3:38 AM
Forex Bond
Notional funding, for the uninitiated, the manner in which the account at face value (value fully funded) fund, but still trade barriers, the bill, as if it were on par. This is becoming increasingly common in the world of institutional investors, with an increasing number of CTAs offering. In recent years, with the support of the NFA and the CFTA operators are now also allowed to evaluate their performance on this basis (as a return on a percentagefully funded basis, even if it is partially funded).
If, for instance, you wanted to invest with a money manager that had a minimum investment of 0K, you could either fully fund your account with the 0K, or, if notional funding was offered, you could partially fund your account - say, with only 50K - but still have that account traded as if it was 0K. If the manager made 20% in that year, you would have made 20K (a 20% gain on a nominal basis), but a 40% gain on a notionally Funded system. Obviously the same applies to the downside, given the disproportionately higher volatility. In this case, your account may be funded more than 50%.
What Is FOREX
Institutional investors are becoming more favorable for it since it gives them a limited amount of capital at any time limit is a manager, risk manager with the company next FCM / Custodial, as the remainder of the capital would have been allowed elsewhere. If A accepts responsibility fictionfunding of 20% on a 500K minimum, the investor would only actually invest 100K with manager A, and would be free to use the remaining 0K to diversify with other presumably uncorrelated managers or simply allocate it to principal protected investments. They would still have the upside of a 0K account with that manager, while the downside on that account would strictly be 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 investment program's return/drawdown expectations. It would be insane to fund an account at 20% of the fully funded level (as with the above example) if there was a significant potential for a 20% drawdown, since that would result in a margin call. Therefore, the percentage of the fully funded level allowed by managers is a a function of their drawdown expectations, in addition to margin requirements. Many will offer different levels of funding (20%, 30%, 50%, etc); as a rule, though, the lower the level of funding, the higher potential gains on a cash-on-cash basis, but with a higher risk of margin call.
This is surely not a new concept; and, really, it is somewhat of a strange concept that I think doesn't always intuitively sit well with people. Chris, I hear you thinking, isn't all of this partial funding the same as increased position risk on a cash basis. Yes, it is. That is exactly right, at least in terms of execution, although conceptually it is very different. I believe that Tdion was one of the few to address this in one of his threads - having the money in your account actually being risk capital, rather than not truly being risk capital for you on an emotional/financial level.
For example, if an investor was to invest in a fund that had a maximum drawdown expectation of 20%, he should be prepared to lose 20% (and realistically some more) since that is within expectation. However, if the fund was to drawdown to 40% on the same investment, would he really be prepared to loss that much? Most people, I would venture, probably wouldn't be, especially if they have specific investment expectations ahead of time. They would likely pull their account at some point below 20%, since any risk significantly below that wouldn't be palatable; that is to say, they really aren't treating the vast majority of their account as risk capital at all. If asked, they would likely justify this large cash portion as being there for margin purposes - but, of course, you don't need nearly that much for margin purposes in forex (or commodities), which is what makes all of possible for such instruments.
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 magnifying both your cash losses and gains. Would you be able to deal with this? Well, that is probably going to be a question of whether you are actually treating the investment from a fully funded perspective. For instance, if someone invests 20% of the nominal level (say 100K again, for a 500K minimum), you must actually have 500K, and must actually be following one of the aforementioned strategies with that money. If you have done such things - and that money is truly diversified in uncorrelated/principal protected investments - it would be much easier to perceive the process in the desired way, and potentially be quite profitable with limited risk. On the other hand, if you only actually had 100K to invest, put it all with the same manager on a 20% funded basis, the volatility might well get to you, and ultimately cause you to prematurely pull the investment, or feel that you lost everything (rather than simply 20%) if that account was to go bust on a cash basis.
Further, even if one was treating the process sensibly, and diversified among various managers, you are still banking on correlation between the managers remaining constant (or, if you are doing this as a private investor, the different trading strategies that you diversify with). If, for example, you were with 5 different managers, 20% funding with all of them - if all of the simultaneously went into drawdown (even if the nominal drawdowns were perfectly acceptable), there could be considerable total portfolio volatility.
There is certainly no right answer to this, as it is all a matter of preference. Regardless, this should only be entertained if you have a firm understanding of the specific strategy that you are trading (or will be traded for you). Without the appropriate margin and drawdown expectations, deciding on the appropriate percentage to fund with would be a shot in the dark.
What is Notional Funding?
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