The Hedge Fund Journal contributing editor Hamlin Lovell talked to Advent Software Solutions Consultant, Brian Stableford, who provided grassroots insights based on his daily on-the-ground interactions with participants in the industry. Stableford’s prior career incarnations have included commodities trading, so he is well positioned to opine on the challenges facing a beleaguered hedge fund strategy that has lately suffered a number of conspicuous closures of names that were once to be conjured with. Stableford helps hedge funds to find solutions for their front, middle and back offices and he keeps a close eye on regulatory developments.

A tough backdrop – but with pockets of opportunity
Advent’s Brian Stableford has seen commodity funds hit by “leverage in the face of redeeming flows from the manic crowd rotating to safe-haven investments with yields as QE III comes to an end.”

Late last year Barclays identified $36 billion of net outflows from commodities funds and said it estimated assets under management in the space were down by $88 billion. Stableford finds that “the knock-on effect of outflows is poor performance, and worst case closure if the client base is not diversified.” He thinks commodity funds are particularly vulnerable to redemptions because “selling positions you do not want to hurts overall performance.” In particular he points out that as commodity contracts can be thinly traded, “forced sellers are catching a falling knife.”

The headline closures in recent years of Chris Levett’s Clive, Jennifer Fan’s Arbalet, John Arnold’s Centaurus, Fortress’s commodity fund, Neil Shear and Jean Bourlot’s Higgs Capital and Pierre Andurand’s (albeit reincarnated) Bluegold are, Stableford surmises, “mainly due to a static investment process crippled by redemptions as Quantitative Easing approaches its perceived expiration which underpins any dollar-priced asset.” In contrast, he says that the “successful commodity hedge funds in our present environment are smaller, nimble, disciplined traders focused on relative value trades rather than trending markets.”

Some such relative value commodity strategies have been more resilient, Stableford has found – particularly when they are using little or no leverage. Typically these funds are doing spread trades, which might be intra-market trades such as Brent Crude Oil versus West Texas Oil, and which could include “crack spreads” like heating oil against crude oil, inter-market substitution plays such as copper vis-à-vis aluminium, or calendar spreads expecting the term structure to steepen or flatten.

Stableford also suggests that investors need to drill deeper to identify the differences between commodity funds. For instance, hard commodities can behave very differently from soft commodities – and even within the soft commodities space, individual products can follow their own path. The two best performing commodities of 2014, when we spoke in late February, were natural gas and coffee. Both price rises were weather-related but had very different drivers: cold weather for natural gas and droughts for coffee. Stableford thinks “a thorough understanding of the investment process of funds is essential,” and also argues that “allocations should be appropriate for the aggregate portfolio.”

Shifting commodity market dynamics
There is a long-running debate over whether commodities are an asset class. Stableford argues, “Broadly speaking, commodity futures were never intended to be an asset class. They exist to facilitate commercial hedging by producers and consumers, and speculators grease the wheels by providing liquidity.” He states, “The presence of large investors such as pension fund giants (CalPERS or APG), not to mention some of the big hedge funds (Paulson & Co), can distort thin commodity futures markets, disrupting the commercial hedging practices.”

Stableford also thinks these markets can become prone to manipulation via “front running, and people working in cahoots.” The links between speculation and commodity prices are the subject of academic controversy. Speculative activity can, Stableford reckons, “also aggravate commodity price inflation as we saw in 2008 and to a lesser extent in the shortages to triggering global recessions in response to oil price shocks.” Then, wider macroeconomic repercussions are felt as central banks will often respond to a speculative surge in commodity prices by raising interest rates, slowing GDP growth in the process.
 
The origins of this vicious circle date back to around 2007, Stableford thinks, “when investment banks and other financial institutions started mainly promoting tracker funds, which were mostly long only. Flows inevitably pushed prices of raw materials considerably higher, creating commodity price inflation, which reached a peak in July 2008. The process was repeated following the credit crisis crash, leading to another expensive bubble peak in 2011, which had little to do with a surge in consumer demand but a lot to do with long-side commodity speculation.”

Stableford explains: “With the advent of tracker funds in commodities, institutional participation in this sector has mushroomed from near zero to hundreds of billions of dollars. This largely one-way flow has inevitably boosted prices for a number of resources, not least crude oil. In the meantime, it is unintentionally compounding economic problems, not least in terms of commodity inflation.”

However, he suggests that this investment approach became a victim of its own success – by steepening the term structure. “The short-sighted investment institutions which purchased commodity futures tracker funds did not do very well because every three months they were hit by contangoand transaction costs when their expiring futures positions were rolled forward,” he observes.

Now it seems the pendulum may be swinging back away from passive investment, as Stableford notes: “Fortunately, that fashion faded and the unwinding of tracker fund positions and ETFs in commodities helped to lower prices in recent years. More recently, exogenous shocks such as the Arab Spring, Hurricane Sandy, and structural changes on the supply side, such as fracking, are contributing factors to a difficult market.”

In Stableford’s opinion, “the only commodity funds that should be considered as investment vehicles are the bullion funds for precious metals. Investors increasingly regard gold, silver and to a lesser extent platinum as hard money currencies, with the attraction of being no one else’s liability.” In contrast, Stableford views wheat and rice as “staples grown to feed people so there should not be speculation.” He warns that “with high rice prices you get revolutions!”

The changing regulatory environment
Stableford reflects how, “In reaction to the 2011 bubble, the US CFTC, emboldened by Dodd-Frank, sought to curb speculation in commodities, but the preamble was initially shot down by the US District Court of Appeals.”

After those early teething troubles, he stresses that current re-proposed legislation has ballooned into something far more comprehensive – covering 28 commodity contracts versus the original eight.

Stableford is sanguine about new CFTC rules capping traders’ position sizes. “The rule limits, established to date, will pose no threat to the vast majority of speculators who help to provide genuine liquidity in futures-traded commodity markets. Similarly, they will not impede normal hedging activities by the producers and commercial consumers of commodities,” he argues.

Of course non-financial traders are in any case exempt from clearing in the US, as are bona fide hedging transactions. But even in the EU, where even smaller non-financial traders must clear and report trades, Stableford is confident that they will be able to do so. “Technology is working and growing geometrically,” he says, with “Advent Data Services which acts as a backbone so even smaller players will be able to access the infrastructure
they need.”

Stableford seems to be an ardent advocate of the rule limits, and foresees that they will be profoundly benign for markets. “They should help to prevent a fashion for commodity trackers from distorting the markets and contributing to damaging commodity price inflation.” Stableford explains how some exchanges are “like clubs where people are looking to game the system the whole time as is the nature of markets.” The rules limits, Stableford contends, are designed to stop people continuing to buy in an upward market.

“The rules are a good effort and they should also make life more difficult for algorithmic, high-frequency and black-box trading,” he argues. “The logic is that traders are being told, ‘This is your ammunition for a day, month or contract’,” and that limits scope to manipulate markets. Stableford expects the rules “should prevent high-frequency traders from front running and causing even greater volatility to the detriment of commercial hedgers.”

There is limited potential in Stableford’s view for funds to side-step the rules through OTC (over the counter) or physical trading as he thinks this activity will also eventually get reported to the regulators, via counterparties’ reporting obligations. For instance, futures, options and swaps referenced to a futures price are deemed to be “economically equivalent” to the future itself and so are not exempt from rule limits or reporting requirements.

Even so, Stableford admits that it can be difficult for regulators to obtain a holistic global view of positioning, but he thinks the situation is improving. “Regarding cross-country positions this data is somewhat vague at the moment, but consolidation within the market landscape has lent a degree of transparency with NYMEX owning LME as well as many US depositories,” he points out. He adds that “Commitment of Traders Reports are published weekly by leading exchanges, such as IPE, ICE, SME, allowing regulators and central banks greater transparency during interim periods within the regulatory time-frames of reporting requirements.”

It is also unclear whether regulators can see the big picture through the lens of exchanges, when some physical trading activity may be hidden from view. Ever the cynic, Stableford says: “On the physical side, the wily investment banks came up with a subtler and even more profitable scheme. Fortunately, The New York Times has done a very good job of exposing it.” It seems that some banks are playing musical chairs with inventories to obscure their holdings, and Stableford concedes that “Sophisticated investors, some hedge funds, and certainly sovereign wealth funds will have similar facilities, which may cloud true positions from regulators.”

Advent in a brave new world
“Clearly regulation is a complex and fluid subject,” admits Stableford, who asserts that “Fortunately, Advent products are at the forefront of meeting the present and future reporting requirements of our clients in this changing regulatory environment.” Advent is helping clients report to all kinds of regulatory bodies worldwide including the FTC, FCA, EU committees, the EU transparency directive, Euroclear, and the SEC.

More than 300 hedge funds use Advent software, which has received awards from The Hedge Fund Journal including ‘Best IT Provider’ and ‘Leading Provider of Fund Accounting and General Ledger Systems’. Stableford says clients are using Advent’s “peerless accounting software which offers true derivative exposure,” meaning it will calculate the overall notional exposures and risk-factor sensitivities across a huge portfolio.

The software aggregates all of this “across
multiple locations and instruments,” which is particularly helpful for global hedge funds using a multitude of prime brokers, counterparties, and trading venues and funds exposed to a spectrum of exotic instruments. In turn, “shock modeling capabilities” help with stress and sensitivity tests for scenarios including rate rises, and volatility spikes. Users can stress-test variables in isolation or in varying combinations.

Moreover, financing and margining capabilities allow for stress-testing of spread, haircut and margin hikes – and are synchronised with collateral management requirements in relation to central clearing. All in all, it sounds like Advent is taking the bull by the horns when it comes to the brave new world of more intrusively regulated markets.

Commodities subject to proposed position size limits

The 28 core referenced futures contracts are: Chicago Board of Trade Corn, Oats, Rough Rice, Soybeans, Soybean Meal, Soybean Oil and Wheat; Chicago Mercantile Exchange Feeder Cattle, Lean Hogs, Live Cattle and Class III Milk; Commodity Exchange, Inc. Gold, Silver and Copper; ICE Futures US Cocoa, Coffee C, FCOJ-A, Cotton No. 2, Sugar No. 11 and Sugar No. 16; Kansas City Board of Trade Hard Winter Wheat; Minneapolis Grain Exchange Hard Red Spring Wheat; and New York Mercantile Exchange Palladium, Platinum, Light Sweet Crude Oil, New York Harbor ULSD, RBOB Gasoline and Henry Hub Natural Gas.