The Margin to Equity Ratio is an important concept to understand, especially when considering managed futures and evaluating commodities trading advisors (CTAs). As futures and derivatives are inherently leveraged instruments, comparing a manager’s margin levels to his total accounts can give investors a sense of how much risk that manager is undertaking.

Q. So today we’re talking about a way to evaluate commodity trading advisors, right?
A. Yes. “Margin to equity” has different uses in different contexts, but its particularly good to know when considering a CTA for possible investment. It’s a way to evaluate how much risk he’s taking in the account, and therefore what his potential for a big drawdown might be.

Q. So how does it work, exactly?
A. Futures contracts and derivatives are very highly leveraged instruments– you might only have to put up 5% initial margin on a position, for example. But the exchanges set those margin requirements over time, and they adjust them upward for riskier positions. Therefore, if you find out what a manager’s ratio is of his total accounts versus how much margin the exchanges are demanding from him, you get a good sense of how much risk he’s taking.

Q. So, what kind of numbers would you be looking for?
A. For new investors in the space, something like 10% or less is ideal: that shows relatively small risk being taken. Maybe you can take that up to 20%, but personally I wouldn’t go higher. Ideally, you want to see a manager with good gross returns, who also has a low MTE.

Q. That makes it sounds vaguely like a Sharpe or Sortino type measurement.
A. Yes. It’s always about risk-adjusted returns instead of gross returns. Now, Sharpe and Sortino are definitely used to measure CTAs, and you should certainly look at those numbers. But they don’t necessarily tell the whole story, because they don’t look at exactly how leveraged the trader is… and the more leveraged he is, the more risk he’s running. Its really as simple as that.

Q. So, backing up, if you’re looking at a CTA, what are the top 1 or 2 things to consider?
A. His background on the National Futures Association website, and his audited track record. Audited records should always be available.