Interpretive Notices

9054 - COMPLIANCE RULE 2-34: CTA PERFORMANCE REPORTING AND DISCLOSURES

(Board of Directors, November 20, 2003; effective May 1, 2004. Revised February 1, 2020 and June 30, 2020.)

INTERPRETIVE NOTICE

I. Introduction

NFA's Board of Directors (Board) 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 rate of return (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 regardless of its clients' 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 clients that explain the effect of partially funding their accounts. The Board has also adopted this Interpretive Notice to provide guidance to CTA Members regarding performance reporting and disclosure requirements for accounts with actual funds that differ from nominal account size, as well as to provide additional performance presentation guidance.

II. Accounts with Actual Funds that Differ from the Nominal Account Size Written Confirmation for Accounts with Actual Funds that Differ from 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. A client may also choose to fund or maintain its account with an amount in excess of the amount the client has directed the CTA to use as the basis for trading decisions. The amount of equity in the client's commodity trading account plus any funds that can be transferred to that account without the client's consent to each transfer is known as actual funds (see NFA Compliance Rule 1-1(b)). The amount of funds agreed to by the client that establishes the level of trading engaged in by the CTA is known as the nominal account size (see NFA Compliance Rule 1-1(x)).¹ The Board believes that the nominal account size should be documented to provide "discipline in the denominator" by ensuring 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 nominal account size and the effect of cash additions, cash withdrawals and net performance on nominal account size for each client with actual funds that differ from the nominal account size by either receiving a written confirmation from or providing a written confirmation to the client with this information prior to the time the CTA places the first trade for the client.² If the CTA is providing the written confirmation, the information may be included in the advisory agreement or delivered to the client as a separate document as long as the written confirmation is provided to the client before the CTA places the first trade for that client. If any changes are made to the client's trading program, nominal account size or the way in which cash additions, cash withdrawals or net performance affect nominal account size, a written confirmation describing these changes must be provided to or received from the client prior to the CTA placing any new trades for the client. In the absence of a written confirmation designating a nominal account size, performance returns must be based upon the amount of actual funds.

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).

Additional Disclosure for Partially-Funded Accounts

Compliance Rule 2-34(c) requires CTAs to provide certain information to clients with partially-funded accounts if those clients are not QEPs. These additional disclosures are designed to provide information to clients on the effects of partial funding on net performance, fees, margin and leverage so that they can make informed decisions when funding their accounts

Subsection (c)(4) requires CTAs to provide a description, by example or formula, of the effect of partial funding on ROR and draw-down percentages. A CTA may provide this information by example using a simple matrix showing the effect of partial funding at different funding levels as illustrated by the following matrix:

Rates of Return Based On Various Funding Levels

In the alternative, a CTA may provide the client with the following formula, which converts ROR percentages based on the nominal account size to ROR percentages based on the partial funding level:

(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

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.

II. Other Performance Reporting Guidance

Actual Funds

Rule 2-34(a)(3) provides that CTAs may include earned interest on actual funds in calculating net performance but may not impute interest on other 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 if they meet the following four tests:

1. The ownership of the trading account and any other accounts holding funds available to the CTA for trading must be identical;

2. The funds must be available for transfer to the client's trading account (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 may transfer the funds to the client's managed account at the CTA's request; and

4. The CTA must be able to verify the amount of these funds.³

Composite Performance Reporting

Compliance Rule 2-34(a) requires RORs to be calculated on nominal account size. As a general rule, accounts in the same trading program should have materially the same ROR and should be included in the same composite performance capsule.⁴ Accounts that have similar RORs but are traded differently are not considered to be in the same trading program and may not be included in the same composite performance capsule.

Whether RORs are materially the same may vary depending on the circumstances. However, accounts that are part of the same trading program that meet the requirements of the following test generally will be considered to have materially the same ROR:⁵

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

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

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

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. However, the CTA should disclose the difference in net performance and identify the factors that are responsible for that difference.

There may be instances in which a population of the accounts included in a CTA's composite performance capsule appear on their face to meet one of the materiality tests described above on an account by account basis, but due to material differences in the nominal size of these accounts they serve to distort the overall performance of the composite. As a result, the ROR of the composite performance is not representative of the actual ROR experienced by a majority of the other accounts. In such instances, the population of accounts with nominal sizes that materially differ from the nominal size of the majority of the accounts should be composited separately.

Additions and Withdrawals

Large additions and withdrawals during the reporting period may distort ROR. If they do have a material effect, however, the CTA must use an approved method to minimize the distortion. Appendix B to Part 4 of the CFTC's Regulations describes two methods that CTAs may use to adjust for additions and withdrawals when calculating ROR: the compounded rate of return method and the time-weighted method. These methods are available to all CTAs under the terms described in Appendix B of Part 4 of the CFTC's Regulations.

CTAs may also use a third method - the only accounts traded (OAT) method - that adjusts for additions and withdrawals by temporarily excluding certain accounts when calculating ROR.⁶ This method can be used if the following conditions are met:

1. As with any performance information, all of the accounts are part of the same trading program;

2. Excluding the accounts does not result in the systematic exclusion of any material costs (e.g., accounts with withdrawals or that are closed during the reporting period must be included in ROR if there is a significant fee that is only charged when funds are withdrawn or accounts are closed);

3. Only accounts that meet one of the following requirements are excluded:

• The account was opened during the reporting period,

• The account was closed during the reporting period,

• The account had no open positions and did not trade during the reporting period because it has not yet been approved for trading or because during the reporting period the client intended to close the account and then closed the account shortly after the reporting period ended,⁷ or

• The net additions and withdrawals in the account exceeded 10% of the beginning net nominal account value for the period for that individual account;

4. Use of this method does not produce an ROR that is materially different from the ROR expected to be produced by either the compounded rate of return method or the time-weighted method over time; and

5. The method does not exclude a significant percentage of the accounts in the trading program.

In general, the CTA should use one method consistently provided that it results in an ROR calculation that accurately and reasonably represents the ROR. The CTA should use this method except where the method would produce results that are materially different from the actual experience of accounts in the trading program,⁸ in which case the CTA should use one of the other methods described above that better reflects the actual experience of accounts in the trading program. The CTA must disclose the method that is consistently used and, if the CTA uses a different method for a particular reporting period, the CTA must disclose the method actually used for that reporting period and describe why that method was used.⁹

CTAs may use any of these three methods without obtaining prior approval from NFA or the CFTC. Pursuant to Appendix B to Part 4 of the CFTC's Regulations, a CTA may use another method of addressing the effect of additions and withdrawals on the ROR calculation if the CTA submits a proposal to the CFTC, prior to use, that demonstrates that the alternate method provides an accurate picture of the CTA's ROR and is more appropriate for that CTA.

Exception to Compounded Returns

CFTC Regulation 4.35 requires that the annual ROR, the peak-to-valley draw-down percentage and the net lifetime ROR be computed on a compounded monthly basis. However, for programs where net performance does not affect the nominal account size, and therefore profits are not reinvested, the CTA must sum the monthly performance returns instead of compounding them when calculating the annual return, the peak-to-valley draw-down percentage and the net lifetime ROR.

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 Another term often referred to in discussing partial funding is notional funds. Notional funds represent the difference between nominal account size and actual funds in a client's account.

² If cash additions, cash withdrawals and net performance will not affect the nominal account size, the CTA must provide in the written confirmation an affirmative statement to this effect.

³ 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.

⁴Accounts in the same trading program generally have the same pattern of trading.

⁵ This same materiality test can be used in other contexts. For example, Interpretive Notice 9029 – NFA Compliance Rule 2-10: The Allocation of Bunched Orders for Multiple Accounts 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 The accounts can only be excluded when calculating ROR. They must be included in the CTA's capsule performance for other purposes, including reporting of total assets under management.

⁷ An account that was open for the entire reporting period and had open positions or trading activity during the reporting period cannot be excluded even if it has not yet caught up to the performance of the other accounts in the program (unless its net additions and withdrawals exceeded 10% of its beginning net nominal account value for the period). An account with a trading pause cannot be excluded solely because of the trading pause, especially if the program dictated the trading pause. If the trading pause results from client-imposed restrictions that cause the account to be idle or traded differently from the other accounts in the trading program the account may belong in a different performance capsule.

⁸ These instances should be rare. If the CTA's principal method frequently produces results that are materially different from the actual experience of accounts in the trading program, the CTA should change to a more consistent method.

⁹ This information should be included in a footnote to the performance capsule. If the trading program experienced an unusual change in the number or size of additions, withdrawals, accounts opened, or accounts closed during the reporting period, the CTA should also highlight that change in a footnote and should describe the reason for the change, if known.