Q&A: Tony Hall at Duet Commodities Fund

After turning one of the highest proprietary trading profits in the history of Credit Suisse Commodities in 2009, Tony Hall launched hedge fund Duet Commodities Fund last year. He will be delivering the keynote talk at Energy Risk’s Commodities and Investment Summit in Geneva in June. Here he talks to Stella Farrington about the fund and his views on the commodities markets

Tony Hall, Duet Commodities Fund

Since its July 2010 launch, Duet Commodities Fund, a long/short fund focusing on energy, metals and agriculture, has posted returns of 10.2%. This puts it on track to meet its target of generating net annual returns in excess of 20% in any market condition with an expected volatility of 10%. Owned by alternative specialist Duet Group and managed by ex-Glencore/Credit Suisse and Deutsche Bank trader Tony Hall, the fund invests in futures, swaps and options, with 70% of the portfolio comprising directional trades, 20% relative value and 10% foreign exchange, the latter being mainly a hedge against the currency risk of commodities trades and to allow the trade to be expressed in the most profitable way.

Within Duet’s energy portfolio, the targeted markets are crude oil, middle distillates, fuel oil, gasoline, US natural gas and coal, all of which draw on Hall’s past expertise. The metals part of the portfolio, managed by ex-UBS and Lehman Brothers trader Arno Pilz, covers all the major industrial metals and precious metals. The agricultural section of the fund is still being finalised.

Hall worked at the Glencore/Credit Suisse alliance from 2008 to 2010 carrying out proprietary trading and running the oil products team. The 2009 proprietary profit was one of the highest in the history of Credit Suisse Commodities.

Prior to this, Hall was global head of middle distillate oil trading at Deutsche Bank, after trading macro-proprietary that covered foreign exchange, fixed income and commodities. His role as chief investment officer of Duet Commodities is the first time he has worked on the investor side of the market. In his offices in London’s Mayfair he talks to Stella Farrington about his views on commodities and upcoming regulation, the fund’s risk management strategy and what it’s like to be on the other side of the fence.

Q. How does running your own hedge fund compare to trading for a bank?

Tony Hall: So far it’s been a wonderful move. The major difference on leaving the banking side and entering the investor world is the amount of people you talk to. The relationships you’ve had in many different places really come into their own. When you’re at a bank the other banks are your competitors, but now they’re your clients, so we can all work together. In terms of starting a hedge fund, it was a big decision for me but an aim I always hoped to achieve one day. It definitely suits my trading style and my attitude, being entrepreneurial. When I was in banks
I was always trying to build teams and create a good place to work. That’s what I’ve done here. We’re expanding at the moment. It’s very much about people for me and getting the right person for the job.

Q. What is the fund’s philosophy and unique selling proposition?

A. We only trade things that we have an edge in. We’d rather trade a few things really well than spread ourselves too thin and be average. We have a deep understanding of the fundamental drivers of commodities at both a macro and physical level. I gained macro and then specialist derivatives knowledge at Deutsche Bank. What appealed to me about working at Glencore was the physical expertise. The physical information combined with financial and derivative knowledge should result in good risk taking and good calls on the market.

Our strategy is to choose liquid instruments over illiquid or complex instruments so we produce a liquid portfolio, which allows for better risk management.

We can go long and short and we will do both. We’re about absolute alpha and it’s discretionary.

In terms of our approach, we go through three phases before we put on a view. We take a big picture approach to start with, looking at the fundamentals and the macro-world and we decide what we believe is happening, then we put it through a technical analysis overlay, and then we look into the physical market as well. The more things line up the greater our conviction in that trade and the more assets under management we put at risk on those trades. Trades can vary from a simple futures trade to a multi-leg option.

Investors can expect performance in excess of 20%. That number is worked out by looking at my trading history. We also look at the volatility of our trading, we look at expected returns and VaR [value-at-risk] use. Investors want to know not only what kind of money we make but how we make it and what sort of movements they should expect. We’re not a very volatile commodity fund. We tend to average between 1–2% returns a month with around 5% on a good month. Unlike many funds we have monthly liquidity.

Q. Describe the risk management strategy used at Duet.

A. We have a 99% 1-day VaR, one-year historical with typical levels between 1% and 3% of the portfolio. On top of that, every trade has parameters, and a stop loss associated with it so we know if we get stopped out of everything what our worst case would be and that would never be more than 10%.

We have a system, Imagine, which calculates the VaR by trade, by product and by portfolio. Then we also add to that with stress tests and scenario analyses on the portfolio. We have a dedicated risk manager, Pierre Bruyant, and before anything goes on we run the trade past him, work out the VaR of the portfolio and how this trade would affect that VaR number. One thing that’s quite different for us – most people stress test big macro events – but we stress test more commodities-specific things such as Hurricane Katrina, volcano ash, the BP oil spill and so on.

Q. How is the fund broken down between energy and metals?

A. It’s currently 60% energy and 40% metals but if we saw greater potential in metals at any one time we could flip that around. There will always be different opportunities in different silos so that will keep the portfolio balanced between silos. The idea of this fund is that we have three experts – one in energy, one in metals one in ags, and we move the allocation around depending on where the best opportunities are in the markets and who’s performing the best.

Q. Do you trade over-the-counter and exchange?

A. Yes, we trade both OTC and on exchange. Since 2008 a lot more of our products, especially in energy, can be put through an exchange. We’ll trade through an exchange if it makes sense and suits us – however, it all comes down to the trade. Some trades are best expressed OTC.

Q. Is the regulatory drive to push all trades onto exchange a concern for you?

A. For lots of products, the OTC market is the most liquid. If OTC is the most liquid and that trade is best expressed OTC then I’ll trade OTC. I don’t foresee the regulatory changes being a problem for us. Of course the issue for us is increased margins and that’s more of a cash management problem, because the more margin we put up the less cash we’ve got to put into interest bearing liquid products.

The real issue though is being able to express the trade in the best way. For example, if you think fuel oil is going to go up, you want to be able to invest in fuel oil, not a proxy for fuel oil or an exchange-traded product that gets carried up by fuel oil, such as gas oil. If you only invested in gas oil you may only capture some of the rise in price that you would get if you’d invested directly in fuel oil. The case in point recently has been funds investing in WTI because they, rightly, think the price of oil is going up. This is what most of the macro funds did, and they’ve done pretty well trading commodities over the last couple of years. However, we as specialists have been able to outperform because we had the knowledge to express our trades in Brent rather than WTI. The thinking of the macro funds was right but they lacked the specialist knowledge to get the superior returns.

Q. How much emphasis do you put on correlations when choosing and forecasting your trades?

A. As well as our technical analysis, we also run a statistical analysis, looking at correlations. We’re primarily a directional fund – 70% directional with the balance being relative value. Relative value to me would be gas oil cracks, WTI/Brent and so on. I’m not a big fan of using correlations as a trading tool. I am in favour of using correlations as a good proxy for risk management.

WTI/Brent is a great example of how correlations break down, but it happened for a fundamental reason. If you were in the know then you would have been able to see that and trade accordingly.

The trouble is correlations change – they work well until they don’t work, and when they don’t work they really don’t work. When commodities go down, equities and bonds behave in a certain way, but in the past five years you could rewrite that book – we’ve had things moving in parallel or going the opposite way – it really depends what’s going on in the world and what investors are doing.

Q. Do you think commodities are a good hedge against inflation?

A. I think that commodities are the best hedge against unexpected inflation and that’s been proven. If it’s expected inflation and you’re risk averse, then my advice would be just to buy inflation-linked products.

Q. Do you think it’s a valid concern that the more investor money that comes into commodities markets the more divorced commodities becomes from their fundamentals?

A. I think one of my advantages and why I’ve been successful is coming from a macro world and understanding how commodities fit in and how other products and events affect commodities. Sometimes the fundamentals don’t exert the influence they should because the sentiment isn’t there. As a trader you have to know what hat to put on – when to have your macro hat on and when to don your physical/fundamental hat – and it does change. I do think the commodities markets are becoming more financial. In the nicest possible way, we are getting more tourists in our market and you have to pay attention to them as it’s a wall of money. I never thought I’d get to the stage where people have oil and metals and ags in their pensions but we are getting to that stage – it’s the way the market’s evolving.

I see indices as the other end of the spectrum to us – they’re a way of buying a whole basket of products. I think they will underperform or give investors problems this year. Not all commodities are created equal – you have to pick the right ones for the right reasons. Some commodities are not only supported by inflation, exposure to the developing world, particularly China, but also fundamentally supported, so when they do go down they are going to be supported by physical buying. Others are being dragged up by the whole market so when they fall they’ll fall faster because they don’t have the support. These are the ones we would short very quickly when things turn round.

Q. Should there be a limit to speculative investment in the commodities markets?

A. I’m a believer in free markets and I think the market will sort itself out. The Volker rule is obviously there to curb speculation especially in places where they believe it shouldn’t be. But if you restrict exchange trading too much, you force people to move to the physical world – either through the use of ETFs [exchange-traded funds] or direct physical purchases – effectively encouraging hoarding, which is exactly the opposite of what you want.

And in places such as China there’s no transparent reporting of what’s being stored. So this is an issue. It’s changing the market dynamic. However, I think ETFs are relatively sticky money. Sure there’s a speculative element looking at them every day, but there’s also a lot of investors looking at them as a long-term investment, especially with interest rates so low. I don’t see why these people would all liquidate their positions at the same time unless there was an event which would affect the commodity anyway. When people say the oil market is only at this level because of speculators, I don’t think that’s the case in the current climate. Canadian oil sands are not really feasible at $70 per barrel (bbl). Below $70/bbl you pretty much lose your Canadian crude. Currently I’d say oil prices at $80–90/bbl have a lot of support, as below that it cuts off a lot of supply. So I think oil has found a new range and it’s certainly strong for the right reasons.

Q. Are you keeping an eye on the shale gas discoveries in the US?

A. Yes, that’s a perfect example of how fundamentals are keeping prices low. The gas has been found and also we have the technology to get to it. Should US gas prices be this low? Absolutely, and for some time to come. I think it’s going to take a while for us to work through the amount of gas found.

Q. Do you take carbon and freight prices into account in your trades?

A. We don’t trade carbon but we do trade freight. We keep an eye on those markets and use movements there as input into our fundamentals and justification for our trades in the other products.

Q. Do you think the Volcker rule [which restricts banks proprietary trading activities] and regulation to limit banker bonuses will lead to more people wanting to start up hedge funds?

A. I think there’s lots of other avenues, not just hedge funds. I think the banks will try to find other roles for their prop traders. Others may look to join commodity traders – such as Glencore, Vitol, Trafigura, the big oil companies – which still have the trading spirit and mentality. And then the third route is hedge funds. You either start one or join a big one. We decided to start one as that’s what excites me. But absolutely I think there will be an increased move of people out of banking into hedge funds – but whether it’s to start new hedge funds remains to be seen. It’s not an easy thing to do, but ultimately perhaps more rewarding. I don’t think there will be as big a move as people are expecting, as not everyone has that mentality or risk appetite. 

Q. Are you daunted by the spectacular losses of previous hedge funds such as Amaranth and MotherRock, which had experienced traders investing in the gas markets?

A. Every time you hear a bad story about commodity funds it’s upsetting and it hurts all of us because it scares investors. Do I think it’s a good time to be in a commodity fund? Absolutely. I think it’s fascinating, the whole world’s interested in energy prices and I think there’s great opportunities in commodities at the moment. The commodities world is a small world and the commodities fund world is even smaller. I encourage people to come in to commodities because I want people to perceive commodities as a great asset class. When you look at commodities against equities, fixed income, distressed and debt, we’re still a tiny slice of the pie. What I want is good people in my industry because I want that piece of the pie to get bigger.

Q. When do you expect to hire an agricultural manager for Duet?

A. We’re in the process of hiring an ags trader. I’ve traded ags in the past, like most people in macro, but that doesn’t make me an ags specialist. I want to get the person exactly right, rather than rush it just so we can say we’re in ags. We want to be very boutique.

 

Duet Commodities – fact file

Duet Commodities Fund is owned by Duet Group, an alternative asset manager founded in 2002 with more than $2.4 billion of equity under management as of January 1, 2011.

Features of Duet Commodities Fund

• Minimum level of investment: $250,000

• Targeted returns: 20+% per year

• Expected volatility: 10%

• Typical range for 99% 1-day 1-year VaR is between 1% and 3%

• Position size never more than 10% of daily volume

• Maximum portfolio drawdown: 10%

• The fund is still open