The 7 big questions about Alternative Investments

In the current market, the search for a decent return is driving more people to consider alternative investments. One attractive option is the Foreign Exchange Managed Account. The reason this has become popular is the potentially highly attractive returns generated by using a leveraged account.

However, like any investment, there are pitfalls to avoid and taking your time to research the underlying system and strategy is critical.

With returns north of 100% per year available it is easy to get caught in the headlights of superb returns without really understanding the risks involved. So to help you understand it all, here we explore some of the key considerations with our 7 big questions about Alternative Investments…

1. Is the trading strategy purely technical, fundamental or a mixture?

With the rise of retail trading platforms comes a myriad of potential systems promising the holy grail of returns. Like everything in life though, if it sounds too good to be true, it usually is. Ensure whichever strategy you choose has a good fundamental reason as to why it works.

Purely technical systems are often curved-fitted to the most recent market conditions. That is not to say these won’t generate a great return, but they are more likely to be time limited. Instead, systems developed on the principals underpinning the markets often have the longest survival rates and although short-term returns may be compromised, its longevity and ability for longer term compound returns can greatly improve your total return.

The financial markets are built on principals of supply and demand, after all the markets are purely a reflection of various opinions of an underlying fair value and orders to move price towards that fair value, so all great systems will be able to link the underlying market principals to explain why the system works.

2. Is the trading strategy fully automated, semi automated or trader dependent?

All of these have positives and negatives associated with them. For instance, a fully automated system has less potential associated to a trader losing his nerve, or the emotions of proprietary trading which can be extremely stressful. That said, fully automated systems can be let down by their inability to really judge fluctuations and changes in market conditions.

The key to this is really understanding how the manager or the group have used the automation or lack of automation to their understanding, ask the questions about why they chose that method and what its positives and negatives are. A good manager will be able to explain them to you.

3. What is the equity position? Does it leave open positions or does it close out positions?

A lot of managed account horror stories in foreign exchange relate to what is referred to as dangling positions. Many strategies and systems hide their true performance by not showing open position P&L, or the true equity position by showing only the booked profits. This is a major pitfall.

Always ensure you can see the equity curve of the system, if it keeps open losing positions it has a higher chance of blowing up. The best systems will book losses early and let profits run and although the return curves may therefore look more volatile, they are actually far safer at generating higher than average returns.

4. What leverage does it have?

Forex is designed to be a highly leveraged system, although you will find many systems stating they use accounts with 100 to 1 leverage or even up to 500 to 1 leverage, the key is to understand the true implied leverage of the account.

Although it may be run on 100 to 1 leveraged account, if it is only using 5% of the available margin it is actually running a significantly reduced implied leverage. At the top end, funds managing hundreds of millions implied leverage will typically be less than 5 to 1 and normally 1 to 1.

This does reduce the potential returns but does offer a more consistent return with far less variance, however the thing to understand is that although your potential returns are increased with leverage, so are your potential losses.

5. What is the draw down?

Typically highly leveraged systems have large potential draw downs. In the search for returns you have to take more risk and this in turn leads to large potential for draw downs. Anything up to 50% is possible on some of the best managed accounts, so the key here is to understand the potential for a draw down and build this into your own expectations.

Typically many managed accounts will require a synchronization period where an initial draw down is possible, but don’t let this put you off if you have the personal risk tolerance to accept it.

6. Is the strategy based on sound market understanding and knowledge?

Would you buy a house or a car without asking lots of questions about its location, running, service history or without getting a survey done? I sincerely hope not. So why should your investment be any different?

The key here is to test the knowledge of the managers and the team. Make sure you ask, how was the strategy developed and built over time? Has the strategy been built on fundamental principals on how markets work? Or is this a purely technical system?

More specifically though, try to avoid curve-fitted systems. Systems which claim to be optimized or have been based on recent market conditions have a higher chance of blowing up if the markets change. Experience tells us that markets typically move in cycles of 5 to 7 years, therefore anything optimized over a period of 2 years or less is likely to have a very short time horizon. So if you must go for one, consider using it to take regular funds out of the account and make sure you build into your return prospects the potential for the system to blow up rapidly. Or simply avoid curve-fitted systems altogether.

7. What will it cost?

The reality is that for a really good managed account you can expect to be sharing your profit with the manager at a rate from 25% to 50% of the monthly performance. This may sound a lot but confident managers are unlikely to charge much, if any, ongoing management fee and therefore they are motivated to make you a return in order to pay themselves.

This can obviously also be a negative in that they make take excessive risk to do this, but managers looking for longer term returns and their future will want to generate you a consistent return that encourages you to refer funds and build your account. After all, the more money you have, the more they can earn.

Just ensure the cost justifies the risk. Like any good trader, all investments should be managed as a risk reward ratio, your risk vs your potential reward.

More questions on Alternative Investments? Contact us by email, or if you prefer, tweet us at @LittlefishFX.