on this basis (as a percentage return on a fully funded basis, even if it is partially funded).

If, for example, you wanted to invest with a money manager that had a minimum investment of $100K, you could fully fund your account with the $100K or, if notional funding was offered, you could partially fund your account with, say, just $50,000. , but that account is still trading as if it were $100,000. If the manager made 20% in that year, you would have made 20,000 (a 20% gain on a nominal basis), but a 40% gain on a theoretically financed base. Obviously, the same is true on the downside, in terms of proportionally higher 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 given manager, which limits business risk with the manager in addition to FCM/custody risk as the remaining part of its capital would remain elsewhere. . If manager A accepted 20% notional funding on a minimum of $500,000, the investor would only invest $100,000 with 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 core 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% drawdown.

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

This is surely not a new concept; And really, it’s a bit of a strange concept that I think doesn’t always sit well with people intuitively. Chris, I hear you thinking, isn’t all this partial funding the same thing 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 their threads: having the money in your account as venture capital, rather than not really being venture capital to you on an emotional/financial level.

For example, if an investor were to invest in a fund that had a maximum drawdown expectation of 20%, they should be prepared to lose 20% (and realistically a bit more) as it is within expectations. However, if the fund were to shrink to 40% of the same investment, would you really be prepared to lose that much? Most people, I daresay, probably wouldn’t be, especially if they have specific investment expectations up front. They would probably take their account below 20% at some point, as any risk significantly below that would not be acceptable; that is, they are not really treating the vast majority of their account as risk capital at all. If asked, they will likely 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 it all possible for such implements.

Now for the negatives. If you were to invest on a notional basis with a manager, your account would experience significant volatility on a cash basis, significantly increasing both your cash gains and losses. Would you be able to deal with this? Well that’s probably going to be a matter of whether you’re Really treat the investment from a fully funded perspective. For example, if someone invests 20% of the nominal level (say 100,000 again, for a minimum of 500,000), they should Really have 500K, and must Really be following one of the aforementioned strategies with that money. If you have done such things, and that money is actually diversified into protected core/uncorrelated 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 actually only had 100,000 to invest, put it all with the same manager on a 20% cap basis, the volatility could well affect you and ultimately cause you to withdraw the investment prematurely or feel like you lost. all (instead of just 20%) if that account went bankrupt in cash.

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

There’s certainly no right answer to this, since it’s all a matter of preference. Regardless, this should only be considered if you have a firm understanding of the specific strategy you are trading (or will be trading for you). Without the proper margin and drawdown expectations, deciding the appropriate percentage to finance would be a shot in the dark.

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