Institutional Investor's Alpha Magazine - February 2008 - (Page 28)

Commodities “The power of that noncorrelation to the broader equity markets cannot be underestimated — even a 5 percent allocation provides some meaningful improvement on the risk-return characteristics of a diversiﬁed portfolio.” Cognizant of the beneﬁts — and leery of inﬂation — pension plans, endowments, foundations and sovereign wealth funds have been pouring money into commodities to diversify their holdings and smooth out the volatility of their portfolios. “We have in place many inﬂation hedges, including commodities, real estate and [Treasury Inﬂation Protected Securities],” says Dartmouth’s Russ, who has invested $170 million, or 4.7 percent, of his college’s $3.8 billion endowment in commodities. Small as those allocations may be — institutions typically invest 3 to 5 percent of total assets under management in commodities — they can be very big in absolute terms. Hedge funds and traditional asset managers are accelerating the development of new funds and increasing commodities exposure in existing products to meet the demand. Investors say that Ospraie has been developing a fund that will invest directly in farmland in North and South America through a dedicated land-management company that the ﬁrm is setting up. Ospraie has also recently been investing in related industries — such as fertilizer companies, seed distributors and barge companies — further up the supply chain. At times it has even taken positions in the actual physical commodities. The Ospraie team is hardly alone. In March 2007 Shonda Warner, founder and managing director of Chess Capital Partners, a London-based fund of hedge funds, launched an unusual hybrid investment vehicle, the Full Harvest Agricultural Opportunities Fund, which invests in U.S. farmland and the crops grown on it. The Nebraska native, who started her career in ﬁ nance on the graintrading desk at food conglomerate Cargill, thought that the most cost-effective way to gain exposure to agriculture wasn’t by investing in commodities futures — and paying the carry, or the storage and interest fees implied There Could Be ( More) Blood N o need, really, to watch Daniel Day Lewis’s Oscar-nominated performance in There Will Be Blood to get the picture. Or to go back and reread Oil!, the Upton Sinclair novel on which the movie is based. Just ask a hedge fund manager: Dabble in oil, and you’ll likely get bloody. The price of crude-oil futures on the New York Mercantile Exchange reached an all-time high in 2007, and trading volume across all energy exchanges continued to increase unabated through the early part of this year. After trading in January 2007 at about $55 a barrel, an 18-month low, crude-oil prices rose to an all-time high of $80 in September and then kept climbing to peak at $99.29 in November. It should have been good news for hedge fund managers, but in September energy-and-metals fund Global Advisors, which has ofﬁces in London and New York, closed two of its three funds after suffering heavy losses. Even hedge funds with celebrated expertise in energy trading failed to match their tripledigit returns of previous years. Among them are Dallas-based BP Capital, run by former oil executive T. Boone Pickens Jr., and Houston-based Centaurus Energy, led by onetime Enron Corp. natural-gas trader John Arnold. Why then, given the rising price of oil, has it been so hard for hedge funds to make money in these markets? Some players wonder if the new volatility in the energy futures markets will push many fundamentals-focused hedge fund managers with specialties in energy to ﬁnd opportunities other than in futures, investing instead in equities. Nevertheless, hedge funds continue to prospect the energy markets. Highbridge Capital Management and Fortress Investment Group in New York are multibillion-dollar firms launching commodities funds that emphasize energy investment. In hindsight, perhaps, any fool could have made money going long on oil in 2007. But as prices continued to rise, the instinct of many managers was to short. “A lot of hedge fund managers are paid to be original,” says Boris Shrayer, head of investor coverage and strategies for Morgan Stanley’s commodities group, whose clients include many of the top hedge fund managers who invest in energy. “You don’t want to explain to your boss or investors being long oil at the highest point in history, and so the temptation is to go short. Hedge fund managers prefer to be contrarian.” Furthermore, energy market hedge funds are not by and large betting on the one-way direction of the sector. Their interest, instead, is in the spreads between certain types of contracts. “The commodities guys are really relying on having better trading strategies to create alpha,” says John Olson, who runs Houston Energy Partners, a longshort equity hedge fund. “On the equities side the trading strategies are certainly important, but we are ultimately coming back to the investing fundamentals behind the oil and gas industry.” (Olson made a name for himself as an analyst for Merrill Lynch & Co. a few years ago for his refusal to buy into the balance-sheet shenanigans of Enron, the notorious Houston-based energy company.) A popular position in oil futures or swaps last year was to be short the ﬁrst part of the year via contracts set to expire in the early months, and to be long longer-dated contracts, due to expire “Hedge funds prefer to be contrarian,” says Morgan Stanley’s Boris Shrayer. later in the year. In 2005 and 2006 that strategy proved lucrative when shorter-term forwards underperformed longer-term ones. But in 2007 the curve ﬂ ipped as oil inventories fell, and the short-term contracts outperformed the longterm ones. Oil prices peaked late, in November, and the short positions proved costly. Hedge funds have long been a presence in the commodities futures markets. There are legendary stories about George Soros’ battles with ﬂoor traders in the futures pits of Chicago. Paul Tudor Jones II began his career as a cotton trader on the ﬂoor of the New York Board of Trade. Today’s 28 • INSTITUTIONAL INVESTOR’S ALPHA • FEBRUARY 2008 Photo by John Abbott for Alpha

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - February 2008

Institutional Investor's Alpha Magazine - February 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Alternative Perspective The Good Guys: A Simple Plan Cover Story: Energy and Commodities: Fueling Opportunity Regulation: Energy Trading: The Brawl on the Hill Interview: Master of Values Regulation: Hedge Fund Registration: Way Out West Research Center: Top Hedge Fund Analysts Alpha Bytes: Rocket Man Unhedged: Commentary: Structured for Success

Institutional Investor's Alpha Magazine - February 2008

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