Tips for Future Money Managers: Notional Funds
In the world of institutional money management you can’t afford to have anywhere near the volatility in your returns that you might on your own account at a retail trader. For example a top hedge fund would look to wind down trading if they were down more than 2% for the month.
In-fact Michael Platt of the hedge fund Bluecrest, is quoted in the book Hedge Fund Wizards, as saying he will cut a traders allocation in half if they lose 3% of their core capital in a year. If they then lose a further 3%, they would be out of a job (for a maximum loss of 4.5% of core capital).
As discussed in the last article typically this means that you would need to reduce the risk on your positions to something like 0.1% for short term trades, or 0.5% on long term positions.
But using this type of money management approach on a retail account might not be all that practical. Yes, you may be able to display that you can manage risk effectively (which is a tick in the box), but you might not attract much interest if you return 12% on a 10K account for the year.
So what’s the answer? Use notional funds.
What are notional funds?
Notional funds is when you fund an account below its full value.
For example you might have 10K in your account, but you trade it like you have 50K. You base your risk management and position sizing off of a 50K account, even though you only have 10K in you actual trading account.
This means you get to display both your knowledge of risk management, and your ability to trade with some size and handle the pressure of having money on the line.
Notional Funding is common practice in institutional money management
Notional funding is actually a very common practice in institutional money management.
Investors in funds want to be efficient with their capital, so they will often use a notional amount of funding. For example they may put 5 million with the fund, but have the fund trade it like its twenty.
It’s good for you as a trader to understand this it gives insight into how investors think. As mentioned its volatility of returns that are important as well as real returns, and notional funding is one of the main reasons why.
How to use notional funds without breaking the bank
This is all good, but you don’t want to necessarily throw 10k in an account and then trade it like its 50 or 100K.
The problem with this is that even if you risk 2% of your notionally funded 100K account a month, it could leave you with 2K hole in your real money account.
What I suggest you do it take it slow, and start by not using any notional funds for the first 1-2 months. Once your account is in profit then you can risk the profits (i.e. by using markets money) to trade a larger notional size. For example if you are up $500 after the first two months you can then trade a 25K notional account (risking the $500 you have made). If you have a losing month, then you can go back to trading a smaller size again and repeat the process.
The benefit of this approach is it shows that you know how to protect your core capital, but that you are willing to trade with size when things are going well. This will help get your into seed funding programs to start your money management career.
How to run your risk management if you want to be a money manager
There is a lot more access to funding programs and opportunities for retail traders to make the transition to managing money these days.
But if you do want to make the switch, the powers that will assess you will be looking very closely at your risk management, and sorry to say, the way you are doing it now is not likely to cut it.
The good news is that if you do understand the principles of hedge fund risk management, you will not find it difficult to adjust your trading to fit. You don’t need to master any fancy algorithms, you just need to know the right concepts so you can apply them – in this case knowledge truly is power.
If you are not interested in managing money, then you will still get a lot of value out of understanding how the elite world of hedge funds view Forex risk management… so don’t disappear yet.
Eliminate Wild Swings
I was discussing this topic with a with a friend of mine who is the principal trader for a hedge fund (who must remain unnamed at this point in time) and one of this comments that struck me was:
“If you drop 5% very quickly, you will be out the back door never to work again”
For a retail trader this may seem quite shocking. You have probably been taught its ok to risk 1 or even 2% of your account on a trade. If you do this then a rapid 5% drop is almost inevitable.
Instead if you are an institutional money manager, you would be trading much smaller sizes. Your core concern when managing risk is to remove volatility from your returns. To do this you would be risking less of your account per trade. For a short term trade this means you may only risk 0.1 to 0.25 % of your account. Or for a medium term trade you might risk only 0.5%.
For example, if the price goes against you and hits your stop-loss you would only lose 0.1 to 0.25% of your account. It’s important to note that this risk is irrespective of how far away your stop-loss is. If you have a 100 pip stop-loss you would lose the same as if you have a 10 pip stop-loss by adjusting the size of your position.
Use different ratios.
Further to the point above about limiting volatility, if you are looking to manage money your investors will look at your Sharp and Sortino ratios. These ratio’s measure your risk adjusted returns, which is of more interest to investors.
It’s the size of the drawdown relative to your profits that matters. I.e. smooth growth of your equity curve. One of the best ways to measure this is to use Jack Schwager’s Gain to Pain ratio (there’s some homework for you). Schwager’s ratio is good because it takes does not punish traders for large upside gains, like the more common Sharp ratio can.
A consistent 1% a month gain would put you in the top 10 funds globally
Did you know that if you were able to return a consistent 1% a month over the last 6 months or so, you would be in a top ten FX hedge funds in the world?
Of course, this 1% a month would need to come with very limited drawdowns.
Why would institutional investors be interested in 1% a month returns you ask?
It all comes down to leverage.
An institutional or high net worth investor will quite happily use leverage to turn that 1% a month return into 4% a month by applying leverage to the investment.
Can you see now why limited drawdowns are so important? If you are using leverage to boost returns you can’t afford to give money to a trader or fund that where you might wake up one morning and suddenly they are down 3%.
That 3% loss on 4 times leverage gives you a loss of 12%, and investors would go running for the hills if that happens.
This is a quick overview
There is a lot more to cover on this subject, so stay tuned for more.