By: Dean Hoffman

Investors who read my previous post on the “problem with past performance”, know that empirical data shows serious flaws with the industry standard methods for choosing Managed Futures programs (Or CTAs). Usually, what most advisors and brokers report is a vast array of historical measures and summaries that have little if any ability to predict future performance.

This begs the question “is there any predictive data available?” The answer, in my opinion, is a resounding yes! Through my work in building predictive CTA models, I have discovered data groups and combinations that are indispensable. One of the most significant of these predictive metrics is the Margin-to-Equity Ratio.

In the coming week, I will start releasing my research showing how and why this is such a weighty measure, and how I combine it with other metrics to help create robust predictive models.

Until then, I will give readers some “teaser” information. In the following graphs, one can see that the Margin-to-Equity Ratio (M/E Ratio) highly correlates to the things that can go terribly wrong when trading, such as the “Worst Drawdown” and the “Worst One Month Performance”. This study includes data from over 350 CTAs since inception who have had at least 6 years of real time performance.

One of the most damaging things that can happen is a quick, violent loss. When losses occur slowly over time one can more easily determine what they want to do, but if those losses occur all at once, there is nothing that can be done. In the following graph, I compare the margin-to-equity ratio with the worst one month losses. The graph shows an overwhelmingly strong correlation between the two.

Margin TO Equity Ratio 2

Not only are high margin to equity ratios highly correlated to quick, violent drawdowns, they also correlate to higher consecutive losses that may occur over a two or three month period.

Margin to Equity Ratio 1

There are substantial risks and conflicts of interests associated with Managed Futures and commodities accounts, and you should only invest risk capital. The success of an investment is dependent upon the ability of a commodity trading advisor (CTA) to identify profitable investment opportunities and successfully trade. The identification of attractive trading opportunities is difficult, requires skill, and involves a significant degree of uncertainty. CTAs have total trading authority, and the use of a single CTA could mean a lack of diversification and higher risk. The high degree of leverage often obtainable in commodity trading can work against you as well as for you, and can lead to large losses as well as gains. Returns generated from a CTA’s trading, if any, may not adequately compensate you for the business and financial risks you assume. You can lose all or a substantial amount of your investment. If you use notional funding, you may lose more than your initial cash investment. Managed Futures and commodities accounts may be subject to substantial charges for management and advisory fees. It may be necessary for accounts that are subject to these charges to make substantial trading profits in order to avoid depletion or exhaustion of their assets. The disclosure document contains a complete description of each fee to be charged to your account by a CTA. CTAs may trade highly illiquid markets, or on foreign markets, and may not be able to close or offset positions immediately upon request. You may have market exposure even after the CTA has a request for closure or liquidation. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

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