Chapter 10
Investing in Energy Commodity Hedge Funds

Know what you own, and know why you own it.

Peter Lynch

This chapter is useful for individual fund managers as well as asset allocators. Although this chapter is written with asset allocators in mind, it will be helpful for individual fund managers to better understand the need and mind-set of their prospective investors.

As an asset allocator, managing a portfolio of hedge funds and other strategies, you quickly realize that you need to kiss a lot of frogs before finding your prince. Finding quality managers is a painstaking process. We hope that some of the points outlined below will be helpful as you consider adding energy commodity hedge funds to your portfolio.

Initially, we will focus on the broader issues faced by all asset allocators as they seek to build and manage their portfolio. We will then build on that foundation by looking at the specific issues investors should be aware of when building a portfolio in this space.

Asset Allocation: Portfolio Building Basics

You may be an endowment, family office, fund of funds, or other large pool of capital seeking to build a portfolio of alternative investment managers that ideally provide superior investment performance while minimizing volatility found in the normal market. As part of your portfolio construction process, you may be considering different geographies, investment strategies, underlying asset classes, investment horizons, liquidity needs, and a myriad of other factors. Though this evaluation process is a necessity for any serious asset allocator, the outcome of such an exercise will likely be different for each institution. A family office may have greater liquidity needs in the short run, while an endowment may not need their allocated capital for seven years. An insurance company in Asia, with a stable revenue base in Asia, may feel a desire to allocate away from Asia and focus on Europe and North America. Each institution that is contemplating allocating to an alternative investment manager will have sui generis needs, so it is absolutely necessary to be thoughtful about the parameters of such an allocation programme for it to be successful.

Once the desired portfolio has been mapped out, the hard work really begins. Building and managing a successful portfolio of alternative investment managers requires three contemporaneously ongoing activities:

  1. manager selection
  2. due diligence
  3. monitoring.

Manager selection is the prince or princess kissing the frog portion of the process. Like most investment processes, screening opportunities is a numbers game. An organization looking to allocate capital will end up meeting countless managers before finding a select few to build a portfolio with. Meeting with managers will be an ongoing process and many experienced asset allocators have a database of hundreds, if not thousands, of firms across different investment strategies they have met over the years. Of this number, only a small handful of the investment managers an asset allocator has met will actually receive capital. This fact conveys that for both asset allocators and investment managers, manager selection is a time-consuming but frequently unavoidable process.

Manager selection will usually start with a meeting or conference call that reviews the basics of the investment manager's strategy, investment performance, the team, and other basic questions. These meetings can be initiated via a capital introduction person at a prime broker, through a third-party marketer, through personal connections or referrals, or a whole host of other methods. The asset allocator will often be asked to be included on any distribution lists the investment manager operates (e.g., monthly newsletter). If an asset allocator is potentially interested, they will ask for more raw data to conduct their own analysis. If the interest continues, this will be followed up by further meetings in person. If interest persists, sophisticated allocators will conduct due diligence. On the quick side, from first meeting to allocation, it could only take a few weeks, however, in the post-2008 GFC, post-Madoff world that we operate in today, the decision to allocate usually takes a few months and could potentially take a few years.

For example, a pension may like a particular fund manager but be a bit concerned because the fund's track record is only two years and the size of the fund is still under USD 100 million. These points notwithstanding, the pension fund would still potentially like to make an allocation at some point, so it continues to track the fund manager by having quarterly calls, receiving the monthly newsletter, and staying abreast of the manager's growth. Then, when the fund manager's track record hits four years and the fund's size is close to USD 200 million, the pension may decide to allocate.

The decision to allocate is almost always preceded by a period of due diligence, which may include at least one, if not multiple, visit(s) by the investor to the fund manager's office for a few hours. This due diligence might be incredibly thorough and protracted or be brief, with capital allocated shortly after the decision to allocate has been made. Investors will have slightly different approaches depending on their risk profiles, internal resources, their own investor base, and their performance history. Larger institutions, such as well-established university endowments, will have much of the due diligence capability existing in-house, while institutions with fewer resources might rely on investment consultants to perform screening and due diligence.

Generally speaking, if an asset allocator has committed to performing due diligence, then the fund and its manager have passed the initial ‘sniff’ test. The performance of the fund, the investment strategy, and the background of the fund manager and his team have satisfied the initial litmus test. Due diligence is conducted to make sure that what has been presented is in fact the truth, to uncover any potential risk factors that have not fully been explored, and to ensure the investor has a comprehensive understanding and comfort with any potential investment they might make. As a fund manager, if your fund has reached this stage then you are on the right path.

To help facilitate this process, most fund managers typically prepare what is commonly called a due diligence questionnaire, as discussed above (please review Appendix C to get a general sense of what a DDQ entails). Each fund may approach preparation of a DDQ differently. Some funds will have one Bible-like DDQ where all information is compiled into one extensive document. This can be convenient since all pertinent information is found in one document and only that document needs to be updated. Alternatively, some firms prefer to separate their DDQs topically. For example, a performance and investment-related DDQ, an operationally oriented DDQ, etc. After carefully considering what works best for a fund and its strategy, a fund manager should select the DDQ style that works best for their particular fund and its investment style.

Regardless of what form a DDQ takes, it should be thorough and updated on a regular basis. At the very least, compiling a DDQ forces the fund manager to think of how best to present factual information to potential investors. This is a useful exercise that will help in both better managing the investment firm as a business enterprise as well as assisting in marketing efforts. Most experienced investors in hedge funds will ask for a DDQ, so it is better to start earlier rather than later on organizing a comprehensive DDQ.

From the perspective of an entity investing in energy commodity hedge funds, a DDQ is a key resource in conducting thorough due diligence. In particular, the background of the fund manager and his team, proper understanding of investment performance, and operational competency are extremely critical when evaluating many energy commodity hedge fund strategies. Given the use of derivatives and sometimes more complex strategies used by energy commodity hedge funds, a DDQ provides insight into how the investment manager thinks about risk and whether they grasp what some of the key risk issues might be.

Assuming a fund manager successfully navigates the due diligence process and is allocated capital by an investor, the next stage is monitoring. As a fund manager might monitor a portfolio of stocks, an investor of hedge funds also manages a portfolio of hedge funds. Some asset allocators may require extensive transparency so they can manage their risk on a real-time basis, while other allocators may take a more laissez-faire approach and only expect updates on a monthly or quarterly basis with minimal visibility of the portfolio. Much of this will be driven by the liquidity requirements, risk profile, and investment timeline of the asset allocator.

From a client service perspective, a fund manager should be ready to accommodate all reasonable requests from an investor once capital has been accepted. As a general principle, good communication and transparency lead to long-term partnerships that are mutually beneficial. Obviously, good investment performance during that time does not hurt either. At the very least, a fund manager should be prepared to write monthly or quarterly newsletters to be circulated to clients and prospective clients. Good examples of these types of investor communication are letters written by Warren Buffet to Berkshire Hathaway investors or by Howard Marks to Oaktree Capital investors. Besides letters, fund managers should be prepared to have regular conference calls as well as possible face-to-face meetings with investors both during good times as well as difficult times.

The reality is that at some point, redemption of capital is a fact of hedge fund life. The process by which redemptions occur, when they occur, and whether a particular investor reallocates capital to a fund manager is not solely driven by fund performance. For investors that have an institutionalized investment process, redemptions may very likely be dictated by results obtained from initial due diligence before the investment. During due diligence prior to the investment, certain redemption triggers may have been identified and when one those triggers are tripped redemptions may follow. Often these redemption triggers may have nothing to do with performance but can be due to factors such as staff turnover, changes in investment strategy, large redemptions that decrease AUM of the fund to a certain level, etc.

Though performance is a major factor, it is important to remember that this is still a people business where relationships are built on trust. Fund managers who have built deep relationships built on trust, placing clients' interests first, and proactive communication will find their lives are easier during difficult times and when raising capital.

Asset Allocation: Understanding Different Strategies

In this section, we begin by reviewing the typical energy commodity hedge fund strategies. We then analyse investment considerations particular to energy commodities, such as:

  • Whether to invest in energy commodities at all.
  • Market maturity (developed regulatory regime?).
  • Energy commodity market capacity constraints.
  • Skill bottleneck: skill specificity requirements and the time-consuming growth of energy trading talent.
  • Volatility.
  • Correlation.

Typical Energy Commodity Hedge Fund Strategies

Let us quickly review the two fundamental types of trading: fundamental and technical. Fundamental analysis-based trading is based on quantitative and qualitative analysis of the underlying physical analysis of the market. Technical trading is based on quantitative analysis, in essence tracking past market behaviour through computer-based statistical modelling programs.

When categorizing typical energy commodity hedge fund strategies we can categorize them into two broad categories: directional trading and relative value trading. As its name suggests, directional trading takes a view on what direction the price of a given commodity will follow, and takes a position accordingly, being long products expected to rise or short those expected to fall. Relative value trading aims to exploit pricing inefficiencies between different products and different time horizons. In essence, relative value trades identify products whose prices are expected to converge over a certain period of time, being long the underpriced product and short the overpriced one.

Generally, certain energy commodity markets have been around for considerably less time than equity or bond markets. This means there is an element of regulatory uncertainty around certain types of product. This is particularly true of emission allowances. Having said that, the upside of their youth is that energy commodity markets are less regulated than traditional investment markets such as equities. This enables traders to be more imaginative and innovative in their strategies.

Two ‘bottlenecks’ make it particularly challenging for investors to locate potential investments: the scarcity of excellent energy traders and the limited capital which may be prudently deployed by trading any particular energy commodity strategy. Many traders seem to be of equal skill, but there are traders who clearly distinguish themselves from others.

Energy Commodity Market Capacity Constraints

Compared with many other hedge fund markets, there are not many excellent start-up or early-stage funds to invest in within the energy commodity space. Furthermore, those that exist are often unable to absorb additional capital. This inability to accept additional capital may be driven by a fund's own success, being able to leverage existing investors, or increasing the proportion of the fund manager's own money. In some extremes, very successful energy commodity funds return considerable portions of their AUM to their investors year after year in impressive double-digit returns. At the heart of these capital capacity constraints lie two limitations. The first is a limit particular to each fund. Every fund manager will have a maximum amount of capital he feels comfortable investing, as constrained by his own intellectual capital bandwidth and that of his team. Second, there is a limit to how much capital can be safely deployed within a given market, as defined by the market size, competitive dynamics, competitor fragmentation, liquidity, and regulation. There will come a point in every market where a position is large enough to move the market, or where positions of a certain size become ‘too visible’ to competitors. The capacity constraints are exacerbated in energy commodity markets given their size and the small number of players that regularly trade them. Accordingly, a key consideration for any investor must be the capacity to expand.

The lack of investment capacity places a premium on an established network of contacts in the energy commodity business. An investor research analyst will need to personally cultivate many relationships within the energy commodity trading community in order to secure capacity in high-quality funds. Furthermore, these relationships will be necessary to conduct due diligence, understand the relevant markets and their evolution, and ensure that any aspiring fund manager will contact them very early in the planning process for a new fund.

Skill Shortage

The dramatic growth of energy commodity markets has outstripped the availability of talent capable of wisely trading these markets. Utilities and energy producers continue to employ the vast majority of the knowledgeable energy commodity talent. Many of these institutions and their employees, however, do not have the financial and trading skills to appropriately deploy risk capital. When it comes to non-knowledgeable talent, the extreme complexity of the markets does not facilitate the quick redeployment of a non-energy trader such as a currency or bond trader. The migration of utility and producer employees to banks, hedge funds, and other financial investors continues at a growing pace. Nevertheless, it is not growing at a fast enough pace to meet demand. Furthermore, utilities and producers are increasing the financial training offered to their staff, and developing in-house capabilities to slow down the migration.

The authors briefly discussed earlier the most important trading strategies and their relevant implications for successful hedge fund managers. We maintain that a portfolio of energy commodity hedge funds should take into consideration different product mixes (e.g., gas, power, oil), different fund manager maturities, different trading styles and strategies (e.g., financial vs. physical, long only, relative value), as well as different geographic exposures (e.g. Europe and North America). While it is well known that start-up and early-stage funds have a high attrition rate, it must not be forgotten that larger funds with established track records (e.g., Amaranth as discussed in the Introduction) often cost investors much more money when their strategies fail or disappoint. Talented early-stage managers can often deliver higher returns – if they are successful. On the contrary, larger, more mature funds can often afford greater investment in research and risk management systems.

Much has been written on portfolio measurement and risk management for investors. The structure of the markets in which these funds invest is often rapidly changing in response to ongoing deregulation or liberalization, as well as the introduction of new mechanisms such as the trading of emission allowances. A fund manager who has performed well in the past may not adapt well or quickly to changing markets. This can be costly to investors. As such, ongoing ‘market due diligence’ and research is required.

Finally, as investors consider allocating to an energy commodity hedge fund they must be acutely aware of both volatility and correlation. The ideal hedge fund strategy is capital appreciative and capital protective. Too much volatility in a fund's performance can erode its capital base. Additionally, a fund with performance that is largely index correlative or market tracking not only lacks true alpha opportunities but is also costing investors since it is an expensive form of beta. If an investor is paying hedge fund fees to invest in a hedge fund product, they should seek a product that is more than an expensive exchange-traded fund (ETF) or market-correlation product. Thus, a prospective fund needs to be valuated in conjunction with an understanding of the fund's risk-adjusted performance, volatility, and correlation.

There are technical measures that should be considered when constructing a portfolio that includes an energy commodity hedge fund. An energy commodity hedge fund may be part of a larger portfolio of energy-oriented investments or may be part of a hedge fund portfolio that includes a wide range of strategies and geographies – where energy commodities are just part of the portfolio. Depending on the niche it fills, different technical measures may be used to measure and balance the portfolio. Being thoughtful about the role an energy commodity hedge fund satisfies in a portfolio is important to ensure the right manager is selected, the right perspective is taken when constructing the portfolio, and the right measures are used to monitor the portfolio's performance.

Checklist for Investing in Energy Commodity Hedge Funds

Though this checklist is not exhaustive, it serves as a starting point for an investor considering an investment in an energy commodity hedge fund.

  1. box  Clear Understanding of the Investment Strategy
    1. box  Does the strategy make sense?
    2. box  Does it correspond with what is visible in the world today?
  2. box  Portfolio Construction and Concentration
    1. box  How is the portfolio constructed?
    2. box  How concentrated is the portfolio?
  3. box  Strategy Liquidity
    1. box  How liquid is the portfolio?
    2. box  Does it meet our required liquidity needs?
    3. box  Has liquidity been considered in worst-case situations (i.e., 2008)?
    4. box  Is the underlying market liquid enough to efficiently facilitate the style of trading the hedge fund manager is planning?
  4. box  Use of Derivatives
    1. box  Does the strategy rely heavily on derivatives?
    2. box  If so, is investment risk and operational risk properly accounted for?
    3. box  How capable is the fund manager with using derivatives?
    4. box  Is there a better way to express the strategy than with derivatives?
  5. box  Strategy Capacity Issues
    1. box  What aspects of the market may prevent this strategy from being successful?
    2. box  At what size (in terms of assets under management) will it become difficult to execute the investment strategy?
  6. box  Regulatory Environment
    1. box  What is the regulatory environment for the particular energy asset?
    2. box  Is it changing?
    3. box  Is it political?
  7. box  Experience of Fund Manager and Team
    1. box  Do the fund manager and his team have experience successfully running this strategy?
    2. box  How do they source/identify investment opportunities?
    3. box  Are they smart?
    4. box  Are they honest?
    5. box  Are they humble?
    6. box  Will they be good partners?
    7. box  What do people say about them? Do they have good references?
  8. box  Fees
    1. box  Are the fees fair/market standard?
    2. box  Given performance, volatility, and correlation are the fees worth it for this product?
  9. box  Side Letters
    1. box  If possible to find out, have other investors signed side letters giving them a different fee structure or other benefits?
    2. box  If so, will I be disadvantaged investing in this fund vis-à-vis the other investors?

Bibliography

  1. Bauer, C., Heidorn T., and Kaiser, D. (2012) A Primer on Commodity Hedge Funds. Journal of Derivatives & Hedge Funds 18, 223-235.
  2. Bernstein, W. (2000) The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk. McGraw-Hill: New York.
  3. Grinold, R. (1999) Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Selecting Superior Returns and Controlling Risk. McGraw-Hill: New York.
  4. Maginn, J.L., et al. (2007) Managing Investment Portfolios: A Dynamic Process. John Wiley & Sons: Hoboken, NJ.
  5. Shain, R. (2008) Hedge Fund Due Diligence. John Wiley & Sons: Hoboken, NJ.
  6. Scharfman, J.A. (2008) Hedge Fund Operational Due Diligence. John Wiley & Sons: Chichester.
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