Commodity Trading Advisors: Risk, Performance Analysis, and Selection Chapter 13 pps

CHAPTER
13
The Effect of Management
and Incentive Fees on the
Performance of CTAs: A Note
Fernando Diz
T
his chapter examines the effect of management and incentive fees on the
performance and volatility of CTA track records. Evidence of a struc-
tural change in incentive compensation is presented that points to a larger
reliance on incentive fees as opposed to management fees. Management fees
have no relationship to performance. No systematic performance or volatil-
ity penalty is suffered by investors by this type of compensation. Incentive
fees are found to be positively related to both net of fees returns and volatil-
ity. An increase in the incentive fee parameter from 10 percent to 20 per-
cent will increase performance by an average of 6.58 percent per year. The
performance increase is net of the effects of leverage and other variables
affecting performance. There is also a small tendency for CTAs with larger
amounts of assets under management to have slightly better performance.
INTRODUCTION
This chapter empirically examines the effect of incentive compensation con-
tracts of commodity trading advisors (CTAs) on their performance. The
analysis is an extension of Golec (1993) and examines the effects of incen-
tive compensation contracts on the risk and return of CTAs. The contribu-
tion of this chapter is twofold. In Golec, the sample used was too small to
248
Partial support for the completion of this study was provided by a grant from
the Foundation for Managed Derivatives Research. The author wishes to thank the
Foundation for its support, and Sol Waksman for his invaluable comments.
c13_gregoriou.qxd 7/27/04 11:30 AM Page 248
draw reliable inferences about the effect of incentive compensation on the

risk and return of CTAs. Current events in the money management world
associated with manager compensation abuses have heightened the impor-
tance of measuring the effects of compensation more accurately. A much
larger database than the one used in Golec allows us to measure these
effects with less error. The advantages of using a larger database are even
more important in view of the structural changes in the composition of total
compensation in managed futures, as documented by Diz and Shukla
(2003). In addition, this study measures the effects of management and
incentive fees on the risk and returns of CTAs more accurately by control-
ling for known effects that other very important variables have on these
measures of performance (see Diz 2003).
CTA COMPENSATION STRUCTURE
CTA compensation contracts generally contain two types of fees: a man-
agement fee, k
m
, which represents a fixed percentage of end-of-period assets
under management, and an incentive fee, k
i
, which represents a fixed per-
centage of investment gains over a year period.
The CTA total fee income for period t can be written as:
or (13.1)
Φ
t
= kmA
t
+ k
i
max[0,A
t

− A
t − 1
]
where A
t − 1
and A
t
= dollar value of assets under management at the end
of periods t − 1 and t respectively.
Defining R
pt
as the CTA’s portfolio rate of return for one period (t − 1
to t), we can redefine A
t
as A
t − 1
(1 + R
pt
). We can then rewrite the total
compensation equation as:
Φ
t
= kmA
t − 1
(1 + R
pt
) + k
i
max[0,A
t − 1

R
pt
] (13.2)
Equation 13.2 shows the dependence of CTA total compensation on
the level of assets under management (A
t − 1
), the one period performance
(R
pt
), the management fee (k
m
), and the incentive fee (k
i
). Base compensa-
tion is a linear function of the level of assets under management. Incentive
compensation is a nonlinear function of performance. Table 13.1 contains
summary statistics for the variables included in equations 13.1 and 13.2.
The median management and incentive fees for a sample of 974 CTAs over
Φ
tmt
if R
pt
k
i
A
t
A
t
if R
pt

kA=+
{
≤
−
−
>
00
1
0
,
() ,
The Effect of Management and Incentive Fees on the Performance of CTAs 249
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this study sample period (1974 to 1998) were 2 percent and 20 percent
respectively.
Although the management and incentive fees presented in Table 13.1
appear high when compared to mutual funds (e.g., Golec 1993), average
monthly returns appear higher than what one finds for mutual funds for the
same time period. This is especially telling if one considers that CTA
reported performance figures are net of all fees. To date, no study has accu-
rately accounted for all fee-adjusted performance of mutual funds when
comparing them to fee-adjusted performance in the managed futures indus-
try. Further, it is a known fact that mutual fund fees have continued to
increase and that this increase has not translated into higher returns for
individual investors. It is generally acknowledged that higher fees in the
mutual fund industry have reduced returns to investors (Trzcinka 1998).
Management fees in the managed futures industry have followed a down-
ward trend from an average high of 2.81 percent in 1982 to an average low
of 1.85 percent in 2002. More of CTA compensation in 2002 came in the
form of incentive fees (Diz and Shukla 2003). The results in Table 13.2

highlight the change in the total compensation structure for CTAs. Almost
50 percent of total CTA compensation came from management fees in 1982
while in 2002 only 35 percent of total CTA compensation came from these
asset-based fees. Two-thirds of CTA compensation came from performance
based fees in 2002. Golec’s study used CTA data from 1982 to 1987. The
structural change that is evident in the 1990s is a third reason for review-
ing Golec’s (1993) findings.
Because the purpose of this study is not to explore the theory of com-
pensation contracting, we refer the reader to Golec (1993) for such a review.
250 MANAGED FUTURES INVESTING, FEES, AND REGULATION
TABLE 13.1 Summary Statistics for CTA Management and Incentive Fees,
Assets Under Management
a
Variables, and Returns
Variable Mean Std. Dev. Median Q(1) Q(3) Min Max
Management
fee (%) 2.46 0.013 2.00 2.00 3.00 0.00 6.00
Incentive fee (%) 20.27 0.044 20.00 20.00 20.00 0.00 50.00
Assets
(Millions$) 34.68 186.950 1.80 0.50 10.52 0.10 2,954.00
Monthly
return
b
(%) 0.99 0.013 0.94 0.38 1.50 −5.23 10.00
a
Assets under management can and often do include notional assets
b
Reported returns are net of management and incentive fees.
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What is clear from equation 13.2 is that total CTA compensation is a func-

tion of performance (R
pt
), the level of assets under management (A
t
), and
the management and incentive fee rates (k
m
and k
i
).
DATA
The data used in this chapter consist of individual CTA monthly returns
provided by the Barclay Trading Group. The database contains records
for 1,253 CTAs and includes both programs that were still listed as of
February 1998 as well programs that were delisted anytime from 1975 to
January 1998. Of the total 1,253 programs, 798 had been delisted by Feb-
ruary 1998. Only 455 programs were listed as of February 1998. Of the
1,253 programs, only 989 (80 percent) reported margin to equity ratios.
The Effect of Management and Incentive Fees on the Performance of CTAs 251
TABLE 13.2 Evolution of Management, Incentive Fees, and Total Compensation
in the Managed Futures Industry, 1982–2002
Average Average MF as % of IF as % of
N Year Management Fee
a
Incentive Fee
a
Fee Revenue Fee Revenue
49 1982 2.81 17.14 49 51
71 1983 2.72 17.36 48 52
105 1984 2.83 17.70 48 52

158 1985 2.82 17.46 49 51
202 1986 2.72 17.31 48 52
262 1987 2.73 17.46 48 52
309 1988 2.77 18.09 47 53
357 1989 2.79 19.17 46 54
417 1990 2.71 19.31 45 55
473 1991 2.69 19.68 45 55
562 1992 2.52 19.60 43 57
622 1993 2.40 19.78 42 58
626 1994 2.36 19.83 41 59
582 1995 2.14 20.03 39 61
582 1996 2.15 20.03 39 61
562 1997 2.12 19.99 38 62
536 1998 2.06 20.13 38 62
515 1999 1.98 20.10 37 63
487 2000 1.92 20.21 36 64
459 2001 1.90 20.31 35 65
96 2002 1.85 20.48 35 65
a
Management and incentive fees are reported fees. Actual average fees are likely to
be lower since these are subject to negotiation.
Source: Diz and Shukla (2003).
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Fifteen programs were eliminated from the sample for various reasons rang-
ing from missing observations to duplication. This left us with a sample of
974 programs. Golec’s sample includes only 80 CTAs. The time spanned by
the two samples is also worth noting. Our sample spans a period of 24
years starting in 1975 and ending in 1998. Golec’s sample spans only a five-
year period from May 1982 to December 1986. Summary statistics were
calculated for each CTA in the sample. Table 13.3 provides a summary of

the averages for these statistics.
The average length of a CTA track record for the sample is about 5.5
years. The longest track record is 23 years and the shortest only 5 months.
The average monthly rate of return for the combined CTAs was 1.31 per-
cent and the annual standard deviation of returns for the cross section of
CTAs was 26.24 percent. These results are consistent with Brorsen (1998)
for his combined CTA sample. Golec’s study reports a monthly average rate
of return of 1.35 percent with an annual standard deviation of 11.56 per-
cent. The sample used in this chapter is more similar in size, composition,
and performance to Brorsen’s.
The average management fee for the sample is 2.46 percent while the
same average is 3.96 percent in Golec’s sample. More strikingly, the median
management fee for this study’s is 2.00 percent while it is 4.00 percent in
Golec’s sample. The average incentive fee for the sample in this study is
20.27 percent while the same average is 16.33 percent in Golec’s sample.
The median incentive fee for this study’s sample is 20.00 percent and only
15.00 percent in Golec’s sample. Finally, the average assets under man-
agement in this study were $34.68 million compared to $5.01 million in
252 MANAGED FUTURES INVESTING, FEES, AND REGULATION
TABLE 13.3 Summary of CTA Average Attributes, February 1974–February
1998, 974 CTA Programs
Attribute Mean Std. Error Min Max
Months listed 65.14 45.91 5.00 278.00
Average monthly return (%) 1.31 1.34 −3.14 13.47
Margin to equity ratio (%) 19.40 10.58 1.03 100.00
Annual compounded rate
of return (%) 12.75 15.14 −47.51 139.00
Annual standard deviation (%) 26.24 18.41 0.79 142.89
Maximum drawdown −0.27 0.18 −0.99 0.10
Management fee (%) 2.46 1.31 0.00 6.00

Incentive fee (%) 20.27 4.45 0.00 50.00
Assets (Millions $) 34.68 186.95 0.10 2,954.00
c13_gregoriou.qxd 7/27/04 11:30 AM Page 252
Golec’s sample. The median amount of assets under management for this
sample was $1.8 million versus $1.5 million for Golec’s sample.
It is clear from the data that the sample is our study is broader in
coverage, size, composition, performance variability, and time span than
Golec’s. As such, it is perhaps more suitable to accurately measure the
effects of compensation structure on CTA performance.
CTA COMPENSATION PARAMETERS
AND PERFORMANCE
In this section we empirically explore the relationship between CTA
returns and the standard deviation of returns to their compensation
parameters by replicating Golec’s (1993) analysis. We examined the issue
by fitting two ordinary least squares (OLS) cross-sectional regressions on
the means and standard deviations of returns of the CTAs on their fee
parameters as follows:
AROR
j
= b
0
+ b
1
k
m
+ b
2
k
i
+ b

3
ln(A
t − 1
) + e
j
(13.3)
s
j
= a
0
+ a
1
k
m
+ a
2
k
i
+ a
3
ln(A
t − 1
) + u
j
(13.4)
where AROR
j
= annual compounded rate of return for CTA
j
s

j
= annual standard deviation of CTA
j
returns
e
j
, u
j
= error terms.
Because the distribution of assets under management is clearly skewed, we
use the natural logarithm of assets under management as the “size” vari-
able. Significance tests use White’s (see Greene 2000) heteroskedasticity
consistent standard errors. Table 13.4 presents OLS estimates of regression
The Effect of Management and Incentive Fees on the Performance of CTAs 253
TABLE 13.4 Estimation of the Relationship between Compensation Parameters
and CTA Mean Annual Compounded Returns and Standard Deviation of Returns
Independent Variables
Dependent Variables Intercept k
m
k
i
ln(A
t − 1
)
Mean Annual Returns −0.255* 0.580 0.693* 0.016*
(0.075) (0.583) (0.259) (0.003)
Standard Deviation 0.229* 1.424* 0.654* −0.009*
(0.057) (0.482) (0.156) (0.003)
*Significant at the 1 percent level under H
0

= 0.
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coefficients from equations 13.3 and 13.4, along with white standard errors
in parentheses.
The results in Table 13.4 show that cross-sectional variation in mean
returns is not related to management fees. This result is in agreement with
Golec (1993), and it is good news for investors as it suggests that there are
no systematic abuses in management fees that penalize performance. The
cross-sectional variation in mean returns also is shown to be positively asso-
ciated with the incentive fee parameter. This is also in agreement with
Golec’s results, and it is also good news for investors because greater incen-
tive fee parameters lead to greater CTA effort or ability that in turn leads to
higher performance. If the incentive fee parameter k
i
were to increase from
10 percent to 20 percent, performance should be expected to increase by 5.8
percent. The magnitude of the increase is roughly half of what was found in
Golec and seems like a much more reasonable number. A 10 percent increase
in Golec’s study would have accounted for a 1 percent per month increase in
performance or more than 12 percent per year, a very large number. It is
important to highlight that the performance increase is net of all fees. Other
things being equal, a CTA with higher incentive fees is likely to deliver larger
performance after fees.
We find the amount of assets under management to have a positive
effect on performance while Golec (1993) finds the opposite result. Our
finding is likely to reflect a known fact in the industry that successful CTAs
tend to capture the bulk of assets under management. The amount of
assets under management tends to reflect performance. The newly created
Barclay BTOP50 Index for managed futures is only a reflection of this
known fact. The increase in performance associated with assets under

management is not spectacular. An increase in assets under management
from $100,000 to $3 billion is associated with a 16-basis-point increase in
performance. Although the effect appears to be statistically different from
zero, its economic importance is very small. A similar increase in assets
under management is associated with a decrease in performance of 71
basis points in Golec. Figure 13.1 illustrates the annual increases/decreases
in performance as a function of assets under management found in this
study and in Golec (1993).
1
The volatility of CTAs’ track records appears to be positively associated
with the incentive fee parameter (Table 13.4). The relationship supports the
idea that CTAs who charge larger incentive fees take on larger risks. It also
appears that risk taking pays off as viewed from the relationship between
mean returns and the incentive fee parameter. The amount of assets under
254 MANAGED FUTURES INVESTING, FEES, AND REGULATION
1
Golec’s results were annualized to make them comparable to the results of this study.
c13_gregoriou.qxd 7/27/04 11:30 AM Page 254
management appears to be negatively associated with the volatility of
CTAs’ track records. Although the effect is rather small, this result is con-
sistent with Golec’s findings. Golec’s explanation of this empirical observa-
tion is appealing. Risk aversion is likely to rise with wealth, and this in turn
may induce CTAs to reduce risk levels. Some indirect support for this expla-
nation is found in Diz (2003), where the level of leverage of “surviving’’
CTAs (the larger ones) appears to be smaller.
One surprising finding is that management fees appear to be positively
associated with the volatility of CTAs’ track records. There is no clear
explanation for this finding other than measurement error.
Because a substantial amount of relative total compensation is contin-
gent on positive performance (incentive fee), common sense and theory

suggest that all factors associated with performance have a potential impact
on total compensation. For example, Diz (2003) shows that CTAs’ level of
leverage is related to performance. CTAs with larger margin to equity ratios
tend to have larger returns and volatility. As other variables such as lever-
age are strongly associated with the performance of a cross section of CTAs,
the exclusion of such variables in regression equations 13.2 and 13.3 may
substantially alter the size, sign, and level of statistical significance of their
The Effect of Management and Incentive Fees on the Performance of CTAs 255
40
20
0
−20
−40
−60
–80
–100
–120
–140
–160
Basis Points
Assets under Management
0 5e+08 1e+09 1.5e+09 2e+09
This Study
Golec (1993)
FIGURE 13.1 Effects of Assets under Management on Average Annual Returns
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coefficients. In an effort to reduce the omitted variable problem, we fit this
augmented model to the data:
AROR
j

= b
0
+ b
1
k
m
+ b
2
k
i
+ b
3
ln(A
t − 1
) + b
4
mdd + b
5
me +
+ b
6
vr + b
7
surv + b
8
Diver + b
9
Syst + b
10
Disc + e

j
(13.5)
s
j
= a
0
+ a
1
k
m
+ a
2
k
i
+ a
3
ln(A
t − 1
) + a
4
mdd + a
5
me +
+ a
6
vr + a
7
surv + a
8
Diver + a

9
Syst + a
10
Disc + u
j
(13.6)
where:
k
m
= management fee parameter in %
k
i
= incentive fee variable in %
ln(A
t − 1
) = natural log of the amount of assets under management
in the previous month
mdd = maximum drawdown variable (drawdown is defined as
the percentage size of an equity retracement)
me = margin to equity ratio
vr = ratio of “positive” to “negative” volatility
surv = dummy variable that takes a value of 1 when the CTA
is still in business and 0 when the CTA or program is
no longer available
Diver = dummy variable that takes a value of 1 when the CTA
is diversified and 0 otherwise
Syst = dummy variable that takes a value of 1 when the CTA
is systematic in trading approach and 0 otherwise
Discr = dummy variable that takes a value of 1 when the CTA
is discretionary in trading and 0 otherwise

e
j
, u
j
= error terms
The results in Table 13.5 suggest that management fees are unrelated to
both the level and volatility of CTA returns. The effect of the incentive fee
parameter remains positive and statistically significantly different from zero
under the augmented model specification. Moreover, the magnitude of the
effect of the incentive fee parameter on the level of returns appears to be
the same as in the previous model specification. The robustness of the
incentive fee parameter to different model specifications lends credence to
the conclusion that CTAs’ incentive fee structure is strongly associated with
their level of net returns. Under the augmented model, an increase in the
incentive fee parameter from 10 percent to 20 percent will increase per-
formance by an average of 6.58 percent annually.
Incentive fees continue to be associated with the overall volatility of
CTA track records. Larger incentive fee parameters are associated with
256 MANAGED FUTURES INVESTING, FEES, AND REGULATION
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larger levels of volatility, although this effect is reduced considerably in the
augmented model. The amount of assets under management continues to be
associated with the mean level of returns. The effect appears to be of the
same order of magnitude in the augmented model. The level of assets under
management is unrelated to the volatility of the CTA track record. This is
in contrast with Golec (1993), who finds a negative and significant rela-
tionship between assets under management and volatility and casts doubts
about the existence of any relationship between size and volatility once one
accounts for other volatility variables.
CONCLUSION

This study examines the effect of incentive contracting on CTA perform-
ance and volatility. Evidence of structural changes in incentive compensa-
tion is presented that points to a larger reliance on incentive fees as opposed
to management fees. Management fees are shown to have no relationship
with performance. This is good news for investors, as the evidence seems to
suggest that this type of compensation results in no systematic performance
The Effect of Management and Incentive Fees on the Performance of CTAs 257
TABLE 13.5 Estimation of the Relationship between Compensation Parameters
and CTA Mean Annual Compounded Returns and Standard Deviation of Returns,
Augmented Specification
AROR S
Performance
Variable Coefficient S.E Coefficient S.E.
Constant −0.275** 0.072 −0.076* 0.038
k
m
0.790 0.546 −0.183 0.283
k
i
0.658** 0.246 0.229* 0.102
ln(A
t − 1
) 0.009** 0.003 −0.003 0.002
mdd 0.186** 0.036 −0.637** 0.029
me 0.300** 0.062 0.247** 0.042
vr 0.051** 0.007 0.060** 0.006
surv 0.078** 0.015 0.034** 0.007
Diver 0.000 0.011 0.008 0.006
Syst −0.009 0.013 −0.001 0.007
Discr 0.004 0.019 0.009 0.011

**Significant at the 5 percent level for H
0
= 0.
**Significant at the 1 percent level for H
0
= 0.
c13_gregoriou.qxd 7/27/04 11:30 AM Page 257
penalty to investors. Management fees are not associated with systematic
variation in CTA return volatility, either. Both results are in agreement with
previous research by Golec (1993).
Incentive fees are found to be positively related to both returns and the
volatility of CTA returns. An increase in the incentive fee parameter from
10 percent to 20 percent will increase performance by an average of 6.58
percent per year. The performance increase is net of all fees and independ-
ent of the amount of leverage used by the CTA. The level of incentive fees
may play a role in the selection of truly outstanding CTAs.
Finally, it is shown that CTA size measured by the level of assets under
management is positively related with the level of returns. The effect is
small and likely to be caused by money flowing to successful CTAs.
258 MANAGED FUTURES INVESTING, FEES, AND REGULATION
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