Performance of commodity trading funds
Based on Aurum’s internal hedge fund peer group data comprising between 16 and 69 funds per year the median return for commodity hedge funds has not been above 1% since 2010. However, if we look further into the figures we can see that the top quartile of the peer group in 2014 returned 11.1%, far exceeding 2012 and 2013 where very few in the peer group made any notable returns.
However, despite the improved performance of a few managers it seems that the prospects for the future of the area as a viable sector for hedge fund investment has taken another hit by the recent closure of a further four high-profile funds, with this news following the 2013 closure of some of the largest commodity funds. Clearly it is a sector that is very much still on the back foot.
For some investors commodity trading and commodity hedge funds bring to mind the macho image of 'old school' macro traders, making their name by correctly calling big moves in the asset class. However, for others the space is known for 'cowboy' traders who are prepared to take large losses hoping that trades will eventually turn for the better. Why did this asset class become so associated with volatility and a reputation for throwing risk control out the window? In this article we look to lift the lid on why commodities are potentially challenging to trade, why almost no-one has profited from the area in recent years, and speculate as to what the future might hold?
Why are commodities problematic to trade?
Even during, what now appear to be, the halcyon days of commodity investing prior to 2011, commodity derivative trading funds had a reputation for being notably riskier than most hedge fund strategies. This reputation has no doubt been fuelled by events such as the failure of Amaranth in 2006 where the fund lost $4.6bn in one week; past stories of traders with names like 'chocolate finger' attempting to corner particular markets; or even the fake crop report scam in well-known movie Trading Places. Underneath these headline-grabbing stories there are grains of truth in this fear as commodities have historically been more volatile than other asset classes.
The principle reason that commodities are so volatile is that the construction of the pricing of their forward curves is at least partially predicated upon the storage costs of a commodity. Part of that cost is therefore based around how difficult that commodity is to store and what the overall storage capacity of a commodity is, which largely determines the volatility of a particular commodity. For example, natural gas (known in the trading world as ‘the devil’s instrument’) is very difficult to store and is well known for its periodic bouts of extreme volatility.
It is well-known that when commodity futures contracts expire the trader theoretically has to either take delivery of – or deliver if they are short – the physical commodity linked to the contract. This contributes to physical commodities players (those who produce, store, or ship commodities) having an advantage in trading the front-month contracts as they know first hand how much of the commodity is being stored, and have more information on on-the-ground commodity prices versus commodity futures prices. Short-term moves in front-month contracts can be quite volatile due to changes in these physical factors where traders who sit outside of physical houses really are at a disadvantage.
This means that commodity derivative traders usually trade in contracts at least three months down the respective commodity curves. However, violent moves in the front months can still cause a reaction further down the curve, which means that commodity forward curves can be very volatile compared to those in other asset classes. This can be an extremely dangerous scenario for someone trading relative value spreads (for example, the March-April natural gas spread known as ‘the widow-maker’).
It should also be noted that it is not uncommon for liquidity in commodities markets to quickly dry up with prices moving ‘limit down’ and blowing through previously set stop-loss limits without being executed.
Why did the average return fall to such low levels?
Despite the dangers discussed above, commodity managers on the whole managed to trade the markets relatively successfully until 2010, so what changed? Similar to other asset classes over the course of 2011 and 2012 commodities were notably affected by the 'risk-on, risk-off' phenomena that occurred during that time, which led to increased cross-asset correlation and increased intra-commodity correlation. This correlation may also have been caused by increased speculation in the space by macro traders and/or the investors that were beginning to invest in commodities through the wave of newly created commodity ETFs. In addition, by 2011 commodity hedge funds had reached their largest size ever.
The period was also known for skittish markets that were highly concerned about the tail risk of European instability with many traders complaining about markets that had a high daily range of movement but ultimately there was a low range of movement over a longer period of time. What this meant in practice was that it was quite difficult to stay in trades and even if you were able to maintain positioning the potential reward was not particularly high. This environment made trading conditions particularly difficult if managers preferred to structure trades through options as the macro concerns led to options that were expensive (higher implied volatility) but ultimately there wasn't enough of a price move (not enough actual realised volatility) to compensate for the cost of the options.
Following Mario Draghi's 'whatever it takes' speech in July 2012 correlations began to come down in commodities, as they did across many other asset classes. However, while returns began to improve in many hedge fund strategies, commodity managers struggled just as badly in 2013 as they did in the prior two years. One factor here may be the lack of trading range and volatility in oil markets due to the glut of oil in North America that had built up as a consequence of the 'shale revolution'. If one looks back at how low performance was for even the upper quartile of the peer group during 2013, we can possibly come to the conclusion that perhaps commodities having high volatility isn't such a bad thing as although this has been one of the key determinants of the area's 'cowboy' reputation, at least it meant that there were moves to trade.
Light at the end of the mine shaft?
The top quartile of the commodity trading peer group in 2014 made a solid return for the first time since 2011 in a year where headline indices suffered a torrid time. That said, one fleeting uptick at the top end of the peer group isn't enough to convince us yet that "commodities are still a fabulous place to be in". However, this has coincided with increased volatility in the oil market and many other commodities which seems likely to continue for the foreseeable future. In addition, the reduction in hedge fund assets in the space from both the reduction in assets in commodity hedge funds and the retreat of macro funds from dabbling in an area where they have been burned in the past is clearly a notable positive for any assessment of the area's alpha potential as crowding is always the greatest risk for a strategy's returns drying up. Furthermore, the ETF growth that many felt disrupted good fundamental analysis is no longer so prevalent in markets with investor interest in the space drying up so there are clearly structural positives that may last for a period.
As the peer group generally exhibits a wider range of performance between winning and losing managers than other hedge fund strategies this isn't a space to go into lightly. Indeed, we would suggest that a due diligence process that focuses heavily on downside risk control and the trading of liquid products is essential to attempt to avert any potential tail risks from the higher volatility in the space.