Wednesday, May 18, 2011

Investors Turning to Active Commodities Strategies?

I hooked up for lunch with commodity relative value fund manager I spoke to on Monday. He's looking to raise capital for this new fund which he will be managing with other experienced traders and we went through his pitch book.

I've sat with some of the best hedge fund managers in the world. The best of the best know the theory but more importantly, they can give you tons of examples of actual trades that went for and against them. That's exactly how this manager presented his views. He has the academic and industry credentials, but it's his actual commodity trading experience in Canada and the US that came through as he walked me through one trading example after another.

I love talented alpha managers. I'll repeat what I've been stating the last few posts, there is exceptional alpha talent in Quebec that is being underutilized or worse still, totally ignored. I met two of Montreal's best hedge fund managers today and I wouldn't bat an eyelash to invest in either one of them (the other is an equity market neutral manager).

The question I get from outside-Quebec investors is if they're so good how come the Caisse and other large Quebec institutions don't invest in these new and existing hedge funds? There are a lot of reasons. First, reputation risk. There have been quite a few scandals in Quebec with institutions getting burned with funds like Lancer, Norshield, Norbourg, and other frauds. The last thing any institution here needs is to read that some hedge fund they invested with blew up, especially if it's a local fund (the media in Quebec are merciless).

Second, unlike other places, Quebec lacks the entrepreneurial drive to develop the absolute return industry here in Montreal. There entrepreneurs and visionaries like Jean-Guy Desjardins over at Fiera Sceptre who are trying hard to change this. His fund runs both long-only and a good size equity market neutral fund.

But no matter how smart and successful Jean-Guy Desjardins is, he cannot change Quebec's absolute return landscape by himself. Quebec institutions like the Caisse, the FTQ, Desjardins, and the National Bank have to do a lot more to develop alpha talent within and outside their organization (Ontario Teachers' has seeded a few Ontario hedge funds and funds of funds).

At one point, Desjardins Asset Management had the largest fund of funds in Canada, but after the crisis they shut that operation down, cutting it at the worst possible time (terrible business decision and way too conservative risk management). Unfortunately, even when they were big, they hardly seeded any Quebec hedge fund and mostly invested in managers based out of New York and London.

There is this misconception out there that managers from New York and London are better. The commodity arbitrage manager explained it to me like this since he worked in both countries: "There are more CFAs per capita here in Montreal who understand theory well, but they lack money management experience. If you go to New York, there are a lot of good traders but they're not brighter than our investment managers".

Another prominent Quebecer who worked in both countries explained it to me like this: "Any bozo could open a hedge fund in New York. Lots of slick Wall Street salesmen who lost their jobs after the crisis were able to raise millions and start a hedge fund. That's why a lot of hedge funds suck and charge alpha fees for beta (we were discussing the Bridgewater paper, selling beta as apha).

That's another topic that I raised with this commodity arbitrage manager. How many bozos are able to make a lot of money in this business either because they can bullshit their way into a position or they're purely lucky and ride the wave for as long as they can. One of the smartest and nicest guys I know in this business works with the Fixed Income group at the Caisse and I can assure you he's not getting compensated anywhere close to what many bozos in finance are getting paid. That's what pisses me off about our business, too many snake oil peddlers are getting away with murder and getting paid way too much money while smart people get shafted.

And don't get me started on brokers. Most of them are pure financial whores who'll do anything to squeeze a buck out of their clients. There are excellent brokers, people who offer fantastic, actionable ideas, but they're a dying breed. That commodity arbitrage manager told me: "I don't shop around trading ideas. I reward brokers who offer me good insight, and trade with them even if they're more expensive." That's the way it should be, reward the brokers who offer you the best ideas.

We started discussing passive commodity indexes, and I told him I don't believe in them. Some of the larger ones are all about energy and even the ones that are more diversified are way too volatile to justify a sizable allocation. Moreover, the diversification benefits of these passive commodity indexes are exaggerated, and most of the returns can be explained by rebalancing and roll yield.

I do, however, believe in active commodities strategies. I listened carefully to his strategy and how it's based mostly on top down fundamental discretionary trading but also uses systematic models to help manage risk ("sometimes commodities move and you only find out later some hedge fund liquidated positions"). Unlike most commodity traders or global macros, their fund will cover several commodities across energy, base and precious metals, softs and grains. They use options to minimize volatility when entering long-term trades. He understands and trades several commodity futures and explained to me in detail the liquidity of each contract. For example, even if you place a tight stop on nat gas or sugar futures, you'll get killed if it gaps down and misses your stop.

He also explained to me how stocks are highly correlated to stock indexes but this isn't the case for commodities. "If Israel launches a nuclear bomb to Iran, you'll see oil spike but base metals will get killed. There are a lot of fundamental factors driving commodities which is why I don't rely on purely systematic approach. Lots of CTAs got killed in May, whipsawed out of positions in silver". He showed me his returns, which deliver low teens with low volatility (Sharpe of 1.0).

[My note: A couple of Montreal CTAs I know agreed that fundamentals are important but told me over the long-run, systematic approaches win out. That's their bias.]

Finally, this commodity arbitrage manager sent me an interesting article which appeared in Institutional Investor in early April, Investors Turn to Active Commodities Strategies:

As investors pour money into commodities, they’re no longer content to merely buy the index. At the $225 billion California Public Employees’ Retirement System, for example, active strategies make up 25 percent of the Sacramento-based pension fund’s $2.5 billion in commodities investments. “We’re seeing a tremendous amount of interest from institutional investors in fully active strategies,” says Michael Johnson, vice president of commodities portfolio management at Goldman Sachs Asset Management in New York.

As recently as 2005 global institutions placed nearly all of their commodities assets — then worth $73 billion — in passive, long-only strategies, according to Barclays Capital. Last year enhanced index and long-short vehicles claimed $55 billion out of $376 billion. “We’re still seeing strong inflows into passive strategies for diversification, but investors now are looking to generate alpha as well,” says Philippe Comer, Barclays’s New York–based head of commodity investor structuring for the Americas.

Demand for third-party managers is growing. “It is a natural maturation of the asset class,” says Adam De Chiara, co-president of Stamford, Connecticut–based Jefferies Asset Management, which manages more than $1 billion in commodities.

The unique challenges of indexing commodities have helped drive investors toward active strategies. Unlike broad equity indexes, commodities indexes turn over each month when the nearest-term futures contracts expire. Active investors can profit by rolling contracts before or after the scheduled trade. Such roll timing has recently added 30 basis points a year in outperformance, says David Hemming, portfolio manager at London-based Hermes Fund Managers, which invests $2 billion of its $40.1 billion in assets in commodities.

The shape of the commodities futures curve can complicate matters. Starting five years ago, the curves for crude oil and several other commodities became upward-sloping, with longer-dated contracts priced higher than those closest to expiration, reflecting expectations that demand from emerging markets and uncertainty about future supplies will boost prices. When index investors roll from the nearest, cheaper contract to the next, more-expensive one, they lose money.

To combat negative roll yield, money managers buy contracts several months out, where the price curves for many commodities tend to flatten. “I can be away from the immediate contract and roll from the third- to the fourth-month contract to avoid some of the negative impact on returns associated with a futures curve that is upward-sloping,” says Johnson of Goldman, whose firm manages some $4 billion in commodities.

Commodities can be rich sources of alpha, especially compared with equities and fixed income. Consolidated data on commodities is not widely available, says Michael Lewis, who is a principal and works in manager research at Mercer in Toronto. Also, because producers and consumers such as oil companies and airlines still dominate commodities markets and they generally seek to lock in prices, financial players willing to accept price fluctuations can earn a premium for taking the other side of the trade.

One manager with an all-in-one, passive-plus-active approach to commodities investing in a mutual fund format is John Brynjolfsson, CIO of Aliso Viejo, California–based Armored Wolf, subadviser to the Eaton Vance Commodity Strategy Fund. Most of the fund aims to match the Dow Jones–UBS commodity index through a total return swap. Armored Wolf adds an actively managed overlay component that can be long or short by as much as 5 percent of the index.

Brynjolfsson uses active strategies from roll timing and curve positioning to relative-value trades based on geographic or qualitative anomalies. He also makes directional bets on individual commodities. As of mid-March the Eaton Vance fund was up 19.75 percent since its April 2010 launch, versus 20.74 percent for its benchmark. The fund trailed the index partly because of a short-term cash position in the first weeks after inception.

Investment managers and consultants predict that active commodities strategies will become even more popular. “Even if you’re trying to invest passively, you need active management to keep up with the indexes,” says Payson Swaffield, chief income investment officer at Boston’s Eaton Vance Investment Managers.

I agree, active commodities strategies will take off in a huge way, but institutional investors beware! Make sure you're investing with experienced managers who can offer you true alpha, not camouflaged beta. Keep an eye out for this new Quebec commodity relative value fund as it will be a very successful fund run by experienced commodity traders. These professionals understand the theory and practice behind active commodities strategies and I wish them many years of success. We need more absolute return funds like this and others in Quebec.

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