Portfolio Diversification with Notional Funding
How notional funding works at the portfolio level, what it can and cannot do for risk diversification, and what to decide before choosing a funding level.
Futures trading involves substantial risk of loss and is not suitable for all investors. Increasing leverage increases risk. You can lose more than the funds you deposit.
This page is part of J.D. Turner Capital’s investment education for high-net-worth self-directed investors and retirement-focused investors considering managed futures within an alternative investments allocation. For the mechanics of margin, nominal account size, and NFA-required disclosures, see [Managed Futures Investor Education: Capital Efficiency]. This page covers the portfolio management question: what happens to the capital you don’t deposit, and what that means for total risk.
The Portfolio Management Problem Notional Funding Addresses
Adding a diversifier to a portfolio usually means selling stocks or bonds to pay for it. Managed futures have a different capital structure. In a typical program, most capital sits in low-risk, cash-like instruments, and only a small portion collateralizes futures trades.
Notional funding builds on that structure. NFA rules allow a client to partially fund an account by depositing less with the FCM than the amount the client directs the CTA to use as the basis for trading decisions. That agreed amount, the nominal account size, sets the level of trading. NFA measures performance on nominal size so that returns reflect the CTA’s trading regardless of each client’s cash management. In practical terms, your nominal account size determines trading exposure. Your funding level determines where your cash sits.
Partial funding increases leverage and may result in more frequent and larger margin calls. Increasing leverage increases risk.
Two Ways to Use the Capital You Don’t Deposit
Illustration only. The figures below are arithmetic based on NFA’s partial funding formula. They are not the performance of any account or program.
Assume a $1,000,000 portfolio, a $200,000 nominal account size, and a 50% funding level. The formula NFA provides converts a return on nominal size to a return on actual funds: (nominal account size ÷ actual funds) × return on nominal = return on actual funds.
| Fully funded | 50% funded, reserve held in cash | 50% funded, reserve invested | |
|---|---|---|---|
| Cash deposited with FCM | $200,000 | $100,000 | $100,000 |
| Nominal account size (trading level) | $200,000 | $200,000 | $200,000 |
| Where the other $100,000 sits | In the trading account | T-bills or money market | Other investments |
| 10% loss on nominal size | $20,000 | $20,000 | $20,000 |
| Loss as % of cash deposited | 10% | 20% | 20% |
| Where margin call money comes from | Existing account equity | Cash reserve | Selling other investments, which may also have declined |
Reserve held in cash. Holding freed-up capital in Treasury bills or a money market fund is one way to manage cash-flow needs. Your total portfolio exposure is similar to fully funding. The difference is where the reserve sits. A CTA may include interest earned on actual funds in reported performance but may not impute interest on other funds, so interest earned on your outside reserve does not appear in the program’s returns.
Reserve invested. Obtaining exposure through derivatives and deploying the freed-up capital elsewhere is what institutions call portable alpha, and what fund sponsors call return stacking. In this example, total exposure is $1,100,000 on $1,000,000 of capital. That is portfolio-level leverage. If both the trading program and your other investments decline together, you may face a margin call while the assets you would sell to meet it are also down.
The trading loss in dollars is the same in all three columns. What changes is the loss as a percentage of the cash in the account, and how exposed you are to losses you must fund on short notice. If the market moves against a position, you may be asked to deposit substantial additional margin quickly. If you don’t, positions may be liquidated at a loss, and you are liable for any deficit.
What Risk Diversification Can and Cannot Do
Research from Graham Capital Management reports that trend following has historically shown low correlation to traditional assets and has tended to show negative downside correlation to equities. The same research cautions that correlations can be positive or negative at any point, including during crises, and that trend following should not be treated purely as a portfolio hedge. It notes the strategy did not provide protection during the short equity sell-off in Q4 2018, and that sharp reversals can be challenging.
These observations are based on trend-following index data, not on any specific program, and investors cannot invest directly in an index.
For portfolios using notional funding with an invested reserve, one more risk matters. Correlations can converge during market stress, exactly when diversification was supposed to help, and a stacked portfolio can see both its core holdings and its overlay fall at once.
The Tradeoffs at a Glance
| What notional funding can offer | What it costs or adds |
|---|---|
| More capital kept outside the trading account for other uses or reserves | Higher leverage on cash deposited, with more frequent and larger margin calls |
| No borrowing: CTAs post margin rather than borrow money | Futures exposure carries an implicit financing cost tied to short-term interest rates |
| Fee dollars stay the same as a fully funded account | Fees rise as a percentage of the cash you actually deposited |
| Returns reported on nominal size, consistent across clients | Your return on cash deposited is magnified in both directions: at 50% funding, a 20% loss on nominal size is a 40% loss on actual funds |
Choosing a Funding Level
Your funding level is a portfolio management decision, and NFA requires it to be documented. The CTA must provide or receive a written confirmation of the nominal account size, and how additions, withdrawals, and performance affect it, before the first trade. Any change requires a new confirmation before further trading. Notional funding requires a written agreement and does not permit the account to trade undermargined.
Funds held outside the trading account can count toward actual funds only if four conditions are met: ownership of the accounts is identical, the funds are available for transfer, you agree in writing that the FCM may transfer them at the CTA’s request, and the CTA can verify the amount.
Retirement Accounts
For IRA investors, one self-directed IRA custodian advises keeping enough liquid assets in the IRA to cover potential margin calls, because personal assets cannot be used to fund a shortfall. If you partially fund an IRA account, the reserve has to be inside the IRA. That makes the “reserve invested” approach harder to manage in a retirement account than in a taxable one. See [Capital Efficiency page] for how IRA futures accounts are structured.
Notional Funding Is Not a Funded Trading Program
The term “funded trading programs” usually refers to proprietary trading firm offerings. In the typical model, a trader completes an evaluation with profit targets and drawdown limits, earns a “funded” account by passing, and splits profits under the firm’s rules. That arrangement is not investing or opening a personal brokerage account. Many of these programs use simulated capital and charge an evaluation fee.
Notional funding is different in every respect that matters for risk:
- It is your capital. Your account is held at an FCM, and a CTA cannot accept trading funds in its own name.
- The CTA trades your account under a written agreement at the nominal size you set.
- Losses are yours and can exceed the funds you deposit.
How J.D. Turner Capital Approaches Notional Funding
J.D. Turner Capital, LLC is a CFTC-registered Commodity Trading Advisor and NFA member. Its Diversified Trend Following Strategy (DTFS) is a systematic program trading 17 global futures markets through separately managed accounts.
- Minimum nominal account size: 100k
- Partial funding: Accepted; minimum funding level 50%
- Fees: 1% management and 15% incentive fee
- FCM: Clients may choose
- Retirement accounts: Self-directed IRA capital accepted
Complete fee, risk, and performance information is in the J.D. Turner Capital Disclosure Document. [Disclosure Document]
Questions to Answer Before Choosing a Funding Level
- If the program had its worst historical drawdown at my funding level, what would that be as a percentage of the cash I deposited?
- Where will margin call money come from, and how quickly can it reach the trading account?
- Will I hold the reserve in cash, or invest it? If invested, what happens if those assets fall at the same time?
- For an IRA, is the reserve inside the same IRA?
- What are the fees as a percentage of my actual funds?
Frequently Asked Questions
Does notional funding reduce risk?
No. It increases leverage on the cash in your trading account. Whether total portfolio risk changes depends on what you do with the capital you don’t deposit, and how those assets behave under stress.
Is diversification from managed futures guaranteed?
No. Correlations between trend following and other assets can be positive or negative at any time, including during crises.
Can I lose more than I deposit?
Yes. Losses can exceed the funds deposited, and you are liable for any deficit.
Futures trading involves substantial risk of loss and is not suitable for all investors. Increasing leverage increases risk. Past performance is not necessarily indicative of future results. This page is educational and is not an offer or solicitation to invest in any trading program. Any offer is made only through the J.D. Turner Capital Disclosure Document, which describes the principal risk factors and each fee charged. Consult your own tax and legal advisors regarding retirement account investments.