AlphaBee Asset Management’s AlphaBee Commodity Arbitrage has won The Hedge Fund Journal’s CTA and Discretionary Trader Award for Best Performing Fund in 2023 and over 2, 3 and 5 Years ending in December 2023, in the Fund of Hedge Funds – Commodities strategy category.
AlphaBee’s White Paper, “One cannot (really) invest in commodities. You should still do it, and especially now,” makes the case for a special type of commodity exposure.
We want a hit ratio as high as possible. Discretionary macro can be erratic – people may have a brilliant 4-5 years and then lose 50% or more.
David Arnaud, Partner and CIO, AlphaBee
In contrast to money, which can be created by central banks, commodities are in finite supply. Physical supply and demand, inventories, transportation costs and weather surprises can all be relevant for pricing. Geopolitical conflicts can disrupt supply chains and increase transportation costs. The shift to a multipolar world moving supply chains from “Just-in-time” to “Just-in-case” means that more surplus inventories need to be held. Meanwhile, green energy transition is increasing demand for many metals.
A simple addition of 20% commodities to a portfolio of equities and bonds adds a significant diversification benefit, but the instruments and vehicles need to be carefully chosen (see Fig.1). It is not practical to invest directly into physical commodities. Investing in equities of commodity producers involves company-specific risk and considerable volatility. The returns from investing in commodity futures are heavily influenced by the shape of the forward curve. “A long only ETF or fund can lose all its capital after one cycle considering storage, insurance, financing or transportation costs associated with the underlying commodity price being equal,” says AlphaBee Partner and Chief Investment Officer, David Arnaud.
AlphaBee reject all these access routes and instead obtain commodity exposure in a very distinctive and differentiated way, namely through “smart” investing with specialist managers who take advantage of the fragmentation and inefficiencies seen even in the largest and most liquid commodity futures markets. Arbitrageurs may trade based on calendar exposures, geographies, substitute products and market statistics. An elevated volatility regime provides a tailwind.
AlphaBee are in fact somewhat constructive on the outlook for commodity prices but would prefer to use their expertise to select arbitrageurs that can generate alpha through bullish, bearish or flat markets.
David Arnaud has been a hedge fund analyst since 2005, including through several crises. His career started in banking and M&A in the late 1990s, but he switched to hedge funds after becoming presciently concerned about valuations and market dislocations during the TMT bubble. Mentored by a Head of Quant, he moved into fund of hedge funds in Switzerland, became a hedge fund analyst at a single-family office, and worked with internal teams of analysts as well as various external advisers, including Albourne Partners. He wanted to set up his own multi-manager specialist for more strategy focus and more alignment with investors: “In 2008, the only profitable strategies had been CTAs, and I wanted to specialize in those strategies as well as arbitrage strategies. It was a must to be positive at the end of the year regardless of the direction of financial markets”.
In 2016, a veteran Swiss fund of hedge funds entrepreneur who had launched a fund of hedge funds in the 1990s was seeking partners for a new venture with the same DNA of uncorrelated returns. The objective was to launch a regulated SICAV, which started as a multi-strategy product investing in the most liquid assets such as equities, futures, rates, forex and commodities. “At that time there was no competition in Europe for our style of fund of hedge funds,” recalls Arnaud, who co-founded AlphaBee with Frederic Guibaud, who has a background in long-only assets, commercial real estate and liquid alternatives. The AlphaBee team of five which sits on its monthly investment committee has cumulative experience in hedge funds analysis and investments of close to 100 years. Though commodities make up only 20-25% of the multi-strategy allocation, they have punched above their weight and made an important contributor to returns, which encouraged the firm to launch the pure play dedicated commodity strategy in 2021.
AlphaBee constructs the portfolio with the aim of generating more upside than downside: “The objective is to achieve positive convexity in the return profile, and this worked especially well in 2018 and 2022 when equity and/or bond markets were down,” recalls Arnaud. For both the multi-strategy and the commodity funds of funds, AlphaBee seeks a Sharpe ratio of at least one from managers and looks at the third and fourth moments of the distribution – skewness and kurtosis – to find positively skewed return streams and avoid fat left hand side tails.
“The commodity product is optimized to be balanced and diversified with around 15 managers, but our methodology of strategy allocations enables us to not be over-diversified,” says Arnaud. The appropriate leverage for each manager is tailored to stress tests. Sizing of allocations is optimized to control volatility and tail risks, which are especially important for commodity managers. “We aim to avoid tail risks,” says Arnaud.
Persistency is also a key criterion in return patterns: “We want a hit ratio as high as possible. Discretionary macro can be erratic – people may have a brilliant 4-5 years and then lose 50% or more,” says Arnaud.
500
AlphaBee has around 500 manager launches per year on their radar.
AlphaBee has around 500 manager launches per year on their radar. The bar is high for new additions to the portfolio: “Returns need to be lowly correlated or uncorrelated to existing managers,” says Arnaud.
Capacity can be limited for some of these strategies, but AlphaBee has been able to identify solutions for accessing funds closed to new investments and niche strategies in arbitrage and relative value. “A lot of emerging managers have grown considerably and are now soft closed, but we can continue investing thanks to our special relationships. We started to invest in some managers when they ran $50 million and now, they have $1 billion of AUM. We have sometimes even co-invested in managers that ran only a few million at launch,” says Arnaud.
Though AlphaBee have a healthy appetite for early stage and emerging managers, they need to satisfy institutional criteria. “They should be AIFMs, have an internal risk manager and best practice risk managers, and so on. We can invest $10 million in a managed account but would not seed a one-man shop. There needs to be a team in place,” says Arnaud. Alignment of interests is vital. All managers need to be well-aligned and invest in their own capital in their strategies.
Most managers are located in the US, Europe and Asia.
Commodity managers may be specialized in a single sub-asset class, such as energy, metals or certain agricultural markets or even a single market. “There are no pure oil traders in our portfolio, though we could do natural gas alone, which is still quite an inefficient market,” says Arnaud.
The balance between producers and speculators can be important in determining the potential for some strategies. “These markets are dominated by fundamentals and the market participants are fairly balanced between US natural gas producers and speculators. Natural gas has become a global market thanks to liquified natural gas and traders also need to model all balance sheets globally to forge a precise view and stay on top,” points out Arnaud.
The book is, on average, market neutral through a full cycle, though it can be partially net long or short of certain commodities at certain stages of the cycle. “Some may even be purely delta hedged. In May 2024, there were a lot of shorts. The more volatile the asset, the better for an arbitrage strategy. But basically, we only invest in strategies with limited directional sensitivities. We must understand both the qualitative and quantitative parts of the strategies they run and understand the drivers of the expected return and risks,” explains Arnaud.
AlphaBee look at a wide variety of strategies on the continuum of relative value and arbitrage: cash versus futures, calendar spreads, location spreads, substitution arbitrage, and production related spreads such as crack spreads for oil versus derivatives like fuel oil or jet fuel or whole soybeans versus soybean oil and meal.
“Arbitrage is like a pyramid of relative value strategies. At the top of the pyramid there is pure geographical arbitrage involving simultaneous trading between exchanges, such as Chicago versus Singapore,” says Arnaud.
Some arbitrage strategies that do not meet the strictest definition are based on mean reversion. How well this works varies between managers, markets, maturities and with global demand. “They need to stay in front of the curve of knowing where supply and demand come from. We try to measure this for each manager when we do due diligence: how they trade, what the drivers are and how to model expected returns to understand which factors are best to define their strategy,” says Arnaud.
The unusual phenomenon of negative prices during Covid was a source of opportunity for some managers. “In May 2020, for example, when WTI oil prices went negative, some managers were long the July and short the May contract,” recalls Arnaud. In copper, the strategy has profited this year from both directional moves and price differences between exchanges. “The price of copper globally should be the same over three months given freight ships will deliver at the location with the more favorable commodity price,” says Arnaud.
Global fragmented commodity markets and their variable patterns of production as well as uncertain demand make those markets quite inefficient and volatile. Some commodities show seasonal variations between summer and winter. Managers need to have a fundamental, quantitative or technology edge and have a robust risk process to hedge portfolio risks, in particular tail risks and worst-case scenarios.
Returns need to be lowly correlated or uncorrelated to existing managers.
David Arnaud, Partner and CIO, AlphaBee
Around 80% of the managers are discretionary, though this can include some hybrids mixing quantitative and discretionary strategies, which AlphaBee still classifies as discretionary. “We would need to see systematic execution to define a manager as purely systematic,” points out Arnaud.
“Systematic managers tend to trade global commodity markets and are more diversified across multiple commodities, but these only make up about 15% of our current commodity portfolio. We are mostly invested in more specialized commodity managers,” says Arnaud.
AlphaBee are researching AI strategies and Arnaud is meeting managers in the US. “A lot of strategies add value with processes using some forms of AI and have been doing so for a few years,” observes Arnuad.
All of them trade derivatives, futures and options, and not physical. “We avoid products that may become illiquid,” says Arnaud. Managers are mainly trading at the front end of the curve and will not be trading several years out as there is usually more liquidity in the first future contracts on the curve.
Managers trade mainly on the global liquid exchanges in the US and Europe and some in Asia, Brazil and South Africa, but not in Russia. Some OTC markets such as certain metals and freight can be traded, as well as some bespoke futures or forwards, so long as they can be cleared. Carbon futures are starting to become liquid enough to trade on multiple exchanges globally.
Commodities can trade on a variety of exchanges and other venues. “We also look at all liquidity providers to analyze how relative value arbitrage trading might work,” says Arnaud.
Freight, power and natural gas are the most volatile commodity assets and various uncorrelated strategies in those assets offer diversification.
Weather is not directly traded, but is an important analytical input, especially for agricultural markets and some energy markets. “Many managers use internal or external weather experts and try to understand the statistics including global warming. They want to predict the most probable weather,” Arnaud observes.
China is listing several commodity markets that do not trade elsewhere, and Arnaud is taking a carefully balanced view on the risk profile: “We have so far been very conservative on Chinese commodity futures, given the possible tail risks around a Chinese invasion of Taiwan. We therefore have most of our exposure to Chinese commodities via non-local prime broker swaps”.
Managers do need to use some leverage to exploit arbitrages, and this is mainly obtained through margin trading of futures via prime brokers.
Managers can leverage up their trading strategy but leverage itself should not be the source of returns. Commodity trade finance is a large market where banks and funds are active, but it does not fit AlphaBee’s risk profile. “We do not like trade finance or leasing strategies as they can have credit risk,” says Arnaud.
“Most of our assets are in a regulated Luxembourg fund, but another investment vehicle has been set up to cater for US investors, with Kettera Strategies based in Chicago as the Commodity Pool Operator. The opportunity set is larger to invest into funds, however the Hydra platform managed by Kettera is an exception where we can invest in managed accounts. Hydra has been approved through internal and external ODD,” says Arnaud.
“We advise a bespoke US family office mandate with whom we co-invested and we benefit from synergies between their analytical teams and ours,” says Arnaud.