The best thing about the future is that it comes only one day at a time.

Abraham Lincoln

1. Will there be further political and regulatory intervention in a way that is harmful to energy hedge funds and their growth?

   When considering regulatory intervention and energy hedge funds, there are three broad themes: (1) regulation of energy hedge funds; (2) regulation of commodities trading (physical and financial); and (3) regulation of other players in the market.

   From what we can tell, there do not appear to be any new political or regulatory initiatives that are specifically targeting energy hedge funds. Following the GFC, position limits that were designed to limit speculation in commodity markets were introduced as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act. Dodd–Frank was signed into law on 21 July 2010. Following the enactment of Dodd–Frank, the Commodity Futures Trading Commission (CFTC) introduced rules on position limits for futures and swaps. In response to a civil action brought by the International Swaps and Derivatives Association, the US District Court for the District of Columbia issued an order on 28 September 2012 that essentially nullified the CFTC's position limit rules and required the CFTC to reconsider new position limit policies, which have not been finalized as of yet.

   That said, regulations that impact hedge funds broadly will obviously affect energy hedge funds as well. For example, over the last few years we have seen different regulations emerge such as the Alternative Investment Fund Managers Directive (AIFMD) in Europe, which is not focused on energy hedge funds, but will by default encompass energy hedge funds that have a European nexus. These types of broader regulation that capture hedge funds in their scope will influence energy hedge funds.

   Beyond increased regulation of hedge funds, regulation of the actual commodities markets has not been significant in the last few years. Besides a burgeoning of the renewable energy and emissions market, the structure of the market for traditional commodities remains fairly stable. The CFTC has taken on a more high-profile role following the GFC but regulation, particularly of the physical markets, has not changed meaningfully. On the non-physical side of commodities trading, different regulations focused on reducing OTC derivative risk may impact energy hedge funds as OTC market participants across asset classes (equities, credit, commodities, FX, etc.) are increasingly being pushed to standardize OTC derivatives documentation in order to facilitate electronic confirmation and central clearing.

   New regulations over the last few years have focused on investment banks and similar financial institutions that were robust market participants in various commodities markets. These new regulations are shaping the participation of these institutions in commodities markets. This will be discussed further in the next question.

2. What will be the impact of hedge funds closing down and the retrenchment of the banks from commodities?

   In recent years, there has been a consistent theme of investment banks retreating from their respective commodities businesses as they look to focus on core business areas that may be less balance sheet intensive in the wake of Basel III and other similar regulatory policies. One major change to futures business is the fact that – as of mid-2014 – the margin posted by clients and kept on balance sheet by the banks will be considered ‘equity’ of the firm, greatly reducing the return on equity (RoE) measures that analysts use when evaluating banks. Therefore, most banks will charge interest on these margin amounts, at which point they can be reclassified and taken off the balance sheet. Most banks will make up for this new charge by charging less in other areas and attempt to keep most clients equal in terms of overall cost or fee load. Although in general we are supporters of increased regulation, we believe new policies must achieve specific goals. In this case, this one consequence of Basel III seems to be a value-destroying endeavour in terms of human time and cost without significantly improving the stability of the global financial markets.

   This significant change in the make up of commodity markets in terms of the nature of their major participants should provide greater opportunities for new commodity hedge funds to enter the marketplace. Additionally, existing commodity hedge funds should also be in a position to benefit from this structural shift. There will be opportunities to fill the void that has been created by the exit of banks from the commodities market. A significant amount of risk that banks used to warehouse is now up for grabs by market participants that have the appetite and sophistication to do so. Additionally, we should see a proliferation of different types of commodities strategy from commodity hedge funds that are focused on trading less liquid strategies – almost private equity style – which may include a financing component and/or a warehousing component in the trade.

3. How will the relationship between energy hedge funds and energy private equity funds evolve? Does the nomenclature define a distinction without a difference?

   Fundamentally, we feel that investment firms which can blend aspects from the private equity world's focus on investing in assets with the ability of hedge funds to trade around positions should excel in the commodities marketplace going forward.

   Owing to the primacy of liquidity immediately following the GFC, this type of hybrid strategy was not attractive. As the memory of the crisis fades and the emphasis on liquidity wanes, investment firms that can convey the benefits of a hybrid strategy will be in a much better position to raise capital for their commodity strategies.

   Although commodities' expertise can be found among both private equity and hedge fund investors, the investment toolkit required to successfully deploy a hybrid strategy requires specialized knowledge that spans both worlds. This will normally require different investment professionals and teams with such specialist knowledge. Additionally, beyond just specific investment know-how, a hybrid strategy also requires a management team that understands the requirements of successfully implementing both types of investment strategy and can act as a bridge between the two worlds. The inherent trade-offs in terms of return drivers between assets and risk positions must be managed in order to maximize returns. This holistic view is the key to success.

   Structurally, and from a business strategy perspective, we do not expect a renaissance of hybrid vehicles, but the emergence of vertically integrated offerings by asset management firms. In such a proposition, firms will offer a beta product, a hedge fund product (with more of a relative value focus), a commodity financing product, and a private equity product more related to warehousing and/or infrastructure. They will however be distinct value propositions and products, attracting investment from varied investor types and different ‘asset allocation buckets’.

4. Will ‘energy-environmental’ hedge funds be enablers of positive climate change or impediments to the success of Kyoto and other market-based regimes?

   We strongly feel that market forces and, by extension, market participants play a critical role in addressing the environmental issues that society faces today, including climate change. Market tools are one prong of a multi-pronged solution to address such issues. For example, the EU ETS has created a robust ‘cap and trade’ system that despite various growing pains and criticisms continues to evolve as a key part of how the EU is addressing greenhouse gas emissions. Admittedly, these structures are far from perfect but we feel that over time, market participants that are active within these types of regulatory framework will positively contribute to addressing the negative effects of climate change. In order for this to occur, however, market participation must be better regulated, better reported, and better monitored in order to avoid abuse of the system.

5. Other than prime brokers, hedge fund managers, and investors, who are the net winners and losers from the presence of energy hedge funds in the market?

   If market mechanisms are working correctly, over the long run it is consumers that should benefit from an energy market that has an increased number of market participants. Consumers should be beneficiaries of lower prices and as more participants enter the market, the market should become deeper and more liquid with more efficient price discovery. Consumers should also benefit from lower volatility. Subtly, it is not market participants that have a dampening effect on volatility, but the number of market participants that have different rationales and trading styles. For instance, in 2006-2008, there was arguably a record number of market participants in crude oil, but they were all focusing on long-holdings in the front month, which drove volatility higher. A variety of market participants is also key and regulators should encourage all sorts of players to participate in the market, from consumers and producers, to speculators and liquidity providers.

6. What is the future for energy hedge funds?

   Generally, energy hedge funds have followed the prevailing trends of the broader hedge fund industry as a whole.

   Currently, institutionalization is the key theme from an operational business perspective (including regulation and compliance); alongside tight and disciplined risk management, which is top of mind in energy and commodity strategies given their typically higher volatility profiles. In practice, this means that players with mature infrastructure and a focus on drawdown management are being rewarded. Following the GFC, there was a flight to size and brand, as these hedge fund managers most easily ticked the right boxes for institutional investors. These hedge fund managers, however, are often constrained by their size. Their size can sometimes make it difficult to efficiently exercise the desired strategy. It is widely accepted in the industry that size is frequently an enemy of performance, with larger funds losing the nimbleness they require to successfully navigate markets and generate profit.

   We feel that this trend, however, is starting to shift as people realize there is a clear inverse correlation between size and assets. Hedge fund behemoths have failed to deliver returns and have increasingly become asset-gathering machines focused on generating revenue from collecting management fees.

   On the back of quantitative easing (QE) policies, US equity markets have been exceptionally buoyant the last few years. The market dynamics of the last few years have made it difficult for many macro strategies, including commodities and energy strategies, to deliver consistent performance, especially on a relative basis when compared with equity markets and even bonds.

As QE comes to a gradual end, commodities should play a key role in portfolio construction for a number of reasons:

1. The historically low correlation between commodities and equities and fixed income.
2. The role of commodities as an inflation hedge given the prospect of increasing inflation (we should point out that there is strong differing opinions on data supporting causality, especially if we believe that the next few years will be an era of asset price inflation due to monetary policy as opposed to inflation due to – artificial – scarcity such as the driver of oil price shocks in the 1970s).
3. The structural demand for commodities in China and emerging markets.
4. In the near to medium term there will likely be a transition in the business cycle towards the latter part of the expansionary cycle, which has historically been the portion of the business cycle where commodities have generally performed well, particularly in the wake of a recession (we caveat this by asking whether this is a historically “normal” business cycle given the technological revolution we are in the early stages, which may mean less capital is needed to provide a historic level of return (e.g., US corporate returns for the past four years), so capital formation will be running below historic averages and this may lead to lower commodity demand than in the past).

The first green sprouts confirming such an upbeat prediction have materialized in 2014:

• In the first six months of 2014, commodities were one of the strongest performing asset classes and a great diversifier against the lesser performance of equities; some of the commodity strategies such as passive beta benchmarks (GSCI or DJUBS CI) are up on the year for the first time in a while.
• There has been a fall in correlation among commodity markets themselves and versus other asset classes as differentiation across individual commodities is again largely driven by individual commodity supply and demand dynamics rather than macro risk on/risk off dynamics that tend to drive correlations to one.
• Some commodities such as oil have returned to a state of structural backwardation, suggesting positive carry may help push returns up for investors with exposure to commodity futures markets.
• The aforementioned decrease in market participation by regulated entities such as banks and other asset managers may lead to less competition that in turn may make it easier to identify and execute trading opportunities.
• Increased speculation that inflation pressure may take hold in developed markets may make investors enthusiastic about putting on commodity-related inflation hedging risk.
• The emergence of macro themes around increases in geopolitical risk or emerging market performance issues may help the return of price trends and volatility across commodity markets.

Hedge funds will continue to be a key player in the investment universe, attempting to deliver alpha and boost investor portfolios. Energy hedge funds and commodities as a whole should return to being considered a great diversifier for a traditional 60/40 balanced portfolio. The increase in correlation that commodity assets witnessed versus equities and bonds during the GFC has now subsided.

Investors would be wise to return to a significant allocation to commodities to improve the risk/return profile of their portfolios. Energy hedge funds will have to continue to institutionalize and professionalize their process. Those who do so will differentiate themselves from the crowd and grow to become market leaders. The increase in barriers to entry to the hedge fund market and the rising minimum efficiency scale driven by increasing cost and complexity will sadly reward large firms and unintentionally increase the systemic risk by consolidating the industry into a smaller number of larger players.

Having said that, through strong innovation smaller players can disrupt the market and continue to thrive as lean organizations that are more nimble and can therefore outperform their bigger competitors. Although the years since the GFC have not been the best for the industry, the trough has likely reached its nadir in 2014 and it is an opportune time to invest in the energy commodity asset class.