April 15, 2012 5:30 pm

Investors wary of volatility after losses

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A combine drives through a corn field during harvest in South Dakota, US©Bloomberg

Corn – demand for which remains constant or growing but whose supply is less predictable. Hedge funds can profit from price fluctuations

Increasing demand by institutional investors for commodities exposure has been a feature of the investment landscape over the past decade. As well as the widely accepted commodities supercycle narrative, investors see the asset class as a way of reducing portfolio risk.

Hans Jacob Feder, head of Deutsche Bank’s dbSelect hedge fund platform, says: “Diversification is a big part of the commodities story.” While commodities overall largely track the trajectory of the global economy and equities, at any one time a number of individual commodities are diverging from this path. When crisis looms, gold spikes and geopolitical worries can lead to a surge in oil.

commodities chart

commodities chart

So while exposure to a wide range of commodities is a sensible portfolio diversifier, simply investing in a broad-based commodity index can lead to large short- and medium-term losses – as was seen in 2008-09 and again last year. Randall Dillard, chief investment officer of Liongate, a fund of hedge funds, says: “One of the problems of indexing is volatility. Holding the index and riding the volatility may breach risk management guidelines for some investors. So a pension fund, for instance, may sell the index when it falls by a certain amount, crystallise losses at the bottom of the market and buy in again at the top.”

The remedy, insist hedge fund exponents, is to invest in vehicles that can constantly adjust their exposures and jump on the right bandwagon at the right time.

The trouble with this argument is that the active trading style has not been very successful of late. The average commodity hedge fund lost 1.7 per cent in 2011, according to the Newedge index, the index’s first loss since 2000. Worse still, some of the biggest and most trusted names in commodity trading lost more than the average: Blenheim, Clive Capital, BlueGold Capital and Merchant posted double-digit losses for the year. Losses of 34 per cent in 2011 finally led BlueGold to liquidate its portfolio this month.

Many funds were not equipped to deal with a seismic event such as the eurozone debt crisis. “They focused on analysing markets from a fundamental supply and demand basis, but the global economic picture proved more important and they got caught in huge positions by the risk-on, risk-off trading behaviour in 2011,” says John Moody, the Portland, US-based manager of the JE Moody Commodity Relative Value fund. Scarred by the experience, some of the same big funds have held back from participating in this year’s rally and thus underperformed.

So the past couple of years may have caused institutional investors pause for thought. Many are searching for options that give them exposure to commodities but with considerably less volatility.

One option is choosing a fundamental stock picker rather than allocating to commodities as a whole or even to commodity sub-sectors. Carmignac Gestion, a French fund management firm, seeks out little-known second-tier commodity producers in Mongolia, Mauritania, Amazonia and other far-flung areas for its Commodities Fund. Eric Le Coz, deputy managing director of Carmignac, says: “It does not focus on the big boring groups such as Exxon. It has the resources to seek out better opportunities.”

To do this, Carmignac hired a trained engineer, David Field, to run the fund. “It is a complex strategy with geological, political and execution risks,” says Mr Le Coz. “So David looks for diversification and experienced managements in the companies he invests in.”

Other funds buy and manage commodity assets – perhaps the ultimate way to impose control on the volatility of an investment. The African AgriLand Fund, for instance, buys farms in Africa, in countries such as Mozambique, Zambia, South Africa and Swaziland. Its assets include a macadamia nut processing factory, a dehydration plant and a banana plantation. Bobby Console-Verma, chief operating officer of EmVest, which launched the fund, describes the fund’s strategy as a “turf to table operation”; the fund owns and controls the growing, processing and distribution of the crops and livestock, 90 per cent of which is sold locally to the growing African middle classes.

Returns depend on the proficiency of the farming skills. “Many of our people are agronomists and have spent their careers running farms,” says Mr Console-Verma.

“Previous owners may have put in irrigation and cleared the land, but have not managed to make the asset economically viable. We buy the asset and improve efficiencies through technology, employee education and improving disease control.”

The fund targets returns of 20 per cent a year, which are rolled up over the seven to 10-year lifespan of the fund and paid out when the asset is sold. But the high rate of return implies not inconsiderable risks, including geopolitical, legal, climactic and disease-borne. To mitigate these risks, the fund is diversified across several countries, at least 40 commodity types and across different stages of commodity production.

Investors need to be completely comfortable with these risks because the private equity structure means their money is tied up for years. “You have got to hold these assets for 10 years-plus to extract the maximum value,” says Mr Console-Verma.

For those who prefer quicker access to their capital, commodities futures funds are decidedly more liquid. Managed futures funds, which typically track momentum in commodities markets, have gathered assets at a rapid pace in the past three years. For investors seeking non-directional strategies, relative value funds provide minimal correlation with either commodity markets or managed futures funds. In contrast with the losses sustained by the large directional funds last year, Mr Moody’s fund returned 12 per cent.

Mr Moody says: “The strategy is not sensitive to changes in the overall level of commodity prices. It seeks to capture alpha whether markets are up or down.”

The fund looks for mispricing in pairs of contracts by analysing the market and fundamental factors affecting supply. Market factors include relative prices, price momentum and trading activity, while fundamental factors include inventory levels and storage capacity.

Knowing that the short-term supply of corn will be restricted while demand remains constant provides an opportunity to buy the short-term contract and sell the longer-term one.

“If you are a company such as Kellogg’s, you need physical corn on hand now, even if prices are high relative to later in the year,” Mr Moody says. “Kellogg’s won’t shut the factory down and wait for lower prices.”

This is the last in a series analysing hedge fund strategies

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