(L-R): Dawid Heyl, Mark Lacey, Bradley George, George Cheveley, Mimi Ferrini, Jonathan Waghorn
Investec has been an established brand name in the world of global asset management since its acquisition of boutique London fund manager, Guinness Flight, in 1998. Since then, under the leadership of charismatic CEO Hendrik du Toit, its distinctive zebra brand has become highly recognisable in both retail and institutional investment circles.
Drawing on its already considerable expertise in commodities and natural resources (partly thanks to its South African pedigree), Investec has been building up an internal team that can manage both long only and long/short strategies in the resources field. The fund is managed by Bradley George, Head of Investec’s Global Commodities and Resources Team and a former Goldman Sachs’ Executive Director. The fund invests both directly in commodities and in equities of resources firms, like mining companies for example. The core team includes ten professionals with experience in commodities and resources.
“This strategy is one of the very few strategies out there which can invest in both [commodities and natural resources,]” says George, whose background at Goldman’s involved holding positions in commodities structuring as well as investment banking advisory in natural resources. The firm is now managing over US$144 million (end August) in a hybrid portfolio of equities and commodities derivatives that can also take short equity positions.
George could see the long term nature of the commodities investment cycle while he was at Goldman Sachs, for instance how client companies were gearing up to meet increased demand for their product. He also felt a fund which blended commodity derivatives with equities would provide investors with an unusual opportunity. Iron ore or fertiliser, for example, cannot be acquired as commodity investments, but exposure can be gained indirectly via equity positions.
The team looks at commodities from a very fundamentally-driven perspective, examining supply and demand trends globally, and analysing whether markets are in surplus or deficit. This can then provide them with views on price trends. A proprietary rolling two year forecast can be broken down into half-yearly periods along with a more long term view. The fund is comprehensive in its coverage, including metals, energy and softs.
Investec’s equity research framework tracks approximately 800 resource companies worldwide, either commodities producers themselves or those providing services to the sector. Weightings by sector and sub-sector will depend on the team’s market view, with holdings generally restricted to firms with over US$1 billion by market capitalisation. The homework being done on commodities also pays dividends for the equities portfolio, as it generates future buy signals for the portfolio management team. Thus the portfolio can combine both commodity derivatives and equities, and the managers have the mandate to employ shorts in the equity side of the portfolio. Investec rules out borrowing to provide the fund with gearing, although it does provide a certain degree of leverage to a maximum of 300%.
In its first year of trading the fund was up 41.2% and, since inception, has delivered returns of 35.98% with a fund size of US$144.7m.
“This is going to be an interesting place to invest for the next 15 to 20 years, and also holds out the possibility of diversification benefits thereafter,” says George.
Investec’s team emphasises variable backgrounds. George, himself, hails from Goldman Sachs, where he spent half his time covering the resources sector as an investment banker and the rest on commodities structuring. He was hired into Investec in July 2006 after seven years with Goldman’s to set up the commodities and resources team.
George Cheveley worked at BHP Billiton, the largest mining company in the world, before he joined Investec to cover base and bulk metals. The firm’s energy expertise comes from Mark Lacey and Jonathan Waghorn, who were co-heads of the energy research team at Goldman Sachs, while precious metals expertise comes from Daniel Sacks and Gail Daniel, both based in Investec’s office in South Africa where they can keep a closer eye on the world’s largest producer of precious metals.
Investec also has three investment analysts, two covering soft commodities and one supporting Sacks and Daniel on precious metals.
George stresses that the team is relying on fundamental research, combined with their diverse backgrounds (eg. Cheveley comes from an industry background, George from investment banking, Lacey and Waghorn are research specialists, while Sacks and Daniels have a fund management background). This makes for a comparatively high level of idea generation for the portfolio.
Given the volatility in the commodities sector, Investec felt a hedge fund structure would be more suitable for the rising saw-tooth pattern it anticipated from the markets the fund would trade. “There are going to be periods of weakness during this long term commodities cycle,” says George. “The short side of the book becomes more relevant during these times. We’re trying to generate risk-adjusted returns for the investor, but reducing the volatility.”
The fund is targeting volatility at between 10 and 15%, and in 2007 its 41% return was achieved with volatility of 13%. Short positions can be put on both within outright commodities and with resource equities. Maximum gross exposure is 300%, although it has historically never reached much above 200%.
The fund’s mandate theoretically permits it to be a pure equity or commodity fund, but it is unlikely that it would abandon its broad hybrid opportunity set. Some allocation restrictions apply on a sectoral basis (eg. an 80% ceiling on exposure to the energy or metals market), and there is also a restriction against taking a position in excess of 20% in any single commodity. This stops the managers from taking highly concentrated bets. Investec also benefits from an internal risk management team that monitors its portfolio volatility and VaR, one of the obvious benefits of being part of a larger institutional asset management business. “We’re very happy with the level of risk that we’re taking for the ideas we’re generating,” says George.
Investec also runs other hedge funds in-house, meaning its risk management team is already familiar with some of the additional risks that hedge funds take on. The portfolio is based on a level of conviction about the underlying commodity. Exposure can be procured via futures and options. For equities, earnings, capital management, asset quality (reserves and production), momentum (share price momentum and volatility) and valuation all come into play. The typical portfolio will have 10-15 commodity positions and 15-40 resource equity positions, both long and short.
As a global fund, Investec Global Commodities & Resources can spread its net wide. As a resource-based portfolio, it has strong weightings in Australia, Canada and South Africa, although it has growing holdings in Brazil, Russia and other parts of Africa. The managers generally favour the more liquid exchanges with better disclosure if given a choice of listings, but there are exceptions to this rule (eg. it bought Impala Platinum in South Africa rather than New York).
Launching a fund like this makes sense on two levels: in 2006, when George joined Investec, a number of hedge fund groups were already making the case for a protracted commodities boom, some within the pages of this very magazine. This bull market reached a frenzy of speculation, particularly
in the first half of this year, with sky-high prices in a number of markets. Indeed, at one stage it seemed as if commodities was the only game in town.
The industrialisation of the BRIC economies, particularly China, remains a core platform for the ongoing commodities investment story. As long as Chinese economic growth remains above 8% this year, Investec’s analysts are confident that its demand for natural resources will continue to provide support for commodities prices, even with a global economic slowdown.
“What’s really come to the fore recently is the Middle East and just how significant the industrialisation of that region is,” says George.
The OECD has also significantly underinvested in its infrastructure, and is now facing the prospect of having to upgrade and replace essential items (see Fig.1). Even if emerging markets fall over, and even if the western consumer struggles, roads, airports, water and power facilities will need improvement. Investec estimates over US$2 trillion will need to be spent in the OECD over the next five years, compared with US$2.5 trillion in the BRICs. A global recession remains Investec’s biggest risk scenario, with potential for a slowdown in commodities demand. The part of the economy most likely to be hit will be consumer-oriented, but Investec is arguing that the infrastructure bill is not something the OECD is going to be able to get away from.
“We don’t have excess inventories,” says George. “Arguably we could do with some sort of slowdown in order to build up inventories. OPEC’s spare capacity is around 2 million barrels. If we do have some sort of slowdown, it would be quite good to build out the number of refiners. If you’ve got no inventory available, you’ve also got volatility.”
There is not enough spare capacity in energy markets at the moment, due to underinvestment in the 1980s and 1990s. The huge infrastructure spend of the 1940s-50s is no longer able to support ongoing economic growth and the need to modernise, both in the developed and developing world, will likely lead to higher prices and more competition for natural resources.
The base metals part of the portfolio is overseen by Cheveley. His days at BHP Billiton give him a useful perspective on the world’s base metals markets. While working for the global mining giant, he spent many months in China which, even then, was hungry for base metals as it embarked on its massive process of industrialisation. Being on the ground, he says, gives the analysts a much better feeling for potential demand trends, in themselves essential for the overall direction of the portfolio.
“It taught me that, when doing the analysis, you have to be very wary of the mood in the locale where you are,” Cheveley explains. “I think that’s more true today than ever. You can sit in the UK, and every time you open a paper, the world’s about to end economically…I speak to people in China and things are good. The domestic economy is still growing very strongly. China’s dependence on trade is far less than people think. There’s a perception that China is an export-led country, when in fact their net trade isn’t that huge. The main driver for China’s economy is investment and the domestic growth. It’s quite difficult to believe that at times, if you’re sitting in the wrong place.”
The China demand story is a very strong under-pinning for the global commodities story, and Cheveley himself says it can’t be over-emphasised. “It sounds really simplistic, I know, but it’s a big place, and it has a lot of people,” he explains. China’s ongoing economic growth, even if it is as low as 8% next year, will still hoover up massive amounts of the world’s annual natural resources output. It remains the most significant macro factor driving commodities and resources prices today, and that is not likely to change, particularly for base metals.
Cheveley himself readily admits that he was a China cynic in 2001-02, but that his views have changed since he carried out extensive research work on the country. “You realise the scale of it,” he says. “It’s not just about Shanghai developing, it’s not just about Beijing and the Olympics, it’s about all these others cities, all developing on a huge scale. The impact of that on the surrounding region as well can’t be under-estimated,” (see Fig.2).
Other Asian countries like Indonesia, Thailand and Malaysia are similarly developing at a rapid pace, perhaps not on the scale of China, but their demands will affect base and bulk metals prices.
Cheveley’s expertise is focused very much on fundamental commodities research. At its core, as he describes it, the process is very much about balancing which countries are likely to produce, and what they are likely to consume. Procuring the numbers, forecasting them and, most importantly, working out where inventory levels are, represents the more difficult parts of the role. “Clearly if there’s a small deficit in an inventory, then the result probably isn’t that exciting,” he says. “Equally, if you’ve got a small surplus, and no inventory around, you can still get a very tight market.”
It is easy to generalise about commodities, but as Cheveley points out, for every metal there is a different supply/demand balance. Over the last year or so, for example, lead and zinc prices have been dropping dramatically, despite the high prices in other base metals. Copper, thanks to supply disruption, has remained high. “If you look at the metals this year, the base metals have followed fundamentals,” he explains. “To prove what the supply and demand imbalance of copper is, you can only look at [the market] three to six months after the event. For instance, at the beginning of this year, fundamentals looked fairly weak, demand was slowing, supply was reacting, the forecaston supply/demand was the market moving into surplus this year. By February, copper prices were rising, and a lot of people were crying foul, or speculative bubble. Copper now looks reasonably tight, and could be tighter going forward. The fact is, inventories were tight for copper. It wasn’t that much of a surplus, and there would have had to be a major surplus to push this market down.”
Half the time it is less an issue of hard-and-fast forecasting, and more a case of comparing the team’s view of markets with what the consensus opinion is. This can, potentially, produce some good arbitrage situations. A classic case was the oil market this year, where inventory levels were conflicting with the high prices crude oil was achieving. This created a good opportunity for savvy managers to exploit the subsequent fall in price over the summer months. Oil has been one of the commodities that has garnered the most attention from investors in recent months, and Investec itself draws for its energy expertise from the co-portfolio managers of its Global Energy fund, Lacey and Waghorn, who joined the firm from Goldman Sachs earlier this year. The highly-rated former analysts are charged with coming up with the energy investment ideas for the hedge fund.
Waghorn is a former offshore oil drilling engineer who has had hands-on experience of working on oil rigs in the North Sea. He met Bradley George while at Goldman’s and ended up broking to him when George left Goldman’s to join Investec and take charge of its commodities and natural resources funds. His and Lacey’s arrival came as part of Investec’s decision to bring management of its Global Energy fund in-house. Both managers have a background in fundamental research, and have an established track record in making good stock-picks, including independent recognition from the likes of Starmine and Extel. “We do a lot of fundamental work on each of the commodities across the energy space, be it refining margins, oil prices, gas prices, or be it investment cap-ex levels from the integrated oils,” says Waghorn. “We monitor all that, keeping an eye on the way inventories are developing, and then playing the individual equities that are best-placed to benefit from the future moves in the commodities environment.”
The team uses proprietary models they have built internally at Investec that help to inform their stock-picks. “It is a development from the process we used to use at Goldman Sachs,” explains Lacey. “There’s a consistency across the whole team – they hired us in because we use a process that is similar to the one Investec was already employing successfully. Our transition into the team was extremely smooth.”
In a matter of four months, Lacey and Waghorn have met over 100 company management teams in the energy space. “That’s absolutely critical,” says Waghorn. “A model can throw up the numbers, but you need to meet the management and get a feel for what they’re targeting. That’s been a significant part of [the process].”
The Global Commodities & Resources Fund is already one of the best-performing vehicles in its peer group. With its South African background, it seems natural that Investec has drawn on its already established pedigree managing long only natural resources portfolios, and the launch of a hedge fund that could tap the diverse expertise of this team of portfolio managers was also a logical step for the firm. Timing could not be better, as the recent commodities boom has led many institutions to reconsider whether they should be broadening their exposure to the asset class.