Unique to futures, notional funding is an investor’s ability to use hypothetical money in order to fund an account within a managed futures or CTA program. Notional accounts can only be utilized by investors who meet specific requirements set forth by the CTA program in which they’re participating.
Let’s review an example of a notional funding scenario:
If you have an account with a CTA program whose disclosure document states that the account has a nominal minimum investment requirement of $500,000 (nominal meaning the full minimum amount), you do not actually have to have the full $500,000 amount in the account in order to trade.
While notional funding amounts vary from one manager to the next, in this example we’ll imagine that 50% notional funding is allowed.
This means that the investor only has to have $250,000 in actual money in the account while pledging $250,000 of notional money. The actual cash amount plus the notional amount equals the nominal minimum investment amount required.
So, the formula we’re working with here is nominal – notional = actual.
Another way to describe notional funding is to envision having $250,000 in actual cash while asking the fund manager to trade as if it were $500,000.
Leverage and Risk
The same number of trades placed in a fully funded account can be placed in a notionally funded account. This increases the account’s margin/equity ratio.
The benefit of notional funding is that it provides an investor with increased leverage, however, this leverage also means that the profit/loss risk potential of the account is increased. If an account fully funded at $500,000 experienced a 2% profit or loss, then by this logic, an account notionally funded at $250,000 would experience a 4% profit or loss.
Notional Funding Costs
There is no interest rate charge to notionally funded accounts like there are in equity markets when buying stock shares on margin. With notionally funded accounts the program advisor will typically take a flat percentage of the nominal account for their management fee, plus a performance fee percentage.
So, how is the minimum investment amount determined?
A minimum investment is arrived at by the consideration of three points: The technical minimum required to place trades on the exchanges, the amount the investor can withstand on the investment in the event of a drawdown, and the amount needed to ensure that the returns are attractive to investors.
Some investors choose to capitalize on their leverage by adding new CTA program accounts or additional allocations to their existing CTA account, and as they realize returns they use the profits to cover their minimum technical amount.
Notional funding is a leveraging feature unique to managed futures accounts which can result in attractive returns. It has become a common offering in the institutional investment space, with an increasing number of CTAs offering the ability for investors to notionally fund accounts.
Additionally, the CFTC and NFA allow CTAs and managers to quote their performance on the basis of partially funded, or notionally funded, accounts.
For more information on managed futures or to learn more about your specific notional funding options, visit RMB Group at www.rmbgroup.com or call toll free 800-345-7026.