Diversification takes homework and a bit of imagination

Once again, hedge fund partners and proprietary trading desk managers have realised that their “non-correlated” strategies become all too correlated in even modest corrections such as that of late February.

Credit, equity, forex, emerging markets, even precious metals were all moving as one.

The result was that “hedged” positions turned into concrete blocks that were tied to daily profit and loss statements.

Yet when they recovered equilibrium, the speculators all went back to the same markets, as if the same thing were not likely to happen next time there is even a mild uptick in volatility. If they really wanted diversification, they would look further afield. But that would take homework and imagination.

There are, however, opportunities out there, and in places that should be right in front of “professional” managers’ noses.

Take electricity trading. Not just the contracts traded on futures exchanges in the US, but on the electronic markets that are now run by the authorities that manage electric grids, known as Regional Transmission Organisations, or RTOs.

The second largest RTO is the Midwest Independent System Operator. A non-profit company based in Indiana, it manages the transmission system in a 13-state region and controls the dispatch of more than 137,000 megawatts of power generation.

Miso administers trading for three products: a “virtual”, or cash-settled day-ahead market for electric power in the 1,500 “nodes”, or delivery points on the system; a “real time”, or physical market, for power on the day of delivery; and a market for “financial transmission rights”, another cash market that allows generators or load-serving utilities
to hedge the price risk of congested power lines.

At the time of a huge blackout in Miso’s service area in 2003, the RTO was one of the more disjointed and ineffectually managed. The blackout led to rapid reforms, and Miso is now one of the best.

The essential problem is that electricity cannot be easily stored and is produced and delivered by large lumps of capital in the form of generators and power lines. The function of Miso’s markets from the point of view of the public interest is to break up the monopoly power of the capital owners, allow for efficient price discovery and lower the overall cost of electricity. The function from the trader’s point of view is to provide arbitrages and speculative opportunities. Since Miso’s markets started operating in April 2005, both sets of objectives have been met. Miso end-user costs are lower, reliability is higher and traders such as James Williamson are making a lot of money.

Mr Williamson is one of several dozen participants in the Miso market and heads one of a few small trading shops that sniff out inefficiencies missed by the large trading houses, generation owners and customer- serving utilities. He started out on his own in December of 2005 and spent about $5,000 on used computers and software. He put up a minimal $25,000 in collateral for the Miso clearing system, then set about looking at
the system’s data for inefficiencies in pricing between locations and between the day ahead and real-time markets.

He now has a net worth in the low seven figures and employs a handful of people in his office outside Denver, Colorado. In addition to trading the Miso market, he trades in the Texas and California electric markets and has enough collateral to trade on the ICE electronic energy exchange. He has also increased his collateral posting on Miso to $150,000, though, as he says, “there are ways to manage your position so the credit risk the system measures is minimised. On that amount of credit, I expect to make about 2,000 per cent annually.”

Of course, the business requires an obsessive attention to detail and a careful eye on regulations and Miso’s business practices. How can he compete with the likes of Morgan Stanley or UBS?

“The markets have proven a lot more insensitive to trading volume than I would have thought,” he says. “My advantage is that I can spend all my time trying to make money, not sending e-mails or stuff like that. In the stock market, if you see a pricing inefficiency it will be hit by a computer program in seconds. Here you can have [arbitrages] that last for days. There is just so much fruit lying on the ground here.”

One might add that it is fruit that has little correlation with other markets. What matters are generator outages, weather and congested transmission lines, along with seasonal use patterns.

Why don’t larger institutions get more involved? “If you don’t make $50m a year in a bank you’re nothing. You can make $15m or $20m, but that’s small in a big bank,” Mr Williamson says.

It is more, though, than the negative figures that a lot of hedge fund partners will receive in the post next month.

johndizard@hotmail.com