Baker Steel Alpha Gold Fund

Originally published in the September 2011 issue

Gold’s attraction to investors shows little sign of abating. A likely Greek default and rising inflation is burnishing gold’s lustre and helping gold exchange-traded funds attract record investment inflows.

All of this has seen the 21st September debut of the Baker Steel Alpha Gold Fund, which invests in gold equities and bullion prices, attract over $160 million, making it the largest product launch in Baker Steel Capital Manager’s 10-year history. The fund is also anew departure for Baker Steel, a specialist natural resources asset manager, with assets under management of over $1.6 billion.

The daily dealing UCITS fund is being run by Steve Ellis who managed gold funds at RAB Capital for four years before joining Baker Steel. The fund’s aim is to blend the long only equities investment skill of portfolio managers David Baker and Trevor Steel with Ellis’ experience in trading long/short physical gold and derivatives. Using the combined approach, the managers believe they can outperform gold by around 10% per annum through active stock selection and active exposure management.

“We think this product is a good entry point for investing in gold equities,” says Ellis. “The expected price of gold as implied by equity is the cheapest vis a vis the forward gold price that it has ever been. This fund aims to give investors equity exposure but with lower volatility than a long only gold equity fund. This is the opportunity that investors want to access now.”

Reducing volatility
Historically, some investors have been reluctant to invest in gold equities owing to their high volatility.

“That is why there is a big disparity between the price of gold and gold stocks,” Ellis says. “The fund is all about making the risk/reward proposition in gold investing more attractive.”

The first basic step to reduce volatility is diversification through blending gold bullion and gold equities exposure. At the same time, the fund offers alpha through stock selection, exposure management and tail event hedging to protect investors from large scale market events.

“With systematic exposure management what tends to happen is that a lot of downside volatility is stripped out of the fund,” says Ellis. “The annual volatility of the whole product (bullion plus equities) is projected at around 17% which is relatively low for the gold world. In comparison, gold equities have a volatility of about 47%.”

Proprietary sentiment model
At launch the portfolio held 70 mid-cap gold mining equities, accounting for its target 45% exposure. The fund’s proprietary gold market sentiment model (“Genex”) allows it to cut that exposure to zero by shorting a junior gold mining index. A sell signal in mid-September meant it launched with this defensive stance. With bullion, the fund opened with 20% gold price exposure obtained through exchange-traded products like the GBS LN (a London ETP) and the ZKB (Swiss ETP). The latter tracks the gold price in Swiss Francs which the manager feels has more upside potential given the authorities’ policy to weaken the Franc.

Genex is at the heart of the fund’s aim to manage exposure. The sentiment model analyses option pricing and open interest on gold exchanges. Given its contrarian approach a sudden surge in demand for calls relative to puts generates a sell signal. A buy signal is generated when the reverse occurs. The model has had a real-time 68% success rate over 2006-2011 and a slightly higher accuracy in back testing to 2002.

The sentiment model is binary in nature and deliberately quite prescriptive. The model changes the signal every six to eight weeks on average. In ‘risk on’ there is 45% gold exposure and 45% gold equity exposure; in ‘risk off’ it falls to about 20% and 0% respectively.

Gold expertise and product design
Ellis has a unique background in gold markets. He began his career in the 1990s with Reserve Bank of Australia and studied gold sales and gold interest rates. He also conducted research into the gold lease market at a time when producers were facilitated by central banks to sell forward gold production, often hedging it out to 10 years.

baker1The rationale for launching as a UCITS fund is to develop a differentiated investor base. Along with institutional investors, the fund should appeal to investors via platforms across Europe. The fund will also be available through independent financial advisors. The aim is to provide investors with a liquid, scalable, low volatility, regulated product.

The fund will compete directly with gold ETFs. Ellis believes there are a large number of investors ready to move into an actively managed gold fund. He has also received positive feedback from holders of physical gold who are considering allocating a proportion of their bullion into an active approach with the embedded tail event protection.

Offering portable alpha
The approach also provides portable alpha. The mid-cap gold equities remain in the portfolio with the index being used to ‘dial up’ and ‘dial down’ net exposure levels. In a ‘risk off’ environment, for example, the model has a sell signal and Ellis uses the index to neutralise net equities exposure to nil.

Typically the fund invests in the mid cap space, including companies like Resolute Mining in Australia. But recently given the deep value across the sector, the fund has increased exposure to larger cap names, including Harmony, Goldfields and Kinross.

Tail event hedging
Apart from general exposure management, the fund also employs strategies with insurance like pay-offs to guard against larger gold market sell-offs. “We like gold’s internal supply and demand so we are not buying puts directly on gold,” says Ellis. “But we are conscious that the periphery markets for gold have been tail winds for a decade now so we are looking to hedge the reversal of that.” The aim is to use derivatives on the factors that have contributed to push gold to record prices. These factors include:

1) hedging for a strong dollar through call options;
2) hedging against higher real yields;
3) hedging against commodity prices collapsing through put options; and
4) hedging against the re-introduction of gold producer hedging through locking in gold borrowing costs.

“The proposed trades are all designed to hedge against a turnaround in any or all of the factors supporting gold,” says Ellis. “We have witnessed a perfect storm and that is why there has been such a strong shift in the gold market.” The fund plans to spend about 1% of NAV per annum on each hedging play, making it unique from other gold funds, which are long only.