Option FanaticOptions, stock, futures, and system trading, backtesting, money management, and much more!

Sub-Adviser- and TPAM-IA Relationships

Last time I detailed two phone conversations I had with recruiters. Today I will continue on my brainstorming journey.

After speaking with EJ and LPL Financial last Halloween, I did some research on how to become a third-party asset manager (TPAM) and generation of a GIPS compliant track record. I will discuss the latter in a separate post.

TPAMs are sometimes a broker/dealer offering. In other words, if an investment adviser (IA) signs on with a broker/dealer then TPAMs may be available under a drop-down menu on the platform.

A fine line differentiates TPAMs from sub-advisers. A sub-adviser is hired by the IA to manage client portfolios. The sub-adviser manages assets in accordance with IA guidelines and objectives. In contrast, a TPAM is an external manager hired by the client to manage assets based on client investment objectives. In a sub-advisory relationship, the IA is responsible for the recommendation and selection of the manager. With a TPAM, the client enters into a separate and distinct contract that gives the client ultimate authority to retain or to fire. An IA may or may not recommend a particular TPAM.

The level of supervision (accountability) maintained in sub-adviser vs. TPAM relationships is noteworthy. Due diligence is the depth of investigation expected of a prudent IA to determine whether a financial arrangement makes sense. This falls under the IA’s fiduciary obligation to clients and is probably greater for a sub-adviser than a TPAM. According to one lawyer, most advisers use questionnaires, in-person and telephone meetings, and performance reports on a quarterly basis to make sure sub-advisers abide by IA guidelines and objectives. TPAMs may be reviewed on a semi-annual or annual basis with regard to performance, personnel, and overall client services.

Due diligence commonly includes manager expertise, assessment of fit between investment strategy and client suitability objectives, fee structure, disclosures, and regulatory status. The IA should also review compliance controls and specify how communication between manager and client will proceed to define expectations for all parties involved.

Sub-advisers and TPAMs are two concepts that help me to better understand XC’s hypothetical scenario where I might trade for one of their clients. In that case, I would be a TPAM rather than a sub-adviser, which is why he would not risk their reputation by explicitly recommending me. I’m sure this could change if he got to know more about me and my trading philosophy.

Brainstorming My Niche (Part 1)

It’s no secret that I am interested in managing wealth for others. The next few blog posts will review some interesting conversations I have recently had along with some related writings that could be pushing me in that direction.

On October 31, 2017, I called and spoke with a recruiter for Edward Jones (EJ). As an EJ financial adviser, my job would be to move clients into products managed centrally by their dedicated investment team. I would also do extensive financial planning (e.g. budgeting, retirement and estate planning, asset protection) for clients.

I never believed that I would be a good fit as an EJ adviser and this was quickly confirmed. First, EJ is “very conservative” and derivatives are therefore not used (I disagree with the claim that options are more risky). Second, I would only be permitted to continue managing my own account per EJ guidelines. Third, rather than concentrating on planning, which is where I believe financial advisers excel, I want to stick with my area of expertise: maximizing investment performance.

Although the phone conversation lasted only 10 minutes, he did give me some ideas for further consideration. He suggested I reach out to some independent advisers affiliated with Raymond James or LPL Financial with the following pitch: “my background is in trading options and I’m pretty good at it. Could we sit down and have breakfast/lunch to talk about what I do and what I’m looking for?” He suggested they might compensate me with a percentage (e.g. similar to this).

I ended the call thinking a niche just might exist for someone like me to trade for the big firms (LPL Financial is #1 in total revenue from 1996-2017 according to Financial Planning magazine). Eager to confirm, I immediately contacted an LPL recruiter who told me they outsource investing to third-party asset managers (TPAMs).

“What does it take to become a TPAM for LPL?”

“About $40,000 to get an AIM-R compliant track record,” he said with a chuckle.

His information was a bit dated; he was talking about Global Investment Performance Standards (GIPS).

I ended the phone call somewhat shocked at the cost. $40K might be enough to start my own IA or launch a fund. Why would I want to undertake the expense to become GIPS compliant with no guarantee of business thereafter? It seemed like I might be headed toward another dead end.

I will continue next time.

Stansberry Research

I received the following e-mail from a friend today:

     > Hey Mark,
     > What do you think of this guy’s predictions???
     > Should one take him seriously?
     > http://thecrux.com/dyncontent/millionaire-warns-to-get-out-of-cash-now/

The first thing I noticed was the byline “by Patrick Bove, Stansberry Research.” I associate Stansberry Research with long, persuasive [and nefarious] advertisements. This is probably because I’ve seen multiple writings from them in the past. At the very least, it was reason to investigate further.

I then noticed “Dr. Steve Sjuggerud,” a name that definitely raises red flags. Again, I’m not exactly sure why but I’ve been looking at these things for the last 10 years. I actually recall researching him somewhat recently and being surprised not to see blatant confirmation of his chicanery.

The Crux (top of page) is not something I recognize as a reputable news source. Like anything else, I can do an internet search that led me here. Not only does the review link it to the questionable “Stansberry Research,” it also concludes:

     > There are many other online publications that share
     > “informational” articles promoting products for sale
     > or that offer newsletters whose ultimate goal is to
     > sell their readers financial products…

This tells us all we need to know about the cataclysmic conflict of interest. Time to run away! Don’t waste another second.

Because I sought further confirmation, I ran an internet search on “Stansberry Research” to find this and this.

Oh by the way, printed above The Crux at the top is “advertorial.” What the hell is that? For me, such a word raises multiple red flags. Any advertisement (“advertorial” is presumably “advertisement” + “editorial”) is quite possibly fake news—especially if it proclaims a doomsday scenario.

Real Risk of Naked Puts (Part 2)

Trading naked puts (NP) carries significant risk that often goes unnoticed. I left off discussing what it would take for me, as a wealth manager, to trade NPs in a client account.

Merely having clients sign a waiver of responsibility would hardly be enough to placate my conscience into trading their money with undefined risk. Also, with regard to protecting me, they could always say the waiver was signed out of duress. As discussed last time, whatever I did to ensure they would never claim ignorance in retrospect would make for the WORST. SALES. PITCH. EVER.

And because even the “worst sales pitch ever” is no guarantee they would later admit to full understanding of all the risks (imagine a case where amnesia or dementia caused them to not only forget the harrowing discussion we had beforehand but also to reject acknowledgement of how I virtually tried to SCARE THEM OFF from letting me trade NPs in their account), I might have trouble being a part of something like this.

Ideally all wealth managers know the mortifying possibilities and therefore act in accordance with high standards to protect client capital. While this may not be the case, I have always been ambitious with a high motivation to outperform.

Making all this even scarier is that while a huge market crash can force unrealized losses to approach Reg T margin requirements, far less would be required to wipe out accounts with much lower leverage ratios.

None of this is to say that I would never trade NPs for a client but as a wealth manager I would feel a responsibility to protect from the downside even at the sacrifice of assets under management or performance metrics. I have previously opined that no more than 20% of a portfolio should be allocated to short premium strategies. Knowing this were the case would make me feel comfortable.*

A better way to eliminate catastrophic is to be net long puts at all times. This might allow me to allocate more than 20% to the strategy, too.


* I believe part of the reason Regulation D (Rule 505) biases hedge funds toward accepting only accredited investors is to increase probability that capital invested in hedge funds remains a reasonable fraction of total net worth.

Real Risk of Naked Puts (Part 1)

Trading naked puts (NP) involves significant risk that people may not realize.

I have written multiple posts on this topic including a nice mini-series beginning here and a more recent exploration here.

NPs can generate respectable total return in a non-crashing market given a high enough leverage ratio. Under portfolio margin (PM) they can be leveraged up to 13:1 or more.

I don’t believe Reg T margin should be considered the real risk of these positions. T + 0 usually floats far above the expiration curve at significantly lower values of the underlying.

Nevertheless, I believe the Securities and Exchange Commission would say even as potential loss, Reg T margin must be acknowledged as real. This seems consistent with “your worst drawdown is always ahead” (mentioned here, here, and here).

Consider the following doomsday scenarios where Reg T margin could closely approximate [un]realized loss:

      • A nuclear bomb is dropped and the market opens down 1400 points
      • Alien invasion causes VIX to spike 100 points
      • NP trader killed by a drunk driver days before expiration as a market correction begins

Excuses might be good enough to rationalize personal losses but I would hold myself to a higher standard when managing wealth for others. I mean really… imagine conversations like, “I’m sorry that I lost your retirement savings, Mr. X, but:

      • My full-time job precludes me from watching the market intraday.”
      • That was a larger loss/volatility explosion than anyone expected” [LTCM anyone?].
      • The hurricane knocked my power out for a few weeks and I was not able to make necessary adjustments.”

None of these would ever be acceptable! Especially with the media refreshing the doomsday thesis on a weekly (daily?) basis, any professional should be aware of the possibilities and have contingencies in place.

The only case where I could accept such an excuse might be one where the risks were made totally clear beforehand. Salesmanship and persuasion are sometimes dubious practices where distraction and deception are used to make people agree to things without complete understanding of risk. I would therefore have to do more than gloss over the possibility of total loss. I would have to hammer it home by having them:

      • Listen to me repeat “you may lose everything” over and over and over again.
      • Write (pen and paper) “I understand that I may lose everything” 10-50 times.
      • Dwell on the catastrophic scenario and share their vision of a life following this catastrophic event.

I will continue next time.

Recent Discouragement

Back in October 2015, I saw this posted in one of my forums:

     > Looking at my past recent trades, I am thinking Mon and Fri
     > are not good days for me to trade. I am also thinking Tues,
     > Weds, and Thurs might not be so good either.

Cause / Effect Illusions

In 2008, Jennifer Whitson at UT-Austin and Adam Galinsky at Northwestern University published an article in Science that is relevant to trading the markets.

One study involved two groups of subjects watching two sets of images on a computer screen.

The first set of images was a series of paired symbols. Subjects were told the computer used a rule to generate the pairs and were asked to identify the rule. Group #1 received no feedback throughout the series whereas group #2 was randomly told “right” or “wrong” regardless of how they answered. This experimental design attempted to make subjects in the second group feel less confident for what was to come next.

The second set of “images” was nothing more than white noise. Upon flashing, all subjects were asked whether they saw anything and if so then what? The vast majority of responses were negative from subjects in the first group while subjects in the second group were significantly more likely to say yes.

Having experienced failure during the first set of images, group #2 approached the second set lacking a sense of control over its surroundings and was significantly more likely to falsely identify patterns.

In discussing the study, Whitson said:

     > All of these false/illusory patterns are connected. All of
     > them are influenced by lacking control so when people lack
     > control, they are more likely to see stock market trends that
     > don’t exist… they’re more likely to see conspiracies in the
     > world around them that don’t exist because it’s our instinctive
     > sense to try and react to the situation in which we lack
     > control by making sense of it and understanding it even if it’s
     > a false sense of understanding… this effect could explain why
     > religion is so successful among the poor or disenfranchised.
     > Whenever people feel like their lives are out of control, G-d
     > helps them make sense of things… there is a lot of randomness
     > in our lives. There is a lot of chaos. There are many, many,
     > many things we do not control. And so we have to pick out of
     > that chaos things that are meaningful to us to make a sensible
     > story out of our lives.

In conclusion, the brain seems more likely to identify patterns in what would otherwise be viewed as randomness when it feels out of control.

As traders never have control over what the market does, we should be careful about seeing definitive patterns that may not actually exist.

Incremental Value (Part 4)

I’ve been discussing the incremental value I would provide to an investment adviser (IA) as a result of outperformance.

The numbers get more interesting if I am able to outperform by 3%. Last time I discussed the incremental value (in terms of the 0.8% management fee) were I to return 7% or 8% (11% or 12%) rather than 6% (10%). If I were able to return 9% or 13%, though, then my incremental value over 25 years would be $102K or $196K, respectively. While still apparently low, my average management fee has now increased to 0.11%.

At some level of outperformance, I feel the management fee should be increased. From the perspective of trading as a business, annual losses are anathema. In the event this accompanies improvement over the benchmark drawdown, I still feel payment should be postponed until a new highwater mark is established. The caveat, as mentioned in Part 1, is that only qualified investors* can be charged performance fees per SEC rules.

Whether clients pay performance fees is up to the IA but I feel it’s fair for me to be paid more as a trader. This goes back to my Part 2 mention of getting more than 50% of the incremental fees. Number and size (AUM) of client referrals may always be proportional to relative performance. Although hard to definitively measure, the value of this may be significant.

It has gone without saying that some benchmark for performance comparison would have to be agreed upon before any of this is finalized. I would also make a case for risk-adjusted returns. Clients who sleep easier at night will be happier than those who are more stressed and fearful. This can be measured by Sharpe [Sortino] Ratio or volatility of monthly returns. As discussed above, I strongly believe this has value albeit difficult to make tangible. One never knows when new referrals might be the direct result of a happier, stress-free clients. One also never knows when a more linear equity curve might directly result in the decision to remain invested during a market correction that would otherwise have sent them screaming for the exits to lock in large losses. These are two extremely valuable possibilities.

If I had 25 million-dollar clients then I would be earning $29K/$63K/$102K or $55K/$120K/$196K per year for relative outperformance beyond 6% or 10%, respectively. While I would not expect to manage $25M immediately upon hire, contemplating numbers like these makes a trading gig more enticing—especially if the IA can persuade me that more assets are available contingent upon solid performance.

What I’m talking about is doing exactly what I do now—executing a trading strategy in which I strongly believe—with 26 accounts rather than just my own and having a good chance of being paid [well] over $50K per year for my efforts.** I could probably get on board with something like this.


* Qualified investors have a net worth, excluding primary residence, of at least $1 million or an annual [spousal combined]
   income of at least $200K [$300K].

** All calculations taken from “IA(R) fees and earnings (hypothetical) (10-12-17).”

Incremental Value (Part 3)

Last time I presented some initial calculations to determine the incremental value I might provide to an investment adviser (IA) as a result of trading outperformance.

To isolate the impact of outperformance, I reran the analysis assuming 10% (rather than 6%) annual returns without me and 11% or 12% (rather than 7% or 8%) returns with me. Invested as previously described, $1M now becomes $8.86M, $11.11M, or $13.91M, respectively, over 25 years. The incremental value to the IA is now $110K or $240K for 11% or 12%. In splitting the difference I would earn $55K or $120K over that time.

Interestingly (to me), although outperformance is important, absolute performance plays a more significant role. Outperformance is identical on a gross basis in both simulations (1-2%). On a percentage basis, 7% or 8% vs. 6% is a 16% or 33% increase whereas 11% or 12% vs. 10% is a 10% or 20% increase. The significantly larger percentage increase is accompanied by a roughly equal ratio of incremental value share [($63K / $29K) = 2.18 ~ 2.17 = ($120K / $55K)] whereas the incremental value itself is almost double that for the 10%-12% versus the 6%-8% scenario.*

Note a similarity in calculated numbers for my share. I would earn $63K (over 25 years) by returning 8% instead of 6%; I would earn $55K by returning 11% instead of 10%. I would prefer a conservative estimate and project 2% outperformance over 11% returns. I can comfortably imagine annual returns of 11%, though. I will also do quite well when the overall market is moving moderately higher. While I will [profit but] underperform when the market is screaming higher, history has not presented many such episodes (e.g. second week of March 2009 onward and following the 2016 presidential election). I almost want to say that I can comfortably imagine 2% outperformance and 11% returns per year.

Past performance is no guarantee of future results. Time, as always, will tell.

I think outperformance would provide more value to an IA than higher absolute returns. It’s great if the IA makes 13% one year unless the benchmark returns 14%. One case where I think outperformance might not be good would be when the IA loses money for clients. Being down less than the benchmark is a marketable accomplishment, but clients may still be upset. Hopefully a conversation about the importance of minimizing drawdowns would correct their perception.

Next time I will talk more about my cut.

* If you are someone who spends modest time doing daily computation then you might be laughing at me just now for a failure to recognize basic arithmetic properties. Admittedly, I am a bit rusty with the mathematical proofs but believe you me, I still crunch numbers quite well!

Incremental Value (Part 2)

The time has arrived to break out the spreadsheets and start dissecting exactly how much I might earn as an investment adviser (IA) representative trading AUM.

I need to begin with some assumptions. Suppose the IA charges an annual management fee of 0.8%, which is assessed at the beginning of every year. As a conservative projection, let’s also assume the IA generates annual investment returns of 6%. A $1M account would therefore grow to $3.51M in 25 years.

Upon joining the IA, what if I were able to generate 7% or 8% per year?

Growth of $1M over 25 years at 6-8% p.a. (10-12-17)

Instead of $3.51M in 25 years, the account would now grow to $4.44M or $5.60M, respectively. That’s a significant boon for the client! This also brings incremental value to the IA in terms of management fees: an additional $58K or $126K, respectively, over 25 years. If I were to split that incremental value with the IA then I would make $29K or $63K with disproportionately more being earned as the years go by.

Keeping in mind that this trading gig must also be worthwhile to me, from a monetary standpoint I see some things not to like. First, my cut of the management fee ranges from 0.01% to 0.08% (or 0.14%). This seems minuscule. Second, that “incremental” detail is a killer. While I could make $29K or $63K over 25 years, if the client leaves the firm earlier then I will be effectively starting over with someone new. This feels like a mortgage where significant equity doesn’t start to build until later in the term. Although the incremental approach would keep me motivated to do well, I would rather be paid the average annual fee of 0.04% (or 0.07%). Besides, I don’t believe my history suggests a need for any additional motivation.

I could make a case for keeping all the incremental fees from my trading outperformance. The IA would benefit by earning more in fees as a result of my employment. My potential reward needs to be large enough for me to take on the challenge, though. If all the incremental fees went to me then it might represent a more acceptable wage (still small at an average of 0.08% or 0.14% over the 25 years) and a much happier client. That could lead to a larger book of business for the IA.

For now, in the spirit of keeping positive I think the bottom line is that I would make some money as a representative without having to do many of the back-office tasks required to launch my own IA. I wouldn’t have to file all the paperwork, come up with Form ADV, have legal work done, establish a new entity, hire a compliance team, deal with E/O insurance, cover all the overhead, or be forced to raise assets—the latter, especially, being no small feat.