Commodity Trading Advisors: Risk, Performance Analysis, and Selection Chapter 13 pps

CHAPTER 13 The Effect of Management and Incentive Fees on the Performance of CTAs: A Note Fernando Diz T his chapter examines the effect of management and incentive fees on the performance and volatility of CTA track records. Evidence of a structural change in incentive compensation is presented that points to a larger reliance on incentive fees as opposed to management fees. Management fees have no relationship to performance. No systematic performance or volatility penalty is suffered by investors by this type of compensation. Incentive fees are found to be positively related to both net of fees returns and volatility. An increase in the incentive fee parameter from 10 percent to 20 percent will increase performance by an average of 6.58 percent per year. The performance increase is net of the effects of leverage and other variables affecting performance. There is also a small tendency for CTAs with larger amounts of assets under management to have slightly better performance. INTRODUCTION This chapter empirically examines the effect of incentive compensation contracts of commodity trading advisors (CTAs) on their performance. The analysis is an extension of Golec (1993) and examines the effects of incentive compensation contracts on the risk and return of CTAs. The contribu- tion of this chapter is twofold. In Golec, the sample used was too small to 248 Partial support for the completion of this study was provided by a grant from the Foundation for Managed Derivatives Research. The author wishes to thank the Foundation for its support, and Sol Waksman for his invaluable comments. c13_gregoriou.qxd 7/27/04 11:30 AM Page 248 draw reliable inferences about the effect of incentive compensation on the risk and return of CTAs. Current events in the money management world associated with manager compensation abuses have heightened the importance of measuring the effects of compensation more accurately. A much larger database than the one used in Golec allows us to measure these effects with less error. The advantages of using a larger database are even more important in view of the structural changes in the composition of total compensation in managed futures, as documented by Diz and Shukla (2003). In addition, this study measures the effects of management and incentive fees on the risk and returns of CTAs more accurately by control- ling for known effects that other very important variables have on these measures of performance (see Diz 2003). CTA COMPENSATION STRUCTURE CTA compensation contracts generally contain two types of fees: a management fee, k m , which represents a fixed percentage of end-of-period assets under management, and an incentive fee, k i , which represents a fixed percentage of investment gains over a year period. The CTA total fee income for period t can be written as: or (13.1) Φ t = kmA t + k i max[0,A t − A t − 1 ] where A t − 1 and A t = dollar value of assets under management at the end of periods t − 1 and t respectively. Defining R pt as the CTA’s portfolio rate of return for one period (t − 1 to t), we can redefine A t as A t − 1 (1 + R pt ). We can then rewrite the total compensation equation as: Φ t = kmA t − 1 (1 + R pt ) + k i max[0,A t − 1 R pt ] (13.2) Equation 13.2 shows the dependence of CTA total compensation on the level of assets under management (A t − 1 ), the one period performance (R pt ), the management fee (k m ), and the incentive fee (k i ). Base compensation is a linear function of the level of assets under management. Incentive compensation is a nonlinear function of performance. Table 13.1 contains summary statistics for the variables included in equations 13.1 and 13.2. The median management and incentive fees for a sample of 974 CTAs over Φ tmt if R pt k i A t A t if R pt kA=+ { ≤ − − > 00 1 0 , () , The Effect of Management and Incentive Fees on the Performance of CTAs 249 c13_gregoriou.qxd 7/27/04 11:30 AM Page 249 this study sample period (1974 to 1998) were 2 percent and 20 percent respectively. Although the management and incentive fees presented in Table 13.1 appear high when compared to mutual funds (e.g., Golec 1993), average monthly returns appear higher than what one finds for mutual funds for the same time period. This is especially telling if one considers that CTA reported performance figures are net of all fees. To date, no study has accurately accounted for all fee-adjusted performance of mutual funds when comparing them to fee-adjusted performance in the managed futures industry. Further, it is a known fact that mutual fund fees have continued to increase and that this increase has not translated into higher returns for individual investors. It is generally acknowledged that higher fees in the mutual fund industry have reduced returns to investors (Trzcinka 1998). Management fees in the managed futures industry have followed a down- ward trend from an average high of 2.81 percent in 1982 to an average low of 1.85 percent in 2002. More of CTA compensation in 2002 came in the form of incentive fees (Diz and Shukla 2003). The results in Table 13.2 highlight the change in the total compensation structure for CTAs. Almost 50 percent of total CTA compensation came from management fees in 1982 while in 2002 only 35 percent of total CTA compensation came from these asset-based fees. Two-thirds of CTA compensation came from performance based fees in 2002. Golec’s study used CTA data from 1982 to 1987. The structural change that is evident in the 1990s is a third reason for review- ing Golec’s (1993) findings. Because the purpose of this study is not to explore the theory of compensation contracting, we refer the reader to Golec (1993) for such a review. 250 MANAGED FUTURES INVESTING, FEES, AND REGULATION TABLE 13.1 Summary Statistics for CTA Management and Incentive Fees, Assets Under Management a Variables, and Returns Variable Mean Std. Dev. Median Q(1) Q(3) Min Max Management fee (%) 2.46 0.013 2.00 2.00 3.00 0.00 6.00 Incentive fee (%) 20.27 0.044 20.00 20.00 20.00 0.00 50.00 Assets (Millions$) 34.68 186.950 1.80 0.50 10.52 0.10 2,954.00 Monthly return b (%) 0.99 0.013 0.94 0.38 1.50 −5.23 10.00 a Assets under management can and often do include notional assets b Reported returns are net of management and incentive fees. c13_gregoriou.qxd 7/27/04 11:30 AM Page 250 What is clear from equation 13.2 is that total CTA compensation is a function of performance (R pt ), the level of assets under management (A t ), and the management and incentive fee rates (k m and k i ). DATA The data used in this chapter consist of individual CTA monthly returns provided by the Barclay Trading Group. The database contains records for 1,253 CTAs and includes both programs that were still listed as of February 1998 as well programs that were delisted anytime from 1975 to January 1998. Of the total 1,253 programs, 798 had been delisted by Feb- ruary 1998. Only 455 programs were listed as of February 1998. Of the 1,253 programs, only 989 (80 percent) reported margin to equity ratios. The Effect of Management and Incentive Fees on the Performance of CTAs 251 TABLE 13.2 Evolution of Management, Incentive Fees, and Total Compensation in the Managed Futures Industry, 1982–2002 Average Average MF as % of IF as % of N Year Management Fee a Incentive Fee a Fee Revenue Fee Revenue 49 1982 2.81 17.14 49 51 71 1983 2.72 17.36 48 52 105 1984 2.83 17.70 48 52 158 1985 2.82 17.46 49 51 202 1986 2.72 17.31 48 52 262 1987 2.73 17.46 48 52 309 1988 2.77 18.09 47 53 357 1989 2.79 19.17 46 54 417 1990 2.71 19.31 45 55 473 1991 2.69 19.68 45 55 562 1992 2.52 19.60 43 57 622 1993 2.40 19.78 42 58 626 1994 2.36 19.83 41 59 582 1995 2.14 20.03 39 61 582 1996 2.15 20.03 39 61 562 1997 2.12 19.99 38 62 536 1998 2.06 20.13 38 62 515 1999 1.98 20.10 37 63 487 2000 1.92 20.21 36 64 459 2001 1.90 20.31 35 65 96 2002 1.85 20.48 35 65 a Management and incentive fees are reported fees. Actual average fees are likely to be lower since these are subject to negotiation. Source: Diz and Shukla (2003). c13_gregoriou.qxd 7/27/04 11:30 AM Page 251 Fifteen programs were eliminated from the sample for various reasons rang- ing from missing observations to duplication. This left us with a sample of 974 programs. Golec’s sample includes only 80 CTAs. The time spanned by the two samples is also worth noting. Our sample spans a period of 24 years starting in 1975 and ending in 1998. Golec’s sample spans only a five- year period from May 1982 to December 1986. Summary statistics were calculated for each CTA in the sample. Table 13.3 provides a summary of the averages for these statistics. The average length of a CTA track record for the sample is about 5.5 years. The longest track record is 23 years and the shortest only 5 months. The average monthly rate of return for the combined CTAs was 1.31 percent and the annual standard deviation of returns for the cross section of CTAs was 26.24 percent. These results are consistent with Brorsen (1998) for his combined CTA sample. Golec’s study reports a monthly average rate of return of 1.35 percent with an annual standard deviation of 11.56 percent. The sample used in this chapter is more similar in size, composition, and performance to Brorsen’s. The average management fee for the sample is 2.46 percent while the same average is 3.96 percent in Golec’s sample. More strikingly, the median management fee for this study’s is 2.00 percent while it is 4.00 percent in Golec’s sample. The average incentive fee for the sample in this study is 20.27 percent while the same average is 16.33 percent in Golec’s sample. The median incentive fee for this study’s sample is 20.00 percent and only 15.00 percent in Golec’s sample. Finally, the average assets under management in this study were $34.68 million compared to $5.01 million in 252 MANAGED FUTURES INVESTING, FEES, AND REGULATION TABLE 13.3 Summary of CTA Average Attributes, February 1974–February 1998, 974 CTA Programs Attribute Mean Std. Error Min Max Months listed 65.14 45.91 5.00 278.00 Average monthly return (%) 1.31 1.34 −3.14 13.47 Margin to equity ratio (%) 19.40 10.58 1.03 100.00 Annual compounded rate of return (%) 12.75 15.14 −47.51 139.00 Annual standard deviation (%) 26.24 18.41 0.79 142.89 Maximum drawdown −0.27 0.18 −0.99 0.10 Management fee (%) 2.46 1.31 0.00 6.00 Incentive fee (%) 20.27 4.45 0.00 50.00 Assets (Millions $) 34.68 186.95 0.10 2,954.00 c13_gregoriou.qxd 7/27/04 11:30 AM Page 252 Golec’s sample. The median amount of assets under management for this sample was $1.8 million versus $1.5 million for Golec’s sample. It is clear from the data that the sample is our study is broader in coverage, size, composition, performance variability, and time span than Golec’s. As such, it is perhaps more suitable to accurately measure the effects of compensation structure on CTA performance. CTA COMPENSATION PARAMETERS AND PERFORMANCE In this section we empirically explore the relationship between CTA returns and the standard deviation of returns to their compensation parameters by replicating Golec’s (1993) analysis. We examined the issue by fitting two ordinary least squares (OLS) cross-sectional regressions on the means and standard deviations of returns of the CTAs on their fee parameters as follows: AROR j = b 0 + b 1 k m + b 2 k i + b 3 ln(A t − 1 ) + e j (13.3) s j = a 0 + a 1 k m + a 2 k i + a 3 ln(A t − 1 ) + u j (13.4) where AROR j = annual compounded rate of return for CTA j s j = annual standard deviation of CTA j returns e j , u j = error terms. Because the distribution of assets under management is clearly skewed, we use the natural logarithm of assets under management as the “size” variable. Significance tests use White’s (see Greene 2000) heteroskedasticity consistent standard errors. Table 13.4 presents OLS estimates of regression The Effect of Management and Incentive Fees on the Performance of CTAs 253 TABLE 13.4 Estimation of the Relationship between Compensation Parameters and CTA Mean Annual Compounded Returns and Standard Deviation of Returns Independent Variables Dependent Variables Intercept k m k i ln(A t − 1 ) Mean Annual Returns −0.255* 0.580 0.693* 0.016* (0.075) (0.583) (0.259) (0.003) Standard Deviation 0.229* 1.424* 0.654* −0.009* (0.057) (0.482) (0.156) (0.003) *Significant at the 1 percent level under H 0 = 0. c13_gregoriou.qxd 7/27/04 11:30 AM Page 253 coefficients from equations 13.3 and 13.4, along with white standard errors in parentheses. The results in Table 13.4 show that cross-sectional variation in mean returns is not related to management fees. This result is in agreement with Golec (1993), and it is good news for investors as it suggests that there are no systematic abuses in management fees that penalize performance. The cross-sectional variation in mean returns also is shown to be positively associated with the incentive fee parameter. This is also in agreement with Golec’s results, and it is also good news for investors because greater incentive fee parameters lead to greater CTA effort or ability that in turn leads to higher performance. If the incentive fee parameter k i were to increase from 10 percent to 20 percent, performance should be expected to increase by 5.8 percent. The magnitude of the increase is roughly half of what was found in Golec and seems like a much more reasonable number. A 10 percent increase in Golec’s study would have accounted for a 1 percent per month increase in performance or more than 12 percent per year, a very large number. It is important to highlight that the performance increase is net of all fees. Other things being equal, a CTA with higher incentive fees is likely to deliver larger performance after fees. We find the amount of assets under management to have a positive effect on performance while Golec (1993) finds the opposite result. Our finding is likely to reflect a known fact in the industry that successful CTAs tend to capture the bulk of assets under management. The amount of assets under management tends to reflect performance. The newly created Barclay BTOP50 Index for managed futures is only a reflection of this known fact. The increase in performance associated with assets under management is not spectacular. An increase in assets under management from $100,000 to $3 billion is associated with a 16-basis-point increase in performance. Although the effect appears to be statistically different from zero, its economic importance is very small. A similar increase in assets under management is associated with a decrease in performance of 71 basis points in Golec. Figure 13.1 illustrates the annual increases/decreases in performance as a function of assets under management found in this study and in Golec (1993). 1 The volatility of CTAs’ track records appears to be positively associated with the incentive fee parameter (Table 13.4). The relationship supports the idea that CTAs who charge larger incentive fees take on larger risks. It also appears that risk taking pays off as viewed from the relationship between mean returns and the incentive fee parameter. The amount of assets under 254 MANAGED FUTURES INVESTING, FEES, AND REGULATION 1 Golec’s results were annualized to make them comparable to the results of this study. c13_gregoriou.qxd 7/27/04 11:30 AM Page 254 management appears to be negatively associated with the volatility of CTAs’ track records. Although the effect is rather small, this result is consistent with Golec’s findings. Golec’s explanation of this empirical observa- tion is appealing. Risk aversion is likely to rise with wealth, and this in turn may induce CTAs to reduce risk levels. Some indirect support for this explanation is found in Diz (2003), where the level of leverage of “surviving’’ CTAs (the larger ones) appears to be smaller. One surprising finding is that management fees appear to be positively associated with the volatility of CTAs’ track records. There is no clear explanation for this finding other than measurement error. Because a substantial amount of relative total compensation is contin- gent on positive performance (incentive fee), common sense and theory suggest that all factors associated with performance have a potential impact on total compensation. For example, Diz (2003) shows that CTAs’ level of leverage is related to performance. CTAs with larger margin to equity ratios tend to have larger returns and volatility. As other variables such as leverage are strongly associated with the performance of a cross section of CTAs, the exclusion of such variables in regression equations 13.2 and 13.3 may substantially alter the size, sign, and level of statistical significance of their The Effect of Management and Incentive Fees on the Performance of CTAs 255 40 20 0 −20 −40 −60 –80 –100 –120 –140 –160 Basis Points Assets under Management 0 5e+08 1e+09 1.5e+09 2e+09 This Study Golec (1993) FIGURE 13.1 Effects of Assets under Management on Average Annual Returns c13_gregoriou.qxd 7/27/04 11:30 AM Page 255 coefficients. In an effort to reduce the omitted variable problem, we fit this augmented model to the data: AROR j = b 0 + b 1 k m + b 2 k i + b 3 ln(A t − 1 ) + b 4 mdd + b 5 me + + b 6 vr + b 7 surv + b 8 Diver + b 9 Syst + b 10 Disc + e j (13.5) s j = a 0 + a 1 k m + a 2 k i + a 3 ln(A t − 1 ) + a 4 mdd + a 5 me + + a 6 vr + a 7 surv + a 8 Diver + a 9 Syst + a 10 Disc + u j (13.6) where: k m = management fee parameter in % k i = incentive fee variable in % ln(A t − 1 ) = natural log of the amount of assets under management in the previous month mdd = maximum drawdown variable (drawdown is defined as the percentage size of an equity retracement) me = margin to equity ratio vr = ratio of “positive” to “negative” volatility surv = dummy variable that takes a value of 1 when the CTA is still in business and 0 when the CTA or program is no longer available Diver = dummy variable that takes a value of 1 when the CTA is diversified and 0 otherwise Syst = dummy variable that takes a value of 1 when the CTA is systematic in trading approach and 0 otherwise Discr = dummy variable that takes a value of 1 when the CTA is discretionary in trading and 0 otherwise e j , u j = error terms The results in Table 13.5 suggest that management fees are unrelated to both the level and volatility of CTA returns. The effect of the incentive fee parameter remains positive and statistically significantly different from zero under the augmented model specification. Moreover, the magnitude of the effect of the incentive fee parameter on the level of returns appears to be the same as in the previous model specification. The robustness of the incentive fee parameter to different model specifications lends credence to the conclusion that CTAs’ incentive fee structure is strongly associated with their level of net returns. Under the augmented model, an increase in the incentive fee parameter from 10 percent to 20 percent will increase performance by an average of 6.58 percent annually. Incentive fees continue to be associated with the overall volatility of CTA track records. Larger incentive fee parameters are associated with 256 MANAGED FUTURES INVESTING, FEES, AND REGULATION c13_gregoriou.qxd 7/27/04 11:30 AM Page 256 larger levels of volatility, although this effect is reduced considerably in the augmented model. The amount of assets under management continues to be associated with the mean level of returns. The effect appears to be of the same order of magnitude in the augmented model. The level of assets under management is unrelated to the volatility of the CTA track record. This is in contrast with Golec (1993), who finds a negative and significant relationship between assets under management and volatility and casts doubts about the existence of any relationship between size and volatility once one accounts for other volatility variables. CONCLUSION This study examines the effect of incentive contracting on CTA performance and volatility. Evidence of structural changes in incentive compensation is presented that points to a larger reliance on incentive fees as opposed to management fees. Management fees are shown to have no relationship with performance. This is good news for investors, as the evidence seems to suggest that this type of compensation results in no systematic performance The Effect of Management and Incentive Fees on the Performance of CTAs 257 TABLE 13.5 Estimation of the Relationship between Compensation Parameters and CTA Mean Annual Compounded Returns and Standard Deviation of Returns, Augmented Specification AROR S Performance Variable Coefficient S.E Coefficient S.E. Constant −0.275** 0.072 −0.076* 0.038 k m 0.790 0.546 −0.183 0.283 k i 0.658** 0.246 0.229* 0.102 ln(A t − 1 ) 0.009** 0.003 −0.003 0.002 mdd 0.186** 0.036 −0.637** 0.029 me 0.300** 0.062 0.247** 0.042 vr 0.051** 0.007 0.060** 0.006 surv 0.078** 0.015 0.034** 0.007 Diver 0.000 0.011 0.008 0.006 Syst −0.009 0.013 −0.001 0.007 Discr 0.004 0.019 0.009 0.011 **Significant at the 5 percent level for H 0 = 0. **Significant at the 1 percent level for H 0 = 0. c13_gregoriou.qxd 7/27/04 11:30 AM Page 257 [...]... average of 6.58 percent per year The performance increase is net of all fees and independent of the amount of leverage used by the CTA The level of incentive fees may play a role in the selection of truly outstanding CTAs Finally, it is shown that CTA size measured by the level of assets under management is positively related with the level of returns The effect is small and likely to be caused by money... INVESTING, FEES, AND REGULATION penalty to investors Management fees are not associated with systematic variation in CTA return volatility, either Both results are in agreement with previous research by Golec (1993) Incentive fees are found to be positively related to both returns and the volatility of CTA returns An increase in the incentive fee parameter from 10 percent to 20 percent will increase performance . CHAPTER 13 The Effect of Management and Incentive Fees on the Performance of CTAs: A Note Fernando Diz T his chapter examines the effect of management and incentive fees on the performance and. Incentive compensation is a nonlinear function of performance. Table 13. 1 contains summary statistics for the variables included in equations 13. 1 and 13. 2. The median management and incentive fees for a sample. regression equations 13. 2 and 13. 3 may substantially alter the size, sign, and level of statistical significance of their The Effect of Management and Incentive Fees on the Performance of CTAs

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