Value proposition seen in more esoteric commodity investments

BDO Stoy Hayward Investment Management believes it has a forward-thinking approach. This is displayed in its compelling macro and micro case for allocating to commodities via a diversified fund of hedge fund (FoHF) format detailed in the presentation for its Fitzwilliam Commodity Plus FoHF.

Two more esoteric areas of investment, land and food, and two metals, ruthenium and molybdenum are also highlighted.

Demonstration of the group's pre-emptive approach is evident also in the establishment of the FoHF. "Back in 2005 we looked at our typical client portfolios which included pension funds and high net worth individuals and sought to ensure that every client had some commodity exposure. In 2005 that was hard, even though commodities had had quite a good year," explains Shaun Port, London-based chief investment officer of BDO Stoy Hayward Investment Management.

When Port and his team looked around, few diversified FoHFs catered for this. The FoHF needed to be a diversifier with little correlation to traditional asset classes and was still considered to be a new asset class. At the same time the investment team accurately forecast the beginning of a commodity super-cycle.

Port's view on this is supported by China's continuing urbanisation and industrialisation, accounting for 22% of global demand for base metals and projected to increase to 30% by 2010.

BDO Stoy Hayward IM did not want a fund of commodity company shares given the correlation of 64% over the past five years between mining stocks and the UK equity market. This was only two percentage points less than the consumer goods sector's correlation to UK shares.

Port reasoned investors would have other allocations to equities and would probably not look to double up exposure via commodity-related equities. "Commodity equities were therefore not a great diversifier," Port says. "Commodity companies are companies first exposed to the economic cycle and equity markets in general. They are physical commodities second."

While mid- and small-cap miners, who may not hedge production so aggressively could partly prevent this concern, investing in them would come at the cost of liquidity, Port notes.

For these and other reasons Fitzwilliam seeks to limit the amount of commodity equity in the fund. However, there are some areas where equity is the only way to gain exposure to the underlying commodity.

BDO Stoy Hayward IM also moved early into commodity classes beyond the mainstream energy/resources, metals and softs, seeking exposure in water, uranium, electricity, shipping and weather derivatives. This brings them outside the GSCI's constituents, with its heavy bias of around 70% to energy, and the Dow Jones AIG index which Port cites as a comparative benchmark.

At the end of 2007 its allocation was 25.57% energy, 32.26% metals, 21.35% softs/agriculturals, 8.01% shipping/freight and 12.82% alternatives.

In these alternative markets Port says Fitzwilliam's managers seek arbitrageurs, such as opportunities between the US east and west coasts, electricity markets or, in the case of one sugar-trading hedge fund, between physical and futures.

"There are interesting arbitrage opportunities partly because the commodity traders are often in virgin territory where they know the market well, but the information they work off is not flowing through (trading) screens," explains Port.

An Asian hedge fund manager can also find opportunities in less liquid, often less efficient Asian commodities exchanges than a peer in New York where "everyone knows what everyone is doing."

Given that liquidity is typically lower outside the main US and European exchange centres, Port emphasises Fitzwilliam keeps a close eye on managers' size. An underlying fund over $1 billion in less liquid markets could trigger a re-evaluation. Fitzwilliam's sweet spot is investing in managers with $100 million to $500 million under management.

Fitzwilliam does not rule out managers at the beginning of their careers. It has seeded a uranium hedge fund for one ex-US power station manager among its 28 underlying managers.

Matthew Towsey, alternative investment analyst at BDO Stoy Hayward, says a "close eye" is kept on such managers, with Fitzwilliam intentionally keeping "quite a low stake" in such a fund.

Port says he and his team seek managers with long track records, ideally of 10 years or longer, in commodities markets. "We're looking for commodity people first, hedge fund people second."

At the FoHF level Port says Fitzwilliam is risk-controlled by its range of 28 managers. These would not typically allocate more than 5% of FoHF assets to any one manager. Another risk control is the FoHF diversity across a wide range of commodity sectors.

This policy has helped keep the volatility of the fund to 9.4% and a maximum monthly drawdown of 4.8% against the Down Jones AIG commodities index's 6.3% since the fund's inception. Fitzwilliam has also outperformed the index, posting 35.5% against the index's 32.2% since inception.

The case for allocating to commodities as insurance is clear. In all but four of the FTSE All Share's (GBP) worst 10 months in the five years to May 2008, and all but two months of the S&P 500 index's worst 10, the Dow Jones AIG index produced positive returns.

These statistics are supported by commodities' highest correlation from 1990 to 2007 to other major asset classes being 23% to hedge funds, while US equities' lowest correlation to other shares is 29% to Japanese equities and 57% to emerging markets equities. Leaving an alternatives allocation just in hedge funds still exposed the holder to cross-correlation of 63% to UK equities and 73% to US equities.

The argument for selecting active FoHF management can be made first by the Fitzwilliam Commodity Plus Fund outperforming both the GSCI and the DJ-AIG index since its February 2006 launch.

Port says the Fitzwilliam Commodity Plus Fund's main goal is "to find good commodity managers". So it is not afraid to veer away from benchmarks' weights. This goal has led it to find good managers as far afield as Australia and Singapore. He adds any single fund would not typically be above 5% of Fitzwilliam's assets.

The FoHF also diversifies between managers engaged in commodity trading long/short in the markets, physical traders conducting arbitraging physical and futures, systematic traders and some commodity equities strategies. Where contango (the upward sloping forward curve of the futures market) could harm returns, the managers note they will actively monitor specific commodity exposures.

The FoHF managers would review any fund in the FoHF portfolio that tops $1 billion, says Port. "If you look out in Asia for example, if you have a big manager from the US going into Asia they are very obvious whereas smaller funds can be a bit more 'under the radar'."

Supporting Fitzwilliam's enthusiasm for Asia, one fundamental-based relative-value fund in Asia, Fitzwilliam found, has produced annualised returns of 33.23% since its June 2004 launch, on volatility of 18.5%.

The issue of size not withstanding, one of Fitzwilliam's underlying funds in Singapore has grown from $40 million to $2.5 billion. "Even at that size, although in some markets they're very visible, the manager is still performing. So we're still in it."

At the FoHF level Port says capacity exists up to around $500 million on current trading styles, leaving a fair amount of headroom from where it sits just short of $100 million.

The FoHF managers are also conscious of leverage employed at the underlying fund level. "We would look to see if they are using their leverage responsibly. I would not say we're against its use as long as the manager is using it wisely."

While some allocators may be reticent to commit to commodities as an asset class due to perceived high volatility - and an equating of standard deviation with risk - Port says believing one to equal the other is wrong.

"You need a broad spread of commodities, and to remember commodities are not just about energy and gold. The indices can be quite volatile, but our volatility is lower, at 9.4%. With risk it is the maximum drawdown you need to look at. With our fund the volatility is being driven mostly by the upside. Delivering 14.5% annualised and getting a drawdown of 4.8% is pretty acceptable."

Because the FoHF managers apply a macro view, the fund has been moving longer term, so managers are trading up to five years out for base metals, for example.

"We need to be very aware of the commodities curve and how managers are trading it. There are opportunities out to five years, and although it can become illiquid as you go out, managers can be trading for curve movements rather than trading on the spot. That reduces the volatility because there's not so much volatility at the long end because the long term is fairly anchored," Port says.

The Fitzwilliam Commodity Plus Fund has also looked at more exotic commodities, for example uranium. "Uranium went up to 140 from 20 and (was then) marked back to 60 but long term the price is at about 65 and that is where 95% of the supply is secured," Port explains.

"The spot market is dominated by short-term supply problems whereas the longer term will be driven by expectation of where prices will go in the future," he says. Distortions and opportunities could occur when news of events, such as the 2006 flooding of the Canadian Cigar Lake mine, hit the market.

Demand has outstripped supply since 1990. Although its price reached an all-time low of $7 a pound in 2001, it has since risen to $60 a pound.

For the future Port expects general supply issues in metals and the start of a consolidation phase in the industry. He believes there will be a recession in the US. Port also thinks the peak demand from China may have passed "although import demand in the first quarter (of 2008) looks reasonable. GDP growth of 11.3% could be the peak and US housing starts are down 50% from their peak, and demand will be lower for copper. That said, copper supply is still likely to disappoint this year."

Port thinks the market could be five or six years into a 16-year super-cycle. "The theme will run and even though we may have a slowing economy in the next 18 months, particularly in China if demand slows dramatically after the Olympics, and even if metals suffer, there will be demand opportunities for softs by way of example.

"The consumption of soyabean in Taiwan is four times that of China per person, so all it takes is a small increase in income in China, to see a much greater absolute demand. Then you add in the extra burden of biofuels, and you could see a reversal of a 40-year down trend in real agricultural prices."

Fitzwilliam has not exhibited especially high manager turnover in its 28-month life, with five funds under redemption and six sold. Port notes style drift as a key reason for its switching. Another could relate to his own macro view.

The thinking of the fund management team is most strongly shown in its alternatives theme basket. This is where the managers have been considering areas such as land as a sub-set of agricultural, benefiting from 80 million global annual population growth and loss of approximately half the arable land of 40 years ago. In addition they are interested in minor metals as a potential future investment areas. Other areas of investment include diamonds, steel, shipping and coal.

"Rising food prices, when one sees in emerging markets the rapid urbanisation and increasing consumption of proteins and processed food, are all very positive for water." BDO Stoy Hayward IM found a water hedge fund manager for its FoHF. This is a private equity-type manager involved in bottling plants and the transport of water.

"The manager thinks water will be commoditised and he is the only one playing water as a commodity rather than through equities and we wanted to get access to the physical commodity, to get something reflecting the physical aspect of the commodity," says Port.

He emphasises water would not form a major part of the FoHF portfolio. The FoHF is certainly not looking at becoming a private equity portfolio by default. Port confirms water exposure is part of BDO Stoy Hayward IM's managers' close examination of the agricultural theme.

For those looking to access such a wide spectrum of opportunities, the Guernsey-domiciled fund requires minimum commitments of £10,000 and sterling and dollar share classes will soon be complemented by a euro class.


Name of manager: Shaun Port

Full name of fund: Fitzwilliam Commodity Plus Fund

Address of manager: 55 Baker Street, London W1U 7EU

Contact: Mark Spedding

Launch date: February 1, 2006

Portfolio size: $95 million

Average annualised return: 14.5% (end April 2008)

Average annualised volatility: 9.4% (end April 2008)

Share classes: US dollar, sterling

Administrator: International Administration Group

Auditor: PKF

Management/performance fees: 1.5%/15%

Minimum investment: £10,000

Lock-in: No

Redemption period: 90 days notice.

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