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IPE special report May 2018

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Systematic evaluation finds right formula for commodities

At a time when pension funds are seeking extra return, as well as diversification, from alternative asset classes, the welter of products in this area can make searching for the right investments a bewidering process.

Bayerische Versorgungskammer, the Bavarian pension fund for professional groups, has shown that a structured approach towards setting up a commodities portfolio can result in setting mandates and appointing managers that offer the best possible prospects of return and diversification, and for this achievement has been named Best Commodities Investor.

BVK was planning to add a commodities portfolio to its investments, believing that this would be a sensible addition if the asset class met its investment goals.
The first step in the process was therefore for BVK to determine what its long-term investment goals were. Any new asset class in its portfolio had to provide a further source of revenue, and show moderate volatility as well as a low correlation with traditional asset classes. There also had to be no risk of long-term loss.

OPTIONS CONSIDERED

BVK then had to structure an investment mandate and, as part of the process, examined the four main options for investing in commodities.

First came passive investment using a commodity index, such as the Dow Jones AIG Index. This idea was rejected for several reasons. There was the potential for long-term loss, but no possibility of benefiting from rolling returns. Each individual commodity had a fixed weighting in the index, so there was no protection from price falls in those specific commodities. Finally, there was high transparency in trading.

The fund also rejected the second option, investing through commodity shares. Analysis showed that commodity shares have a far higher correlation to share indices than to commodity indices, which would defeat the object of buying uncorrelated assets.

The third option, long-only investment, makes it possible to avoid the negative aspects of purely passive index investment. Active long-only managers can generate alpha, for example by utilising the cyclical or seasonal behaviour of commodities that can be forecast relatively well (such as harvest times).

Long-only managers can also benefit from adjustments to commodity indices, because they are made according to a set process and at set times. Active long-only managers can proactively position themselves prior to these publicly announced index adjustments, to benefit from the market impact of passive index replications (front running).

Active long-only investing was therefore selected as an option because it generates alpha returns. It also offers risk reduction based on active risk management. There is only moderate use of short selling and leverage, and the investor receives the whole collateral yield.

The final investment option was investment via commodity hedge funds. A hedge fund has the key advantage of being profitable where there is undervaluation or overvaluation of commodity markets, because it can make use of long and short positions.

Moreover, a hedge fund should assume a so-called beta-neutral position in relation to the general commodity market, by the appropriate weighting of long and short positions. In this case, an alpha return can be achieved as a result of inefficiencies in the commodity markets. This strategy also helps safeguard against the high risk of loss associated with commodity markets.

However, a fund of funds solution is even better than a single hedge fund, as it offers the key advantage of broad diversification across various commodity hedge funds, further reducing risk.

These arguments persuaded BVK that commodity fund of hedge funds would also be a sensible addition to its portfolio.

LOOKING FOR MANAGERS

The pension fund then screened the many commodity fund of hedge funds managers and active long-only managers in the market for business.

The managers' funds had to have a minimum size, so that BVK would be able to invest the sums it wanted. Funds also had to have a track record of at least two years. This would allow BVK to assess each manager's investment style and focus. BVK backed this up with statistical analyses, ensuring that the subjective statements of the managers could be assessed with complete impartiality.

Finally, the managers selected from this process were subjected to due diligence procedures, beginning with a statistical analysis of their track record of returns. Of particular interest to BVK were those funds of hedge funds which did not contain any beta exposures, but just alpha returns. BVK also expected active long-only managers to have had alpha returns.

In the end, six commodity fund of hedge funds and six active long-only managers were invited to make presentations, describing their companies and their investment and risk management process in detail. The managers were also confronted with the results of the statistical analyses, while individual statements were challenged.

All candidates that were still considered good investment targets after this examination were asked to complete two detailed questionnaires.
On the basis of the responses, BVK arranged visits to the premises of those managers still being considered.

At the end of the process, two commodity fund of hedge fund managers were selected, alongside three long-only commodity managers, and mandated with a starting volume of €250m.

HIGHLIGHTS AND ACHIEVEMENTS

BVK used a systematic four-step process to determine how to invest in commodities, and who with. First, it checked that the asset class met its long-term investment goals. It then considered different ways to access commodities, discarding a passive index approach and investment via commodity shares, instead selecting active long-only investment and commodity hedge funds. Potential managers were then screened on the basis of their track records, and a shortlist was invited to make presentations.

Detailed questionnaires and office visits followed to check whether managers really practised what they preached. BVK's painstaking selection process has given it comfort that the five managers selected will produce extra returns from its commodities portfolio, while providing low correlation with its other asset classes.

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