Adam Taylor of Liongate Capital argues that a diversified portfolio of alpha managers is the optimal exposure to the commodities story

The benefits to institutional investors from allocating to commodities have long been agreed upon, but the most appropriate method of investment remains unclear to many. A growing range of strategies offer exposure to commodity futures or the equity of commodity-producing companies. Long-only options such as individual futures or equities, indexes, enhanced indexes, ETFs, mutual funds, private equity and real assets like land will generally expose investors to the full volatility of commodity price beta. Other, less directional, strategies include systematic and discretionary hedge funds and funds of hedge funds. Comparisons (see table, overleaf) show that the most suitable solution is investor-specific - there is no catch-all panacea. For certain institutional investors, it will be shown that a diversified, liquid and professionally-managed fund of hedge funds may be one of the most appropriate methods of adding commodities to a portfolio. 

Commodities are not a single asset class - prices and volatilities can diverge significantly over time. The ability to take short as well as long positions allows discretionary hedge fund managers to produce positive returns in uncertain markets.
During the second half of 2008, for example, a long position in a basket of more defensive a gricultural commodities with strong fundamentals alongside a short in a basket of more cyclical energy commodities would have generated profits for hedge funds, while a passive investor in the GSCI would have lost 59%. 

Similarly, during Q1 2009 copper rose 26.02% while aluminium fell 12.20%. An equal 50/50 investment in these two metals would have realised a gain of 6.91%, but a manager with an understanding of the relative oversupply of aluminium from Chinese smelters and the possibility of a faster increase in demand for copper as global government fiscal expansion took effect would have returned 19.11% by going short aluminium and long copper. 

A discretionary commodities hedge fund manager should also have the ability to make this ‘bullish' copper view in the most efficient way, investing in those parts of the futures curve which show the lowest contango (which characterised the copper curve during Q1 2009), or by choosing which specific contract to invest in based on the exact time at which the anticipated supply/demand imbalance is least reflected by price.

The market is currently bullish sugar due to a future expected deficit in India, but this deficit will not put pressure on prices until later in 2009 or 2010 as the market is currently quite well supplied from the last sales of a large Brazilian crop. Discretionary managers would therefore be expected to purchase late 2009 contracts and, if the hypothesis is correct, make a profit. Index investors (exposed to front-month contracts) would be less likely to profit because these discretionary investors would already have bid up the price by the time they come to purchase.

Given that the profitability of strategies such as these is due to the specific manager's expertise, manager selection is exceptionally important. We look for managers who have spent 20 or more years in the physical commodities industry, typically with firms like Louis Dreyfus, Cargill, Glencore, Shell or Vitol, developing a vital understanding of the true fundamentals of the commodities they trade - whether the risks in a new oil exploration venture, agricultural disease or the specifics of shipping logistics - before moving into investment management. But it is just as important that they have spent several years trading or investing in commodities, building their own investment discipline and philosophy and a solid understanding of the market participants, liquidity and volatility characteristics of the instruments traded.

A soybean farmer cannot run a commodities hedge fund, nor can a freshly-minted MBA graduate with a couple of years' long-only investment experience. Occasionally it is possible to identify discretionary managers with expertise across more than one sector, but the best performers tend to specialise, focusing intently on every aspect of only a few commodities in the energy, metals or agriculture complex.

For our commodities fund a basic qualitative and operational screening of managers cuts the potential universe down from approximately 800 funds to 100. The fund generally avoids systematic black box managers because without disclosure of the underlying models it is not possible to identify and analyse the risks and anticipate future performance in a given market environment.

Similarly, because of the unknown nature of risks present, we avoid asset-backed lending and newer, niche strategies such as carbon trading. Screening for prudent cash management, third-party administrators and auditors, independent boards of directors, redemption terms which can realistically be met by the liquidity of underlying investments, management companies which are viable businesses and offering memorandums which do not remove the general fiduciary duties of the fund manager account for the rest.

From here, 20-25 of the best are selected to form a diversified portfolio appropriate for the current macroeconomic environment. A well-constructed portfolio must be diversified, liquid, professionally monitored for market and operational risk - and profitable.

Diversification should be across sectors (energy, base metals, precious metals, agriculture and softs), time frame (short, medium and long-term trades), markets (US, European and Asian) and investment style (some managers focus more on supply, demand, market flows or technicals), with respect to both futures and equities.

In order to detect exposure concentrations, data on allocation by investment sector, at a minimum, must be collected from managers and aggregated at portfolio level on a monthly basis. In addition to standard Monte Carlo stress tests, we run multivariate regressions against 3,000 benchmarks to detect any undesired portfolio correlations and portfolio sensitivities to a series of factors in both stressed and unstressed environments. It is also important to ensure that the portfolio is not short volatility, ie, that it does not earn premium by selling uncovered options, which can be tempting for hedge funds that crystallise fees regularly without a claw-back provision. 

A fund of hedge funds must also have the sufficient liquidity to reallocate capital to its best use. Market and operational risk management protects capital, whereas rapidly reallocating capital produces profit throughout commodity market cycles. The most efficient use of capital will vary at different points in time for a number of reasons: as the economic environment changes different hedge fund strategies become more or less profitable; some hedge funds will grow too large, causing returns to fall; while other managers will simply lose their edge on the market. Ensuring an acceptable and reliable rate of return rests largely on the skill of the investment committee and analysts in identifying and understanding the investment strategies of underlying fund managers, their skill sets and how their particular strategies will perform in the anticipated medium term economic environment.

An ongoing forum for debate exists in our firm, led by the investment committee and fed by the analysis of raw global economic data, sell-side and buy-side research and discussion with fund managers across sectors who hold views which both agree and disagree with our own.  We re-weight, add and remove managers by 5% per month on average, placing capital in the hands of those best able to invest in the prevailing market environment. 

Given the varying net exposures at the manager level and a dynamic approach to portfolio management at the fund of hedge funds level, should such an investment be considered independent alpha or commodity market beta? 

The answer is both. At all times, the objective of a well-run commodity fund of hedge funds should be to provide the benefits of investing in commodities, including a high rate of return, while also managing market and operational risks to protect capital from the volatility inherent in the asset class - maintaining a portfolio that will participate in the beta of the secular commodity bull market while targeting a high return on capital during cyclical commodity bear markets.

Adam Taylor is lead analyst for Liongate Capital's commodities fund of hedge funds