The fact that Brevan Howard Commodities Strategies Master Fund Limited (BHCS) won the performance award with relatively modest returns of 7% last year goes to show how challenging times have been for discretionary commodity traders in recent years. Correlations between commodities and other asset classes have never been so high, with risk-on/risk-off dynamics rather than fundamental supply/demand factors driving markets. Given this macro-oriented market, it is natural that a macro approach has helped, although the returns of BHCS are not in fact correlated with those of the Brevan Howard Master Fund. The active trading of BHCS, almost exclusively using options, has out-performed passive buy and hold investing such as tracking the Goldman Sachs Commodity Index (GSCI).
The strategy has participated in 75% of the upside of the GSCI and only 27% of the downside since 2004 when the strategy manager, Stephane Nicolas, was lured away from heading Bank of America’s energy options desk. The strategy’s annual returns of 9% were within the Brevan Howard Master Fund until 2010, when it became accessible through a separate fund.
Although BHCS has the freedom to invest across the entire commodity space – and has five specialists covering energy, precious metals, base metals, agriculture, and derivatives – it will often have no exposure to certain commodities and is highly opportunistic about focusing on the most promising areas. For instance, in 2012 no major positions were taken in base metals and there was only a brief soybeans trade in the agricultural space. Three trades were the main drivers of performance in 2012.
The first was an arbitrage trading strategy, owning European Brent crude oil and shorting the US oil benchmark, West Texas Intermediate (WTI). The rationale behind this trade was fundamental as WTI was vulnerable to shale oil coming on stream and delays to pipeline logistics. Meanwhile, Brent was not pricing in enough tail risk for possible supply shocks (Iran-Israel, Sudan and Yemen conflicts). As typical for BHCS, options were used to express the ideas and create an asymmetric risk/reward profile. The term structure added to the appeal of the trade since an upward-sloping contango made it cheaper to short WTI and steep backwardation in Brent generated a positive roll yield. This spread trade generated approximately half of the 9% gross return for BHCS in 2012. The second key trade was initiating an outright long in gold after Draghi’s “whatever it takes” speech. BHCS chose to own gold in euro terms, partly because precious metals were expected to benefit and the euro was expected to suffer. Additionally, call options in euro terms were cheaper than in dollar terms.
The third trade was owning energy with strong downside protection. Between January and July last year the energy market corrected by 25%, but the fund only lost 3%. BHCS was using just one-third of its Value at Risk (VaR) limit as the macro picture from Europe was worrisome, with negative news coming from Spain and widening credit spreads. Like all Brevan Howard funds, BHCS is opportunistic in deciding when to use its risk budget and can stay cautious for extended periods if the right trades cannot be found. The fund is overseen and helped by Brevan Howard’s 26-strong risk management team.
Nicolas forms top-down views based on the supply and demand balance for commodities. His 2013 outlook is potentially bullish. Commodities have lagged behind equities to such a degree that there could be scope for a catch-up rally if global growth becomes more sustainable. Two additional factors also mean that BHCS could construct trades with as much potential upside as those that made 35% over a few months in 2008. The low levels of implied volatility in energy markets mean that the fund could buy a substantial amount of optionality without overstepping its risk budgets. Moreover, the term structure in energy markets once again results in positive carry. Elsewhere, the view is that unprecedented monetisation from the Bank of Japan could cause a gold rally, but BHCS is also well aware that a shift into equities has been bad for gold. This strategy currently runs approximately $1.5 billion including $700 million from the Brevan Howard Master Fund.