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Notice I-04-02

January 20, 2004

Performance Reporting

Since at least 1987, the Commodity Futures Trading Commission required CTAs to base their rate-of-return (ROR) calculations on the amount of funds on deposit with the FCM. NFA and the industry, on the other hand, have long believed that CTAs should calculate ROR based on the amount of funds committed to trading (nominal account size), since that calculation measures the CTA's trading decisions rather than the clients' cash management practices.

On July 21, 2003, the Commission adopted a core principle approach to CTA performance reporting for partially-funded accounts. The core principle - which is codified in CFTC Rule 4.35(a)(7) - states that CTAs may present the performance of partially-funded accounts in any manner that is balanced and does not violate the antifraud provisions of the CEA or CFTC regulations. The preamble in the release voices strong support for using the nominal account size when calculating ROR for partially-funded accounts, but the rule does not require it.

NFA and the industry believe that CTAs should use a uniform performance calculation so that clients can compare the performance of different managers more easily. As a result, NFA has adopted new Compliance Rule 2-34 and a related Interpretive Notice that require Member CTAs to base ROR on nominal account size. The new requirements are attached to this notice and will become effective on May 1, 2004.

Summary

NFA Compliance Rule 2-34 contains four sections. Section (a) requires CTAs to calculate ROR - including drawdown information - based on nominal account size. It also allows CTAs to include interest earned on actual funds in their performance calculations. The terms "nominal account size" and "actual funds" are defined in Compliance Rule 1-1. In particular, "nominal account size is defined as the account size agreed to by the client that establishes the level of trading in that program, and "actual funds" is defined as the equity in the account plus funds that can be transferred to the account without the client's consent to each transfer (known in the industry as "committed funds").

NFA Compliance Rule 2-34(b) requires a written confirmation for each partially funded account. This confirmation must contain the name or description of the trading program and the nominal account size agreed to by the client and the CTA, and it must be updated whenever that information changes.

NFA Compliance Rule 2-34(c) requires CTAs to provide certain disclosures designed to ensure that clients understand the consequences of partially funding their accounts. The disclosures do not have to be given to clients with fully-funded accounts or to qualified eligible persons.

The final section of the rule requires CPOs to report CTA performance on the same basis that the CTA is required to report it. This will ensure that the performance reported in a commodity pool disclosure document is the same as the performance reported in the CTA's disclosure document.

The Interpretive Notice further explains the requirements in Compliance Rule 2-34. The four sections of the Interpretive Notice are summarized below.

  • The section on "Documenting the Nominal Account Size" describes how the written confirmation can be given and provides the CTA with flexibility in complying with the confirmation requirement.

  • The section on "Disclosure" provides examples of the type and manner of acceptable disclosure.

  • The section on "Actual Funds" provides a test for determining whether funds that are not in the trading account will qualify as actual funds. This test is based on the test for "committed funds" in CFTC Advisory 87-2.

  • The section on "Materiality Standards" provides a materiality test for determining whether accounts can be included in the same performance capsule. This test is based on the materiality standards in CFTC Advisory 93-13 and a 1991 release regarding additions and withdrawals.

NFA Compliance Rule 2-29(b)(5) has been amended to conform to the provisions of new Compliance Rule 2-34. Additionally, Compliance Rule 1-1 has been amended to include definitions of "actual funds," "nominal account size," "partially-funded account," and "qualified eligible person."

Implementation

As mentioned above, the new requirements will become effective on May 1, 2004. The confirmation requirements in NFA Compliance Rule 2-34(b) will apply to all existing accounts, and Members can comply with those requirements by sending clients a "negative consent letter" that requires them to notify the Member if they disagree with the information in the letter. The disclosure requirements in NFA Compliance Rule 2-34(c) will apply to only those accounts opened on or after May 1.

The performance requirements in NFA Compliance Rule 2-34(a) and (d) will be effective for all disclosure documents as of May 1, 2004. CTAs will not be required to restate their previous performance, which means they will not be required to recalculate performance that was calculated using one of the current methods. If the calculations produce significantly different results, however, the CTA should disclose the difference and explain the reason for it in a footnote to the performance capsule.

* * *

Questions about the new requirements can be directed to Mary McHenry, Senior Manager, Compliance, at mmchenry@nfa.futures.org or (312) 781-2237 or to Christine Roche, Manager, Compliance, at croche@nfa.futures.org or (312) 658-6536.


COMPLIANCE RULE 1-1. DEFINITIONS.

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(b) "Actual Funds" - means the equity in a commodity trading account over which a CTA has trading authority and funds that can be transferred to that account without the client's consent to each transfer.

* * *

(t) "Nominal Account Size" - means the account size agreed to by the client that establishes the level of trading in the particular trading program.

(u) "Partially-Funded Account" - has the same meaning as in CFTC Regulation 4.10(m).

* * *

(w) "Qualified Eligible Person or QEP" - has the same meaning as in CFTC Regulation 4.7(a).

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COMPLIANCE RULE 2-29. COMMUNICATIONS WITH THE PUBLIC AND PROMOTIONAL MATERIAL

* * *

(b) Content of Promotional Material

No Member or Associate shall use any promotional material which:

* * *

    (5) includes any specific numerical or statistical information about the past performance of any actual accounts (including rate of return)

      (i) unless such information is and can be demonstrated to NFA to be representative of the actual performance for the same time period of all reasonably comparable accounts and,

      (ii) in the case of rate of return figures, unless such figures are calculated in a manner consistent with CFTC Regulation 4.25(a)(7) for commodity pools and with CFTC Regulation 4.35(a)(6), as modified by NFA Compliance Rule 2-34(a), for figures based on separate accounts, or

* * *

COMPLIANCE RULE 2-34. CTA PERFORMANCE REPORTING AND DISCLOSURES

(a) Performance Information

    (1) Member CTAs must calculate rate of return according to CFTC Regulation 4.35(a)(6) using nominal account size as the denominator.

    (2) Draw-down information reported under CFTC Regulation 4.35(a)(1)(v) and (vi) must be based on rate of return figures using nominal account size as the denominator.

    (3) In calculating net performance, Member CTAs may include interest earned on actual funds but may not impute interest on other funds.

(b) Written Confirmation for Partially-Funded Accounts

    (1) For partially-funded accounts, a Member CTA must either receive from a client or deliver to a client a written confirmation that contains the following information:

      (i) the name or description of the trading program, and

      (ii) the nominal account size agreed to by the client and the CTA.

    (2) For new clients, the written confirmation must be received from or delivered to the client before the CTA places the first trade for the client.

    (3) For existing clients, the written confirmation must be received from or delivered to the client before the CTA places the first trade after any of the information required under Section (b)(1) of this rule changes. The written confirmation must include the new information and the effective date of the change but need not include any information that will remain the same.

(c) Additional Disclosures for Partially-Funded Accounts

CTAs must provide the following information to clients with partially-funded accounts if the clients are not QEPs:

    (1) A statement of how management fees will be computed relative to the nominal account size,

    (2) An explanation of how cash additions, cash withdrawals, and net performance will affect the nominal account size,

    (3) A brief explanation regarding the effect of partial funding on margin and leverage,

    (4) A statement that partial funding increases the fees and commissions as a percentage of actual funds but does not increase the dollar amount of those fees, and

    (5) A description, by example or formula, of the effect of partial funding on rate of return and drawdown percentages.

(d) CPO Use of CTA Performance Information

Member CPOs who are required by CFTC Regulation 4.25(c) to disclose CTA performance must report the CTA performance on the same basis as the CTA is required to report it.

INTERPRETIVE NOTICE

COMPLIANCE RULE 2-34:
Performance Reporting and Disclosures

In July 2003, the Commodity Futures Trading Commission adopted a core principle for calculating rate of return (ROR) for partially-funded accounts. The Commission noted, however, that its core principle approach would not preclude NFA from developing more explicit guidance or performance standards.

NFA's Board of Directors believes that Member CTAs should use a uniform calculation to make it easier for clients to compare the performance of different CTAs. The Board also believes that ROR should be based on the amount that is the basis for the CTA's trading decisions so that ROR measures the CTA's true performance rather than its client's various cash management practices. Therefore, NFA's Board has adopted NFA Compliance Rule 2-34 to provide performance standards for Member CTAs and to require certain disclosures to ensure that clients understand the consequences of partially funding their accounts. The Board has also adopted this Interpretive Notice to provide additional guidance to CTA Members regarding performance reporting and disclosure.

CTAs will not be required to restate their previous performance, although they may choose to do so. As with any other information, however, a CTA must make any additional disclosures that are necessary to ensure that its performance record is not misleading.

Documenting the Nominal Account Size

The Board recognizes a client may elect to partially fund its account by depositing less funds with the FCM carrying its account than the client has directed the CTA trading the account to use as the basis for trading decisions. The Board believes that the nominal account size should be documented to provide "discipline in the denominator" by assuring that the client and the CTA have agreed on the account size before the account begins trading. This documentation will also provide an objective audit trail to verify past performance records.

Compliance Rule 2-34(b) requires the CTA to document the trading program and nominal account size for each client who partially funds its account by either receiving a written confirmation from or providing a written confirmation to the client with the required information. For example, the information could be included in the advisory agreement or delivered to the client as a separate document. Although NFA assumes that most CTAs will receive or provide this confirmation at the same time the CTA enters into an advisory agreement to direct or guide the client's account, NFA Compliance Rule 2-34(b) only requires that it occur before the CTA places the first trade.

The Rule does not require the CTA to get the client's written acknowledgement to a confirmation provided by the CTA, although the CTA may choose to do so. If the CTA does not require a written acknowledgement, the confirmation should inform the client that the client must notify the CTA, within a reasonable period specified in the confirmation, if the client does not agree with the terms included in the confirmation. The confirmation may be delivered in any manner consistent with CFTC requirements for delivery of account statements by commodity pool operators under CFTC Regulation 4.22(i).

Disclosure

Compliance Rule 2-34(c) requires CTAs to provide certain information to clients with partially-funded accounts if those clients are not QEPs. This information is designed to ensure that less sophisticated customers understand the effects of partial funding so that they can make informed decisions when funding their accounts.

Subsection (c)(2) requires the CTA to explain how each element of cash additions, cash withdrawals, and net performance will affect the nominal account size. If these items will not affect the nominal account size, the CTA may make an affirmative statement to that effect.

Under Compliance Rule 2-34(c)(5), the CTA must provide a description, by example or formula, of the effect of partial funding on ROR and drawdown percentages. A CTA may provide this information by example using a simple matrix showing the effect of partial funding at different funding levels. In the alternative, it may provide the client with the formula for converting ROR percentages based on the nominal account size to ROR percentages based on the partial funding level, e.g.:

    (nominal account size / actual funds) * n = a

    where n is the ROR percentage based on the nominal account size and a is the ROR percentage based on actual funds

This same formula may, of course, be used to convert any other information that is given as a percentage of the nominal account size, such as estimated commissions and fees.

The disclosures required by Compliance Rule 2-34(c) can be included in the CTA's disclosure document or the advisory agreement. They can also be provided in a separate document delivered to the client before the CTA places the first trade for the client.

Actual Funds

Compliance Rule 1-1(b) defines actual funds as the equity in a commodity trading account over which a CTA has trading authority and funds that can be transferred to that account without the client's consent to each transfer. Funds that are not in the trading account, often referred to as committed funds, qualify as actual funds only if they meet the following four tests:1

1. The ownership of the accounts must be identical;

2. The funds must be available for transfer (e.g., free credit balances that are not committed to another CTA's trading program);

3. The client must agree in writing that the FCM can transfer the funds to the managed account at the CTA's request; and

4. The CTA must be able to verify the amount of these funds.2

Materiality Standards

As a general rule, accounts in the same trading program will be included in the same composite performance capsule.3 Since Compliance Rule 2-34(a) requires ROR to be calculated on nominal account size, the RORs for these accounts should be materially the same. Accounts with materially different RORs should not, however, be included in the same performance capsule.4

Whether RORs are materially the same may vary depending on the circumstances. However, as long as the accounts are part of the same trading program, the following test provides a safe harbor for determining whether the accounts have materially the same ROR.5

  • If the composite ROR including the account and the composite ROR excluding the account average 10 percent or more, they are materially the same if the difference between the two RORs is less than 10 percent of their average.

  • If the composite ROR including the account and the composite ROR excluding the account average less than 10 percent and greater than 5 percent, they are materially the same if the absolute difference between the two RORs is no more than 1.5 percent.

  • If the composite ROR including the account and the composite ROR excluding the account average 5 percent or less, they are materially the same if the absolute difference between the two RORs is no more than 1 percent.

The primary reason for this materiality test is to objectively demonstrate that each account included in the performance capsule is part of the same trading program. For that reason, the materiality test should use gross trading profits and losses rather than net performance. If a particular account in the capsule has a material effect on the capsule's net performance due to account-specific factors (e.g., commissions or interest), the CTA may continue to include that account in the capsule if it meets the materiality test using gross trading profits and losses.6 However, the CTA should disclose the difference in net performance and identify the factors that are responsible for that difference.

* * * * *

All performance information must be presented in a manner that is balanced and is not misleading. CTAs have an obligation to disclose all material information even if it is not specifically required by CFTC or NFA rules. Compliance Rule 2-34 and this Interpretive Notice do not relieve CTAs of that obligation.


1 These tests are derived from CFTC Advisory 87-2, [1986-1987 Transfer Binder] Comm. Fut. L. Rep. (CCH) paragraph 23,624 (June 2, 1987).
2 Compliance Rule 2-34(a) provides that Member CTAs may include interest earned on actual funds but may not impute interest on other funds when calculating net performance. The CTA must be able to verify the amount of interest earned on the funds if the CTA includes that interest as part of its net performance.
3 Accounts in the same trading program generally have the same pattern of trading.
4 Accounts that use different trading strategies should not be included in the same performance capsule even if their RORs are materially the same.
5 This same materiality test can be used in other contexts. For example, NFA's interpretive notice entitled "NFA Compliance Rule 2-10: The Allocation of Bunched Orders for Multiple Accounts" (paragraph 9029) requires CTAs to modify their allocation methods if accounts in the same trading program have materially different performance results. This is another instance where materiality would be measured using gross trading profits and losses.
6 As with the test for material differences in trading results, whether the account has a material effect on net performance is determined by comparing the net performance of the composite with and without the account.

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