12/11/2009 Author: Tony Griffiths

The golden age

Skyrocketing oil and gold prices have seen the commodity markets outperform most other strategies this year. Yet commodity-trading hedge funds have struggled to capitalise on the boom, with volatile returns and disparate performance across the sector. But are managers biding their time and waiting for the commodities wave to break?

The hedge fund industry may have had a better-than-expected year to date (YTD), but, in terms of pure performance, even its results have paled compared to those of the commodity market. Boosted this May by its largest monthly gain in more than three decades, the commodity sector, and its corresponding indices, has been besting the majority of its financial counterparts throughout 2009.

This year alone oil has surged more than 50%, while gold is up over 10%. As of 4 November, the Goldman Sachs Commodity Index (GSCI), perhaps the sector’s best-known, was up 14.52% YTD, while the Diapason Commodities Index, considered one of the most comprehensive, boasted a ten-month jump of 20.78%. The HFRX Global Hedge Fund Index, in comparison, was up 11.21% YTD – impressive, still, but lagging nonetheless.     
 
News last month, therefore, that commodity hedge funds were trailing benchmark commodity indices by the widest margin in four years appeared somewhat incongruous. As of the end of September, the monthly HFRX Commodity Index’s yearly return was down 3.21%. Naturally, this meant commodity trading was among the year’s poorest performing hedge fund strategies. Commodity hedge funds, the numbers would suggest, have been unable to capitalise on their market’s strong performance.

Clearly this is a challenging period for commodity-trading hedge fund managers, but should the glaring disparity between the performance of commodity indices and that of commodity hedge funds be cause for concern? Not according to Troy Buckner, managing principal of NuWave Investment Management, whose futures portfolio has around 40% in commodities. As he explains, commodity prices may have surged, but the nature of the surge has made profit hard to come by.

“While the commodities price moves are generally to the up side in 2009 at this point, the path of upward price movement has been very choppy with significant but short-term corrections to the downside along the way,” he notes. “This type of price action can be damaging to the return prospects of tactical traders, especially when the up and down price action occurs in rapid succession.”

During the price crash of 2008, as Buckner is quick to remind, the more-stable nature of the descent saw short positions on a range of commodities reap dividends, and promoted commodity hedge funds to among the industry’s strongest-performing strategies. Traders have not lost the Midas touch, he argues, but the current volatility is playing havoc with the window of opportunity.

The volatile nature of 2009’s surge has not surprised Andrew MacDonald, an investment consultant with Watson Wyatt’s commodities team. He attributes this to the “inelastic” nature of commodity “supply and demand”. For example, it takes a long time for people to cut down their use of oil, as it does for producers to find more or halt production. This leads to large price swings, but also heightens the potential for rapid and persistent volatility.  

“As we tell our clients, what you like about commodities, the diversification benefit that comes from long-only exposures to commodity prices, commodity hedge funds don’t necessarily give you that,” MacDonald explains. “They might give you a good source of alpha, but that alpha is very different from just buying commodities.”   
 
As such, though a number of MacDonald’s clients have exposure to long-only commodity funds, he is unlikely to recommend single-manger commodity hedge funds. He will, where appropriate, however, advocate investment in funds of hedge funds with underlying exposure to commodity traders.  

“The commodities market is probably inefficient and quite attractive for active management if you have sufficient knowledge of production, and supply and demand, but it is so commodity-specific that we feel you would want a number of funds in order to efficiently cover the universe," he says.

“Once you say you’re going to need a lot of them, it’s not a productive use of an investor’s time to discuss and allocate to a large number of commodity hedge funds. It’s a case of being practical. Because, for example, the mechanics of the copper market are so complex, you’ve got to be specialist to do the due diligence, so it’s natural to delegate that work to a fund of hedge funds.”

However, despite the flat performance of HFR’s commodity index, and the blatant volatility, there have been single-manager commodity hedge funds able to capitalise on the rise in prices. It is, after all, natural for volatile markets to induce a large deviation in a sector’s performance, MacDonald concedes.

In October it was reported that The Louis Dreyfus Commodities Alpha Fund had jumped 10% in the first nine months of the year. The fund attributed its success – assets had quadrupled to $410m since its inception in November 2008 – in part to a heavy investment in raw sugar, which had gained 115% in New York trading in the previous nine months.

Another example of success can be found at London-based asset manager Threadneedle. Since the inception of its commodity hedge fund in November 2008 – a “challenging time to launch”, the firm’s head of commodities, Daniel Donora, admits – the fund has grown from $20m to $23m, and can boast a rise YTD of “around 8%”.  

 “We were cautious to start with, but we have, through the course of this year, been increasing our risk profile and improving performance,” says Donora, who attributes the fund’s success to a refusal to specialise and a focus on liquid markets. “Diversification has helped us, as has getting some directional calls correct. We’ve been bullish on precious metals most of the year.”

Donora is adamant that the current disparity between HFR’s commodity index and generalised commodity prices does not paint commodity hedge funds in a negative light. The sheer number of markets and strategies that comprise the commodity hedge fund community, he says, make it a particularly complex facet of an already complex industry.
“To put it in perspective, the capacity utilisation for copper production is about 97%, and there are very few industries that are currently running at capacity,” Donora says. “The capacity utilisation for the aluminium production is running more like 70%. And so, even among commodities as similar as copper and aluminium, it is difficult to generalise because they are very different industries.”

For every fund down a sizeable chunk, there is an equivalent, such as the Dreyfus or Threadneedle vehicles, up by a similar percentage and boasting strong performance. Nicolas Maduz, managing partner at Tiberius Group, a Swiss commodity asset manager with $1.5bn in AuM, highlights a key differential. Though “trend followers” may have struggled, he says, other commodity-based hedging strategies have seen their particular niche come up trumps.

“The relative value strategies looking at price discrepancies between commodities are showing better results. That’s why they are so-called ‘market neutral’ because they don’t depend on price direction.” Tiberius, Maduz adds, covers both directional and market neutral strategies, so allocation tactics can be adapted to the trading environment.

As a trend-following hedge fund, Global Advisors’ Global Commodity Systemic (GSC) programme has found positive performance hard to come by this year – though up over 87% since inception in mid-2005, GCS’s YTD performance as of September 2009 had stagnated at minus 0.14%. Still, GSC is outperforming HFR’s commodity index, which, when considering its trend-centric strategy, has led Danny Masters, co-principal of Global Advisors, to deem relative performance strong.      

“We have had flat performance and, as such, outperformed most of our peers in the quantitative and trend-following space,” he tells HFMWeek. “More pleasingly is that the reason for this outperformance is the third of our three models, which contains information beyond just price, gleaned from our decades of experience in commodities.”
For Masters, the key is not to panic as, throughout the commodity hedge fund community, peers record both heavy losses and strong gains.   

“One of the most important characteristics of any investment vehicle is that you don’t lose a lot of money while waiting to make money,” he adds. “When imbalances become large, as we believe they will in an economic stabilisation and recovery over the next two years, strong trends will emerge and we will, as always, manage them well.”

The current financial environment has not been kind to commodity hedge funds, with May’s price surge flattering to deceive. Though the notable disparity between fund performance and commodity prices may appear newsworthy, the volatility inherent in the price gains, as managers argue, has forced most proprietors, trend-followers in particular, onto the back foot.

The wealth in depth of commodity-led opportunities means that there will always be those focused, or fortunate, enough to benefit. But, for widespread performance to return to 2008-levels, commodity-based price swings will have to resume a smoother trajectory. Until that occurs, the majority of commodity hedge fund managers will quietly and patiently bide their time.