HOME > What is notional funding?
Notional funds, or notional funding, is in its simplest terms, the ability to use "imaginary money" to fund an investment in a CTA program or trading system investment. Whether there was some legal issue way back when, or whether the term "imaginary money" didn't sit well with most people - the term "notional funds" is commonly used in its place to describe this practice.
What do we mean by imaginary money. Well, a quick example is probably the easiest way to describe it. Say you have a CTA program which has a minimum investment amount of $1,000,000 in its disclosure document. An investor does not actually have to have all $1,000,000 in her account in order to trade the program. Levels of notional funding vary between managers, but for this example, we'll assume this hypothetical manager allows clients to use 50% notional funding.
That means the investor only has to have $500,000 in her account, and can meet the minimum investment amount by pledging an additional, "imaginary" amount of $500,000. The actual cash balance plus the "imaginary", or notional, balance equals the required minimum investment amount of $1,000,000. Another way to think of how this works is to imagine having that $500,000 account, but telling the manager to trade is as if it was $1,000,000. That is in effect what an investor is doing with notional funding.
To understand how an investor can use these imaginary, notional funds, we must first back up a step and understand how an advisor's minimum investment amount is arrived at. Minimum investments could, or perhaps should, be further split up into three distinct levels, specified as
1. the technical minimum amount needed to actually place the trades on the exchanges
2. the amount for an investor to withstand any eventual drawdown of the investment
3. the amount to make the percentage returns fit into generally accepted levels
1. Technical Amount: The first part of the minimum investment amount - the amount technically needed to place trades - is what the exchanges and clearing firms refer to as the margin requirement. Any account which wishes to trade a futures contract on a regulated futures exchange like the Chicago Mercantile Exchange must first have enough money in the account to cover the performance bond requirement of the exchange (the margin) This insures that the exchange can make the trader who takes the other side of the trade good should the trade go against the account. Margins can sort of be thought of as the amount of money which could be lost on that position in a single day - and the exchanges and clearing firms make sure each account has that much money - or else the whole system doesn't work. If this wasn't in place, where would a winner get her winnings from - the loser could disappear.
2. Drawdown Amount: The second part of the minimum investment amount - the amount an investor needs to withstand any eventual drawdown - is another technical level of sorts, on that we must have at least that amount in order to stay above zero. If the investment has the possibility of losing $150,000, for example, in the normal course of operation - than an investor better have at least that amount in order to proceed. If they didn't, they would have to get out of the investment during the normal ups and downs of the investment. Think of it like a tank of gas. If your driving 100 miles and need 5 gallons of gas to get there - you better have at least 5 gallons of gas in the car - or else you'll never get there. What we general recommend is notional levels at 33% only, which means trading at 1.5 times already.
3. Window Dressing Amount: The third part of the minimum investment amount - the amount needed to make the percentages appealing to potential investors, or "window dressing" amount - is simply a subjective amount the advisor computes in order for the average returns and risk of his or her program to come out "nicely", for lack of a better term. Imagine an advisor with average annual returns of $100,000 and drawdowns of $50,000. If that advisor sets his minimum at $100,000 - the average annual return in percentage terms is 100% with a 50% drawdown; while if the advisor sets his minimum at $1,000,000 - the average annual return in percentage terms is 10% with a 5% drawdown. While the returns in dollars are exactly the same, the advisor may want to use the $1 Million minimum amount because he finds the 5% drawdown number catches peoples attention more. The difference between the desired minimum and the minimums needed for margin and drawdown is the window dressing amount, and it is often this amount which can be "notionallized"."
Sophisticated investors who can handle having 3 to 4 times the percentage gains and losses ask what the margin to equity ratio is (a ratio of the technical margin requirement to minimum required capital) to back out the technical amount needed, than look at the worst max DD to come up with the bare bones minim um they need to invest in a program. The advisors also provide this number, however, in their D-Docs, defining what notional levels they will accept. Notional levels of funding usually range from 25% to 75%.
Now come the fun part. The cost of doing this is zero. There is no interest rate charged on the notional amount like you have in the stock market when buying shares on margin or when buying a house with less money down. Only difference is....THIS IS FREE MONEY"