Bottom-up and Top-down

The two main elements of investment strategy design involve selecting the markets the fund will operate in and the products the fund will build its portfolio with. These two decisions are not to be made sequentially, but in parallel, and the strategic analysis involved in the decision-making process must be forward looking – it must make allowances for the evolving nature of the fund as it matures.

In this chapter, we will approach investment strategy design through the consideration of start-up and early-stage hedge funds. Much of the same thought process is equally applicable to well-established hedge funds, but the concept and process of investment strategy design is most intuitively discussed and explained with reference to start-up or early-stage hedge funds. Many mature and successful hedge funds seem at times to be purely opportunistic with respect to the evolution of their investment strategy, as opposed to using an ongoing and consistent approach to investment strategy development. We have observed that some large hedge funds with long track records lose sight of the core investment strategy of their fund, leading to a decline in returns or a failure of off-shoot funds. The investment strategy design and development is based on our experience with both early-stage and mature hedge funds.

This chapter is written mainly from the point of view of the existing or would-be hedge fund manager, however, it is equally relevant to those who invest in commodities hedge funds. Investors should understand what considerations determine a fund's investment strategy – they will then be able to assess whether the value proposition of a fund is sustainable in the long term. In selecting funds, this understanding will enable investors to identify whether a prospective fund manager should return to the trading desk he or she came from, or help investors determine the potential size of initial and subsequent investments in those who pass the test. Additionally, it will help investors judge whether a string of good performance data is the result of luck or of carefully planned and diligently executed investment and trading strategy. Investors should ensure that a fund manager is consistently mindful of both short-term trading strategy and long-term investment strategy.

It is important that a fund manager thinks strategically about the development of the hedge fund's investment exposures because energy commodity markets can change significantly over a period of two to three years. A fund manager who is not planning ahead as these markets develop is likely to have a brief period of excellent performance followed by a long and frustrating decline when the trading and portfolio strategies of yesterday become increasingly out of date. Given the liquidity restrictions associated with energy investing, strategic investment planning in terms of market coverage and portfolio design is of equal importance. The catalogue of considerations we review in this chapter in selecting target markets and designing the hedge fund portfolio will serve would-be fund managers and investors in hedge funds alike.

We start by examining the two functional components of a hedge fund: the trading operation and the fund management business. Then we tackle a fundamental question that drives the thinking around the objectives of the fund – what is our edge?

Trading + Managing a Business = Successful Hedge Fund

There is an important distinction to make between hedge funds as a trading operation and hedge funds as a business. It is a frequently repeated statistic (perhaps apocryphal but one which we are partial to) that half of all start-up hedge funds fail during their first year of operation and more than half of those failures are attributable to operational failure rather than unsuccessful trading strategies. Operational failure includes events such as: risk management failure, bankruptcy due to no liquidity, regulatory non-compliance, money laundering, tax fraud, and many others – whether intentional or not.

In general, a trader's scope is limited to trading strategy and execution as well as limited middle and back-office activities necessary to facilitate execution. This reflects the tendency of banks, large physical merchants, large hedge funds, or commodity-producer trading operations to insulate traders from all non-market-facing, non-transaction-oriented activities, enabling complete focus on trading.

The functions performed by the trading operation of a fund are pretty much the only functions a trader at a bank or trading house is generally exposed to. They include only tasks that are directly related to trading: investment research, investment analysis, trade execution, and trade settlement. Almost logically then, when bank or utility traders decide to launch their own hedge funds, they often underestimate the resources and planning required for the many aspects of managing a business.

The business of managing an investment firm includes such varied activities as paying the light bill or managing payroll administration as well as a host of other factors. The trader on the bank trading floor who thought these functions were bureaucratic distractions suddenly discovers their importance when running his own fund. This discovery, however, frequently takes place too late, after having ignored the business until the office rent is overdue, profits disappear into unanticipated taxes, or employees fail to get paid. Many well-compensated, senior-ranked traders on the trading floor have little concept of the components or need for non-market-facing business management.

An aspiring fund manager must commit to both trading well and managing well. Only focusing on one without paying attention to the other will ultimately lead to failure. There are methods to make sure both trading and managing functions are taken care of, which are discussed throughout this book. At a very basic level, a fund manager must accept responsibility for the fund's performance as well as the integrity of its ongoing management.

The Edge?

A key starting point for our market selection and portfolio analysis is to determine what makes a fund unique. Tackling this fundamental question enables the fund manager to start with tangible objectives in mind that shape the design of the trading operation to chosen markets and strategies. We sum this point up by asking the question: What is our edge? Or posed another way:

• What is the source of alpha?
• Is the alpha-generating competitive advantage sustainable?
• What will an investor get from investing in this fund manager that he or she cannot get from investing in an index or other passive exposure instrument of these markets?

Trading is sometimes viewed as a straightforward maximization exercise (i.e., maximizing absolute returns and minimizing risk). When aiming to establish and grow a trading business, however, one must consider the complete trading strategy. All too often traders turned fund managers replace the big picture of analysis with an excessive focus on the trading itself. Upfront decisions will be required not only for marketing purposes, but also to help plan the business venture.

Initially one must ask: what will be our unique, sustainable, competitive advantage? What is our edge? If there is a clearly distinguishable track record, one must identify past reasons for good and bad performance. There are three key issues to consider.

First, the reason behind good (or bad) performance could be dependent on the future portfolio manager's former seat (in terms of informational advantage that is a function of his or her role), or his or her former team. One or both of these may not follow the trader to the new hedge fund. The potential downside of leaving this seat and team behind should be considered by both fund manager and investor. Additionally, it is critical to remember that performance numbers alone do not reveal the whole story of a portfolio manager's performance. Such performance numbers must be considered in the context of contemporaneous risk parameters that the portfolio manager was guided by when managing the portfolio being reviewed.

Second, the portfolio of counterparties and associated credit terms may become an issue, since they are unlikely to be available in the early stages of the fund.

Third, the organizational infrastructure going forward must be evaluated. If the trader is leaving a big bank or institutional investor, it is unlikely that much of that infrastructure will be replicated in the firm in the near to medium term.

Beyond the top-down approach of establishing the competitive advantage and exploiting it, a bottom-up approach is also required. This lies in evaluating the market in which the fund will play. The trading strategy must ask: to what products and geographies do target investors want exposure?

The start-up or early-stage fund manager almost always starts his business strategy with a focus on the products which he has the greatest experience with. For many hedge funds the entire strategy can be deduced from the CVs of the team that will comprise the portfolio trading staff. Nevertheless, this is an inadequate basis for determining the strategy of the firm and its constituent funds or portfolios. The initial inputs to the process of determining the optimum playing field in terms of product and geography will of necessity include the experience of the would-be fund manager him/herself as well as his/her planned team. Though the experiences of the would-be fund manager are important, the interests of potential investors are also significant. Investors know that traders like to ‘talk their own book’. A rigorous investment analyst is interested in understanding not only the trading strategy and products but also why the market or markets are interesting. Europe offers an excellent example.

The NordPool electricity markets of Norway and Sweden were liberalized well before other European power markets. Not surprisingly, there are a large number of experienced NordPool traders who would consider launching hedge funds. Many investors, however, perceive that the NordPool market alone offers too much risk for too little return and that there are few truly excellent traders in that market. Investors are often looking for Germany-focused strategies that can also trade the Nordic markets as relative value plays and for portfolio diversification.

Here we find at least four aspects of strategy: (1) the core competence of the fund manager; (2) the interests of the investors; (3) the possible construction of a portfolio with an attractive risk–reward profile; and (4) the availability of additional intellectual capital to exploit additional strategies.

The characteristics of certain products (e.g., regional vs. global) and of certain investor portfolios suggest that the geographic coverage of the fund – including limiting it – is important. For example, a US natural gas hedge fund manager suggests that because of increasing correlation between US and UK natural gas, it will be necessary to trade both to be an effective investor in the US natural gas market. For a US natural gas trader, trading UK natural gas inherently implies a trading presence on a different continent in a different time zone and under a different regulatory regime. Clearly, the portfolio risk–reward features associated with the multi-continent strategy must be balanced by the increase in operational risk and management distraction. These are the types of consideration that go into developing good fund management company business strategy.

Trading Energy Commodities

At a high level, trading energy commodities can be divided into trading the physical and trading the financial derivative of the physical commodity. For example, an oil trader for an industrial or manufacturing company might actually trade barrels of oil with the intention of his company taking physical delivery of those barrels of oil in order to use the oil as input in their value chain to create a product. This simple example represents a trader involved in trading the physical commodity.

In contrast, a trader that is trading an option, future, or other derivative where the underlying component of the derivative is an energy commodity such as oil is said to be trading the financial derivative of the physical commodity. In this situation, the trader generally does not want to take physical delivery of the commodity but is either hedging or speculating using derivatives based on volatility, price, or other factors. Most of the traders that we think about in this book are generally traders who are involved in this type of activity.

Quite often it is a different group of traders that dominate the physical markets vs. the financial markets – the former being dominated by physical trading houses such as Glencore, utilities in their hedging capacity, and other energy companies; the latter often being dominated by the speculative capital of banks (less and less given increasing regulation of the banking sector), hedge funds, and the proprietary desks of utility trading divisions. But the physical market's evolution, and the evolution of its regulation, investment in its infrastructure, and even the perceived preference of its products (e.g., gas vs. coal, LNG, etc.) is not at all independent of the speculative capital markets whose direct investments may tend to be more focused on the financial markets. While no trader would expect the markets to be unrelated, energy executives and regulators often ignore or underestimate the importance of speculative capital in commodity markets. At the same time, financial speculators have often underestimated the importance of active involvement in the regulatory evolution of the physical markets.

We will highlight here the impact of speculative capital markets on the operation, regulation, investment, and development of the physical underlying markets. Additionally, we will explore the evolution of financial institutions including exchanges, brokers, clearing houses, regulators, and banks in response to the growth of speculative capital in these markets. The impact on service providers – both to the energy industry and to the energy commodity-related capital markets – continues to evolve in response to the increasing presence and dynamism of speculative capital in these markets.

As with most markets, almost all energy markets in the world are regulated. Deregulated or liberalized markets are regulated in the sense that they have become differently regulated from what they were in the past. In more mature liberal markets, greater losses or gains are often made by speculative market participants than by the relevant underlying energy industry participants. The brief but spectacular collapse of Amaranth and the economic catastrophe of trader-induced chaos in the California power markets are but two examples of the important connections between speculative capital markets and the markets of the physical underlying.

As investors evaluate fund managers as well as the suitability of markets for hedge fund trading they must be aware of the ‘feedback loops’ between the largely financial speculative capital energy markets and the largely physical markets of the underlying. Investors, fund managers, and service providers should be active participants in the political and regulatory processes that give shape to the evolution of these markets. Energy executives and investors in energy companies, including utilities, dare not ignore the development of speculative capital markets as they strategize or evaluate the strategies of the companies in which they invest.

For example, if large amounts of risk capital are trading in German power and emissions, what does that do in the ‘real world’ of electricity users, generators, transporters, etc.? There is a real impact due to this activity and regulators should be interested. In another example, investors long on emissions drove up emissions prices, which drove up electricity prices that German utilities pushed through to their small commercial and household customers through regulated rate increases. Through their trading arms, utilities were frequently able to benefit from this trading activity, which began in the financial markets but ultimately disadvantaged everyday consumers. Regulators and government policymakers must consider the speculative markets when designing regulation, rate design, and other market structures that shape the energy commodity markets.

Additionally, utility strategists cannot ignore speculative markets. They must either actively participate as traders or find a way to hedge themselves. Some large ones – such as RWE and EDF – have developed substantial competence in energy trading, while other firms such as E.ON seem to have decided they will not and expose themselves to that potential market risk.

In the previous chapter, we highlighted principal energy commodities such as electricity, natural gas, coal, and oil industries along with their respective logistics value chains. Much of the dramatic volatility associated with natural gas and electric power markets derives from logistics constraints and weather variability. Additionally, the complexity of regulations when it comes to power, which is compounded by multiple jurisdictions and agencies that might be involved in such regulation, creates a complexity that offers potentially attractive returns to deep research and analysis as well as trading skill. The volatility – though often extreme – is not random. It is understandable and often predictable. Each of these energy and related commodities has its own set of supply and demand drivers for price, logistics capacity, and physical commodity. Nonetheless, there is enough interconnectedness in the supply–demand drivers (e.g., weather) to potentially predict price volatility and some extreme events (or at least foresee them as a reasonably likely possibility). These features of the energy and related commodities will be explored at some depth, allowing the reader to understand the great potential for ‘alpha’ and uncorrelated return generation in these markets.

For the investor new to these markets, beyond the economics there are also unique political and regulatory environments of the commodities to consider. Whereas a brief delay in the delivery of coffee beans or newsprint might cause a temporary price spike and a logistics log-jam in certain industries, a brief delay in the delivery of electricity or natural gas can cause shutdowns of entire industries and blackouts, leading to an associated crime increase in major metropolitan areas or the death of vulnerable citizens due to interrupted air conditioning or heating. The financial investor cannot afford to ignore the very real possibility of force majeure events resulting from threats to human life and safety, property, or economic activity.

Basic Financial Knowledge for Commodities

There are some key concepts and themes that one must know to begin understanding energy commodities. We will highlight a few of the key principles in this section.

When thinking about commodities, a foundational concept is that they are intrinsically different from investing in an asset class like equities or bonds. The same factors that drive equities and bonds will affect commodities differently. For example, commodities are generally positively correlated with inflation, while stocks and bonds are generally negatively correlated with commodities. Additionally, since stocks and bonds are driven by calculating a revenue stream or cash flow, their pricing is very much forward looking, while commodity pricing tends to more directly reflect the immediate to near-term situation.

The basic underlying framework of commodity investing revolves around forward or future contracts and statistical jargon. Forward contracts and future contracts are essentially the same thing. Each is a contractual promise to deliver a certain quantity of a certain item at a specified time at a specified price. People can enter into these contracts to lock in prices if they are afraid the price of a particular item may increase in the future or if they want certainty in budgeting. They can also be used for speculative purposes. For example if an investor believes the current price of something they own will decrease in the future and they would like to lock in a guaranteed price now in case there is depreciation. The difference between a forward and a future is that a future is traded on an exchange, while a forward is not and is usually privately negotiated between counterparties.

Energy commodity traders may use a future or other derivative to take a view on a particular commodity; however, the basics of futures pricing underpin many of the different products that a trader may use. For example, any sort of swap product that a trader uses can be viewed as a series of forward contracts put together into one derivative.

As forward contracts are operative for different lengths of time before they expire, there is a particular vernacular that is used to signal if a contract is expiring sooner or if it is expiring later. For example, if an investor is viewing two futures contracts, the contract closest to expiry is the nearby contract while the contract that has more time to expiry is the deferred contract. This distinction is important to remember as it exemplifies the principle of the term structure of forward prices. The term structure of forward prices represents the relationship between the price of the forward and the time of delivery for that forward. This pattern of price and time makes sense if we use a basic real-world example. During the summer months in Arizona, more people are using their electricity to power their air conditioners because of the heat. The forward price of electricity will reflect this cyclical pattern of price and time. This relationship is captured in the term structure of forward prices.

Perhaps the last piece of basic information to cover is the jargon that is used to discuss commodity pricing. Traders or people involved in the markets frequently use the words ‘contango’ or ‘backwardation’. These words are simply adjectives to describe a particular situation. Neither contango nor backwardation is inherently bad or good, they are just terms that capture the current market.

When a market is in contango, this refers to situations where the futures price exceeds the expected future spot price. Conversely, a market is in backwardation when the futures price is lower than the expected future spot. For a visual image of both contango and backwardation, see Figure 4.1.

Conclusion

This particular chapter on trading and investing in energy commodities could easily have been a book in its own right, and indeed many books have been written on the topic. This chapter was written with two groups in mind: (1) traders who know the technical aspects of trading energy commodities very well but may not understand the investment mindset of asset allocators; and (2) asset allocators and other investment professionals who may not be experts in energy commodities but need to know the basics to understand some of the tools and jargon that is used by fund managers trading energy commodities.

With the idea of continuing these themes, we have included a checklist for both groups that will help you think through the different issues and constraints you may face when thinking about starting a new hedge fund or when considering where to allocate capital to such an endeavour.

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