Gold’s 5,000 year history as a repository of value makes it the ultimate safe haven, something that hasn’t escaped some hedge funds and institutional investors. The upside for gold could be substantial if central bank money creation eventually stokes an inflation storm and leads to widespread currency devaluation amid a prolonged period of economic instability. Gold has rewarded investors in recent years, though its long-term returns (see figure 1) include considerable periods of flat or even negative returns.
At RAB Capital, portfolio manager Steve Ellis is managing two funds, RAB Gold and a hybrid product RAB Gold Plus. He is optimistic that the gold market is poised for another sustained period of outperformance. This could give RAB Gold Plus an attractive opportunity. It combines an 85% allocation to alpha strategies (RAB Gold is 100%) with the remaining 15% of the fund used to buy gold on margin giving 100% exposure to the metal’s price direction.
“Traditionally gold doesn’t have a return – there is no dividend, no yield,” Ellis says in an interview at RAB’s offices off The Strand in London’s West End. “If anything you have to pay storage and insurance fees.There must be a better way of giving investors the gold return plus some type of yield. The hedge fund approach is to give you the yield by the active trading strategies.”
For investors, the choice of funds means they can take advantage of the beta in Gold Plus when markets favour a directional strategy, while having the option to switch at month end into the pure alpha strategy. The process is a simple one since RAB just sells the gold derivatives position to unload the beta.
Alpha strategies offer flexibility
The investment process underlying the alpha strategy is three-pronged: directional (60%), precious metals volatility trading (30%) and relative value (10%). “All three strategies don’t really have a directional bias to gold in the long run,” Ellis says. “I just focus on generating alpha.”
The directional part of the portfolio uses gold price exposure based on an investor sentiment model comparing calls and puts. In terms of a particular hedge fund strategy bucket, Ellis likens the directional component to a CTA since it is taking long and short positions in gold futures over six-to-eight week time periods. A key focus is comparing the relationship of open interest and premiums in gold calls with the open interest and premiums in puts. “The most familiar concept is a simple put-call ratio where you look at the pricing of similar delta calls and puts, and see who is overpaying for which option type,” Ellis says. “This just tacks on a few more factors.” The strategy, which is clearly contrarian, boasts a 70% hit rate since the launch of RAB Gold in October, 2006.
In early March, for example, a 10 Delta call costs 50 but a 10 Delta put is 37, indicating skew to the call side. “That is giving us a sign that the market is a bit overheated,” Ellis says. “Interest is quite high. Most people who want to be long are already long. So we would short gold. The reverse is when there is panic. Then we would want to be on the long side.” The buy signal used by the fund lasts some six to eight weeks on average.
“You can’t do a net present value or cash flow on gold so it does have a sentiment side to it,” Ellis says discussing the sentiment index. “You have people getting overly bullish and then overly bearish quite often. It is more the turning point we are interested in than the absolute level. With sudden shifts it is a good warning system.”
The second part of the directional strategy looks to generate returns from investing around the lease rates charged by central banks on gold lending. A lease rate percentage is paid by an investor or mine operator to borrow gold in order to hedge a sale. One year lease rates, despite interest rates plunging, have risen from around 50 basis points in 2007 to just under 150 basis points in early 2009.
When Bear Stearns’ two hedge funds collapsed in mid-2007 the fund locked in a 50 basis point lease rate for five years levered three-fold. In the worst case scenario, the fund can lose 150 basis points per annum. But should lease rates soar to, say, 6% amid hyper demand for gold the potential return (paying 0.5% and receiving 6% gives net of 5.5% with 3X leverage) passes 15% year-on-year. “The skew is quite pronounced on this trade,” Ellis says. “The downside is not too bad. The upside could be a fantastic return for us.”
Precious metals volatility trading
The second biggest component of RAB’s gold alpha strategies takes a directional view on the volatility of gold itself. Though the strategy deals mostly in gold calls and puts, it is also active in other precious metals with Ellis sometimes putting on relative value trades featuring silver or platinum. When Bear Stearns imploded the fund bought long term gold volatility in the low teens on the basis that typical price comparisons with currency volatility on the bottom and commodity volatility on the top end had eroded but would return to trend.
More recently, the funds endured a torrid time in October, being short volatility when it spiked, while the price of gold fell nearly 20% – the biggest monthly percentage movement in over 25 years. “We stress tested our implied (volatilities), our delta and our gamma, and we hadn’t over positioned on the book,” says Ellis. “So we were able to do a little delta hedging and hold on. We made it all back and a little bit more in November when volatility came back to more normal levels. That was a good stress test for us.”
When the fund buys calls, it focuses on the 0.30 t o 0.40 initial delta area just out of the money. Historically, Ellis says this area has had the best returns. Potentially higher return initial delta positions of 0.5 to 0.10 offer spectacular upside but only a remote probability of a pay off. Why this occurs is straight forward: if there is a sharp rally in gold central banks will generally sell bullion to moderate it. “It prevents the far out of the money calls that the gold bugs like to buy getting a good return,” he says. “It is safer to get plenty of delta attached to the calls.” He expects this may change in the future when central banks’ gold holdings fall from their current level of about 15% of world reserves to below 10%.
Targeting macro strategies
The third prong of the alpha strategy Ellis uses targets macro plays. One trade that worked well in 2008 was shorting copper as the financial crisis fed into the economic downturn while being long gold. In early 2009, the trade was reversed during a period when copper rallied about 20%. He says the trade reflected both a macro view and technical analysis of positioning that showed copper to be oversold. “We just needed a little bit of Chinese improvement or re-flation and we thought copper would rebound faster than gold,” he says. “Generally we are quite comfortable with all metals across the board. I don’t think there is a great incentive to get short.”
The funds also have the capability to invest in gold equities, but Ellis doesn’t find that attractive now. “Gold producers destroyed a lot of shareholder value over the last 10 years by selling at $250 and buying back at $800-900 – and not hedging their costs,” he says. “Everyone thinks mining equities are a leveraged play on gold, but it hasn’t turned out that way. The fact that our fund is 70% ahead of gold equities is proof that just buying gold equities is no longer the answer. There will come a time when this strategy will be long gold equities and short gold, but right now we prefer gold itself.”
The three components of the alpha strategy each have different exposure levels. The directional book generates net exposure, typically about 60%, by being either long or short gold futures. The lease rate play takes on the most gross exposure – 300-400%. Like an interest rate swap, its notional exposure is quite large but the market risk is relatively small since the funds are paying fixed interest rate swaps. In the volatility book net exposure is generally capped at 30%.
With the funds displaying low to negative correlation with major asset classes Ellis reckons their risk profile most closely resembles that of market neutral hedge funds. With the alpha components drawing on CTA, volatility arbitrage and global macro elements, RAB Gold could be part of any diversified hedge fund investment strategy.
“It definitely has a unique style and different underlying instruments,” he says. “I wouldn’t call it a commodity strategy because you are taking a view on volatility,” Ellis says of RAB Gold. Gold Plus, in contrast, fits into the commodities bucket owing to its directional play through the margin purchase. The sentiment model, which has up to 60% of the capital, is pre-programmed, but the size of the positions is determined by Ellis.
The fund manager also manages the net exposure. Most positions are converted into ‘gold equivalents’ by adjusting the raw exposures by their sensitivity to gold. Since it depends on the volatility of gold prices, Ellis has actively reduced the overall directional exposure as the underlying gold volatility has doubled to 40% from 20% since the fund’s launch.
The funds had around $100 million in assets under management but that has fallen to $35 million owing to its 30 day notice term and investors’ needs to raise cash. This has occurred despite Gold Plus outperforming gold futures by an annualised rate of 12.8% since launch, while RAB Gold has delivered 20.9% of alpha over the same period. (See Figure 2) Given the liquidity of the markets where the fund is investing, Ellis says the fund could comfortably scale up to $500 million.