swissHEDGE 1st Half 2011
A Review on Developments in the Hedge Fund Market
Opportunities in a changing environment Editorial | Georg Wessling | Harcourt AG Hedge fund industry commentary | Zeba Ahmad | Harcourt AG
3 4
Commodities and correlation | Ernest A. Scalamandre, Founder | AC Investment Management LLC
10
Commodities trading | David Skudder, Trading Principal | Global AG LLC | David Zelinski, Trader | Opus Futures LLC
15
Emerging markets and the world of tomorrow | Karthik Sankaran, Managing Principal | Covepoint Capital Advisors LLC
18
st
Roundtable discussion 1 Half 2011
24
Events 2011 | Harcourt Events | Upcoming Conferences
29
Imprint swissHEDGE | 1st Half 2011 Subscription: granath@harcourt.ch Published by: Harcourt AG Stampfenbachstrasse 48 8006 Zurich | Switzerland Tel: +41 (0)44 365 10 00 | Fax: +41 (0)44 365 10 01
Editor: Bernhard Schneider | schneider@harcourt.ch Design: Linkgroup | Zurich Printing: Printlink AG | Zurich
swissHEDGE 1st Half 2011
A Review on Developments in the Hedge Fund Market
Opportunities in a changing environment Editorial | Georg Wessling | Harcourt AG Hedge fund industry commentary | Zeba Ahmad | Harcout AG
3 4
Commodities and correlation | Ernest A. Scalamandre, Founder | AC Investment Management LLC
10
Commodities trading | David Skudder, Trading Principal | Global AG LLC | David Zelinski, Trader | Opus Futures LLC
15
Emerging markets and the world of tomorrow | Karthik Sankaran, Managing Principal | Covepoint Capital Advisors LLC
18
Roundtable discussion 1st Half 2011
24
Events 2011 | Harcourt Events | Upcoming Conferences
29
Cover Picture: Neue Monte-Rosa-H端tte Wenger Leander, Zermatt, 2009
swissHEDGE is a semi-annual publication of Harcourt AG intended for informational purposes and based solely on information and data supplied by either investment managers or qualified third parties. No information contained in this review should be interpreted as a solicitation for an investment and mention of a particular manager or product under no circumstance represents an endorsement of the product or the manager by the publisher. A prospective client for any product or service mentioned in this publication should independently investigate the investment manager and/or service provider and consult with independent, qualified sources before engaging in any activity. Investors should also be aware that historical performance numbers presented herein are not indicative of future performance and furthermore, investments in hedge fund vehicles involve significant risks, including loss of capital. Opinions expressed in the publication are not necessarily those of Harcourt and Harcourt assumes no responsibility for the contents of contributed articles. Harcourt AG is an alternative investment solution provider to institutional investors. For further information concerning Harcourt and its services visit our webpage at www. harcourt.ch.
Editorial | Georg Wessling | Harcourt AG
Hedge Funds are well positioned to deal with the challenging environment
Georg Wessling | CIO Increasing regulation of ďŹ nancial markets and ďŹ nancial intermediaries, historical low interest rates and bond yields, record-high sovereign debt in many advanced economies, geopolitical tensions in the Middle East, and lately the human tragedy resulting from the natural and nuclear catastrophe in Japan. The world is confronted with tremendous challenges. This issue of swissHEDGE is focusing on investment opportunities in this challenging environment. A particular focus is spent on emerging markets and commodities. While many investors have invested in both emerging markets as well as commodities for the last few decades, we strongly believe that these markets will get much more important going forward. The emerging economies of today will be the advanced economies of tomorrow. Getting there, the economies will follow a strong growth path which will offer interesting investment opportunities. Strong growth in the emerging economies will also come along with growing demand for commodities. To the extent that supply will not be able to meet the increasing demand also commodity prices are expected to rise. But as we already have seen over the last couple of months, growth in the emerging markets is not a straight upward move. Inflationary pressures push central banks in emerging economies to tighten and therefore to cool down growth at times. This can and will have an impact on emerging
market assets and commodities as well. Nobody should be surprised by continued volatility. This highlights the importance of active portfolio management. As we consider hedge funds to be the most efficient form of active portfolio management they are well positioned to generate attractive returns in a volatile environment. While facing interesting investment opportunities hedge funds have to deal with the changing regulatory environment as well. As stated by hedge fund representatives in our roundtable discussion, these changes can both limit hedge funds in their investment activities, but also offer new opportunities. Without question, hedge funds will have to adapt to these changes. Indeed, they already have started to adopt. Improved transparency, increasing assets in managed accounts, and continued launches of UCITS hedge funds witness hedge funds’ ability to adapt. Given the flexibility of hedge funds we are convinced that they are perfectly positioned to deal with the changing environment and generate superior risk-adjusted returns on the opportunities ahead.
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Hedge fund industry commentary | Zeba Ahmad | Harcourt AG
Hedge Fund Industry Commentary, Q1 2011
Zeba Ahmad & Harcourt Research Team The ďŹ rst quarter of 2011 could not have been more eventful. The rising tension in the Middle East was one of the earlier events to unfold causing a surge in oil prices. Simultaneously, the continued debasing of the USD saw it reach new lows versus currencies such as JPY and CHF while gold reached all time highs. Europe was bracing itself for the ďŹ rst rate hike in several years and most of the Emerging world is several months into policy tightening. All this followed by the tragic events in Japan. Who would have thought that in such a context global equity markets could end the quarter in positive territory?
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Directional Equity The HFRI Equity Hedge Index ended at +2.2% for the quarter which compares to +4.3% for the MSCI World Index. The positive number posted by the most followed global index masks the numerous gyrations that took place across the quarter as well as some regional divergences. While US markets were strong with the S&P and Russell boasting returns of 4.2% and 7.6% for the quarter respectively, Europe was barely flat for the quarter with much national disparity. Performance in the Long Short Equity space reflected the market moves to a degree where Long Short US managers strongly outperformed their European counterparts. For US managers most alpha was added in January and February while March saw negative alpha contribution as the Financials and Technology stock declines were detrimental overall. European Long Short Equity managers made most
Hedge fund industry commentary | Zeba Ahmad | Harcourt AG
of their alpha in March where they were able to deliver flat returns in a declining market with positive net exposures. There was some regional diversity and unlike the US almost half the sectors were negative for the quarter, enabling managers to also generate returns from their short books. Japanese equities were amongst the leading indices in the developed world until the earthquake drove markets down sharply. The Topix was down –3.3% for the quarter while the small cap indices such as TSE2 actually ended in positive territory. Japanese managers were able to deliver positive returns in January and February while limiting the losses in March. MSCI Emerging Markets delivered a paltry 0.3% and saw some divergence within regions. Two main themes have been driving investor’s appetites. The Middle East tensions firstly have impacted equities in those regions negatively for the quarter. This development has benefited Russia as an
oil dependent economy and has also strengthened its geopolitical positioning. Secondly, in the makings already since last year is the development of inflation in these rapidly growing markets. Where Central banks are perceived to be lagging or have swayed in their message, markets have been less forgiving while in countries where investors feel that the problem is being addressed more aggressively and where we may be farther along the tightening process, markets have already started to display more positive behaviour as in China. Long Short Emerging Markets managers were positive on average, but most of the strong performance came from long exposures to Russia and China. Relative Value Equity Event-driven managers had a strong quarter with the HFRX Event Driven Index gaining 2.4%. Convertible Arbi-
swissHEDGE 5
Hedge fund industry commentary | Zeba Ahmad | Harcourt AG
trage managers continued to perform well with a gain of 3.4% through March. The Newedge Volatility Index had a very strong March as intra-month volatility was elevated helping to drive first quarter performance of 2.4%. The HFRX Market Neutral Index gained 2.8% for the quarter with increased volatility supporting trading models. Event-driven funds started 2011 with the strategy supported by rising equity markets and spread tightening. Global deal activity was strong with USD168bn announced in January. Notable deals in January included Duke Energy merging with Progress Energy in a USD13.7bn deal, Alpha Natural Resources bidding USD8.2bn for Massey Energy and Rock-Tenn announcing a bid for Smurfit-Stone a post reorganization equity for USD3.5bn. Smurfit was notable as a number of investors were publicly contesting the Smurfit offer as inadequate and questioning the auction process. February was a continuation of positive results with gains driven by both rising equity markets and deal specific news. Interesting new transactions included exchange deals with the LSE/TMX and Deutsche Börse/NYSE. Managers benefited from Danaher announcing a definitive offer for Bechman Coulter and Genzyme and Sanofi formally revising terms of the takeover which included a contingent value right added to the deal on top of a cash payment. March provided small strategy gains as markets withstood volatility from continued uncertainty in the Middle East in addition to the tsunami in Japan. M&A deal activity in Q1 was USD809bn which was the most in 3 years. Interesting new transactions included AT&T’s USD39bn buyout of TMobile, eBay’s USD2.4bn acquisition of GSI and Berkshire’s USD9bn acquisition of Lubrizol. Managers benefited from British Sky Broadcasting following UK regulatory statements on potential takeout. Other positive drivers included Tronox, Dollar Thrifty, ING Industrial Fund and Genzyme. Spreads remain tight but the outlook for the strategy remains positive as deal flow continues to increase in-step with rising equity markets. Other positive drivers are the re-emergence of private equity that needs to deploy capital as well as growth in corporate cash balances during the financial crisis which should drive M&A in a slower growth environment. Convertible arbitrage started the year with strong results driven by strength in equity and credit markets as well as a pickup in implied volatility across most regions. Performance was fairly spread across credit quality with midcaps outperforming small and large caps. US new issuance was light to start the year with 5 deals pricing in only USD1.8bn in issuance. Organic growth was flat on the month. Febru-
swissHEDGE 6
ary was a continuation of the positive equity markets providing managers with positive backdrop. Credit spread tightening and a pickup in realized volatility also supported valuations while the decline in implied volatilities offset some gains. Global new issuance totaled USD6.4bn in February dominated by USD3.5bn from Sinopec in China. US new issuance continued to lag with 7 deals pricing in USD1.2bn in the US. US Organic growth was negative with over USD5bn redeemed during the month. Strength in equity markets supported Convertible valuations in Q1 with the exception of March which saw roughly flat performance. Credit tightening remains supportive with lower quality credits leading the way. Spreads are at historic lows and some managers are more cautious for a pull back and running balanced portfolios. Organic growth remains limited but 2011 new issuance is likely to be back to 2008 levels with 21 deals pricing in USD9.4bn in March alone. Performance should remain attractive in the near-term with natural redemptions and outright buyers supporting valuations. Volatility arbitrage managers were up in January with intra-month volatility providing trading opportunities. Volatility declined through mid month as equity markets rallied only to price in some risk as the crisis grew in Egypt and some concerns surfaced in the Eurozone. Markets are awash in liquidity and continue to shake off most fears. The VIX began January at 17.61 and dropped as low as 15.37 intra-month but finished the month at 19.53. Many Funds were able to deploy risk during the month either as volatility came in or as markets panicked. Volatility arbitrage managers were down slightly in February. The VIX on the surface appeared subdued during the month starting at 19.53 and ending at 18.35 which masks what was a fairly volatile month with a range of 14.86 on Feb 8th to 23.22 on Feb 23rd on a pickup in Middle East tensions. Managers have suffered from unusually high correlations but this should provide for decent trades as we move through 2011. Volatility arbitrage finished the quarter with a strong March. Investor demand for downside protection has created a significant spread between 12 month S&P variance versus realized volatility. While implied volatility has come down across all regions, the skew in both 3 month and 12 month shows that the market is pricing in concern for a pullback. Similar to February, the VIX exhibited significant intra-month volatility creating trading opportunities. It closed at 17.74 down from 18.35 in February but reached a intra-day high of 31.28 on March 16th. Market Neutral Funds were down in January. The higher level of intra-day mean reversion improved the opportu-
Hedge fund industry commentary | Zeba Ahmad | Harcourt AG
nity set for statistical arbitrage. Fundamental-based strategies were more successful than technical strategies. Factor performance reversed from the previous quarter with momentum suffering, and value and reversion based factors performing well in contrast to analyst and financial factors. Market Neutral Funds were up sharply in February. Statistical arbitrage strategies had a positive month, with single stock opportunities amidst a moderate overall level of market volatility providing an attractive environment. Liquidity momentum expanded in developed Europe and Japan, was neutral in the US, and strongly contracted in Emerging Markets. Reversionary strategies were observed to perform well in Europe and Japan while momentum factors performed better in the US. Fundamental signals appear to be strengthening and are observed to be bullish for global de-
veloped equity markets. March proved to be another strong month. Market neutral strategies are directly benefiting from lower average pair-wise stock correlations and from having neutrality and global diversification levels within strong constraints. The new volatility conditions presented opportunities to technical systems and for some fundamental strategies. Given the macro headwinds for equity markets, market neutral strategies are increasingly attractive in their risk/reward and in a portfolio context. Fixed Income Returns within the relative value fixed income hedge fund universe were mainly dominated by MBS and ABS managers. Agency MBS managers benefited from the performance in IO (Interest Only) strategies as a result of the continued
swissHEDGE 7
Hedge fund industry commentary | Zeba Ahmad | Harcourt AG
slowdown witnessed in prepays and the likelihood of a government led universal refinancing decreasing. Prepayment continued to decline as witnessed by the MBA Refinancing Index while mortgage rates continue to rise with the Freddie Mac Survey Rate reaching 5.5% at the end of the quarter. Non Agency RMBS managers benefited from the positive technicals present in the space; more specifically driven by increasing demand for securities in a market with no supply. The month of March was a proof of the positive technicals currently present in the space: during the month structured credits bonds were difficult to sell during the selloff, but were subsequently heavily sought by both fast and real money investors; for example some Pay Option Arms initially experienced a 5 to 10% drop in value during the de-risking phase but then easily regained their pre-crisis value. Demand was also exacerbated by mainstream institutional investors such as banks, insurance companies and money managers getting more involved and the return of leverage in the system. The environment for fixed income arbitrageurs was not as favorable. Despite the lack of competition in the space arbitrageurs were mainly able to generate returns by being active in specific strategies such as relative value volatility trading. Directional fixed income strategies performed well in general. We witnessed unusual performance dispersion among emerging market macro managers: managers that were mostly involved in emerging market foreign exchange benefited from the re-pricing driven by higher inflation in emerging markets; the relatively lower volatility in EM FX witnessed during the month of March helped those managers outperform by a stretch. Emerging market managers active in emerging local and external debt while hedging via developed market fixed income instruments suffered from a break up in correlations. Long short credit managers continued to benefit from the continued rally in credit markets and many benefited from the dispersion witnessed among single name issuers. Distressed securities posted a good quarter as many were involved in post reorganization and distressed equities that performed well on the back of an overall uplift in equity markets and idiosyncratic situations by for example being M&A targets (Smurfit Stone, Hughes Communications). Due to a lack of distressed opportunities in corporate credit with default rates hovering below a percentage point, managers have become more active in taking advantage of the last leg of the cycle via stressed and post reorganization equities, focusing on complex litigation cases and/or being more opportunistic by sourcing opportunities within the municipal space.
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Commodities Prices across the commodity spectrum saw increased levels of volatility during the quarter due to a conflagration of geopolitical events, natural disasters, and tightening supply and demand fundamentals. Beginning in January social and political upheaval in the Middle East and Northern Africa roiled markets as concern over potential supply disruptions pushed prices sharply higher, impacting prices across the commodity spectrum but most notably in the energy sector. In March focus shifted from ongoing conflicts in the Middle East and northern Africa to the disaster in Japan. Commodity prices across the board plummeted suddenly on fears that the world’s third largest economy would drastically reduce imports in the aftermath of the earthquake, tsunami, and finally the crisis at the Fukushima nuclear power facility. As the days passed however it became clear that although the disaster wreaked havoc on a broad scale across the region, most major commercial ports were not seriously damaged and on the whole continued to function. Thus investor attention began to return once again to the ongoing civil war in Libya, causing a reversal of the earlier price corrections. Commodities market movements were largely dominated
Hedge fund returns Q1 2011
Q1 2011 HFRI Fund of Funds (non-investable, net)
0.89%
Eurekahedge Global Fund of Funds Index
0.63%
HFRX Global HF Index (investable, gross)
0.40%
Event Driven
3.54%
MBS Arbitrage
3.45%
Fixed Income Corporate
3.37%
Distressed/Restructuring
3.20%
Convertible Arbitrage
2.76%
Relative Value Arbitrage
2.52%
Long/Short Equity
2.16%
Equity Market Neutral
1.92%
Merger Arbitrage
1.58%
Emerging Markets CTAs
0.91% – 0.12%
Macro
– 0.79%
Short-selling
– 5.97%
MSCI World
4.29%
JPM Bonds
– 0.58%
Source: CSFB/Tremont HFs, HFR, FTSE, JPM, MSCI and Barclays
by the two main themes of energy and agriculture. Q1 2011 saw the entirety of Libyan crude output taken out of the market, leaving a deficit that impacted European markets in particular. While Libyan production was relatively mini-
Hedge fund industry commentary | Zeba Ahmad | Harcourt AG
volatility trading environment, natural gas and power managers are turning to trades like basis and geographical spreads (UK vs. Nordic markets, for example). Some more opportunistic managers are shifting portfolios to add more exposure to such markets as power, utilities, or emissions vs. natural gas, until volatility picks up and prices break out of the current ranges. Agriculture markets were also characterized by whipsawtype price movements during Q1; the relatively modest quarter-end results belie the rise in volatility seen during the period. After falling sharply immediately following the disaster in Japan, grain prices corrected upwards upon the release of the USDA acreage report on March 31, which indicated much lower inventories than previously sup-
mal compared with total global crude output, it represented a much larger percentage of the available high-quality light crude that refineries in Europe require. OPEC has demonstrated willingness to increase output of spare capacity in an attempt to fill the gap, but the effect on dampening prices has been less effective than expected due to the inability of refineries in Europe to process the heavy grade of crude that Saudi produces. One interesting phenomenon observed in crude markets during the quarter was the widening spread between WTI and Brent prices. Spreads, typically very tight, widened in February to unprecedented levels, based on the plentiful supply of crude and limitations of the transport system in the US vs. tighter markets in Europe. This de-coupling of regional prices prompted
Hedge fund returns
2010
Ret pa 2000 – 2010
Ret pa 1994 – 2010
Stdev pa 2000 – 2010
Corr MSCI 2000 – 2010
0.89%
5.70%
4.13%
5.92%
5.51%
0.68
0.63%
3.96%
4.71%
4.73%
0.61
0.40%
0.40%
5.19%
4.40%
6.16%
0.61
Event Driven
3.54%
3.54%
11.87%
8.36%
11.22%
6.82%
0.79
MBS Arbitrage
3.45%
3.45%
12.90%
8.84%
9.36%
3.88%
0.29
Fixed Income Corporate
3.37%
3.37%
11.80%
5.97%
6.55%
6.13%
0.64
Distressed/Restructuring
3.20%
3.20%
12.12%
9.45%
10.22%
6.43%
0.64
Convertible Arbitrage
2.76%
2.76%
13.17%
7.49%
8.58%
8.54%
0.55
Relative Value Arbitrage
2.52%
2.52%
11.45%
7.71%
8.89%
4.54%
0.63
Long/Short Equity
2.16%
2.16%
10.47%
5.90%
11.40%
9.03%
0.83
Equity Market Neutral
1.92%
1.92%
2.87%
4.16%
6.24%
2.97%
0.20
Merger Arbitrage
1.58%
1.58%
4.60%
6.17%
8.66%
3.46%
0.61
Emerging Markets
0.91%
0.91%
11.44%
10.69%
9.85%
12.22%
0.81
CTAs
– 0.12%
– 0.12%
7.06%
5.85%
6.01%
7.08%
– 0.05
Macro
– 0.79%
– 0.79%
8.09%
7.43%
9.10%
5.50%
0.29
Short-selling
– 5.97%
– 5.97%
–18.01%
1.42%
– 0.85%
18.74%
– 0.71
Q1 2011
YTD
HFRI Fund of Funds (non-investable, net)
0.89%
Eurekahedge Global Fund of Funds Index
0.63%
HFRX Global HF Index (investable, gross)
MSCI World
4.29%
4.29%
9.55%
– 0.62%
4.69%
16.59%
1.00
JPM Bonds
– 0.58%
– 0.58%
4.24%
5.30%
6.03%
3.07%
– 0.29
Source: CSFB/Tremont HFs, HFR, FTSE, JPM, MSCI and Barclays
questions as to whether WTI remains an accurate benchmark for crude prices. Nevertheless, the volatility in spreads provided new opportunities for hedge fund managers, who were able to take a view on the future direction of the spread. Going forward relative value and directional hedge fund managers alike should benefit from the uptick in volatility across crude markets, as well as derivatives and related products such as gasoline, gas oil, heating oil, ethanol, and kerosene. Natural gas prices on the other hand remained caught in a narrow range during the quarter due to a continued glut of supply and relatively mild temperatures. Frustrated with the lack of opportunities in this very low
posed. In addition to being subjected to the same macro factors as energy markets, agriculture and soft commodities sectors have also been impacted throughout the quarter by unfavorable weather conditions that affected large swaths of major growing regions in the early part of the quarter, most notably in Australia, China, and Brazil. Although growing conditions have improved in some regions (such as Brazil), late snowfall and extreme drought in areas of the US have delayed new crop plantings, pushing prices higher at the back end of the curve. Additionally, inventories of many agricultural products (most notably corn and cotton) are at historically low levels and
swissHEDGE 9
Hedge fund industry commentary | Zeba Ahmad | Harcourt AG
continue to draw. Increasing global demand for grains and soft commodities continued unabated, fuelled in part by Chinese imports, both real and rumored. Governments remain concerned with continued high prices and the prospect of future shortages and have begun to talk of stockpiling resources, though because governments tend to be relatively price in-sensitive it is likely that re-stocking will occur eventually regardless of cost (and will likely have the effect of driving prices higher still). The more nimble hedge fund managers have responded to this environment by actively alternating between long and short positions within the sub-sectors. Other strategies to capture alpha and participate in the upswing in volatility have included intra-commodity spread trades, calendar spreads, and bear spreads. Going forward, agriculture markets should continue to provide managers with opportunities to capitalize on momentum strategies. Directional Multi-Asset Class Trading Directional multi-asset class trading indices were negative for the quarter, driven by broad market reversals in January and March. The Barclay CTA Index posted –43bp, Newedge CTA Index –144bp, AlternativeEdge Short-Term Traders Index –266bp and HFRI Macro –61bp. Short-term trading strategies had the most difficulty due to a combination of volatility being constrained by the influence of liquidity, optimism and complacency, and abnormal patterns when market did move strongly in crisis. In the Barclay CTA subindices, Discretionary Traders (+93bp) outperformed Systematic Traders (–196bp). Markets in January were characterized by improving developed economy fundamentals offset by concerns about global inflation and Middle Eastern political stability. Equity markets maintained a positive stance through the month benefiting long trend positions. ECB indications of earlier rate hikes given above-target Eurozone inflation caused losses for trend and macro long positions partly offset by gins in short Euro positions. Several EM currencies reversed on inflation-related policy changes hurting long macro, trend and carry positioning. Precious metals markets took profit on multi-decade highs. Rising prices for Brent oil (Egypt/Suez), grains and softs benefited long trend and macro positions. Middle East tensions in February caused global equity markets to give back early month gains that benefited trend and short-term trading strategies, drove profits in long trend and macro oil positions, drove profits in precious metals longs based on trend and currency debase-
swissHEDGE 10
ment concerns, rallied bond markets in a flight to safety that was detrimental to short positions based on trend and sovereign indebtedness concerns. The USD weakened against the GBP and the EURO on interest rate expectations, and against stronger commodity-linked currencies. Macro shorts in JPY continued to suffer, while long trend positions benefited from the currency’s continued strength. The catastrophic events in Japan in March came on the heels of EZ sovereign downgrades, weak China trade/inflation data and rising US trade deficit. Markets were dominated by deep V-shaped moves across major equity, bond and FX markets creating a difficult environment for actively risk managed strategies. Trend programs reallocated risk with portfolios strongly favoring commodities by the end of the month. Bank of Japan liquidity injections and concerted G7 JPY intervention were significant events for global liquidity and policy action. Cocoa trend positions were hurt as prices corrected on an improving political situation in Ivory Coast. Strong US economic data later in the month helped the pro-growth trend portfolios recoup some of the losses from the earlier sell off. Outlook An important question facing managers across various styles today is how the end of QE II may affect their strategies. Macro managers will be at the forefront of this development and should be able to capitalize on future moves that are expected to be less binary. We remain positive on the Agency MBS space as a consequence of prepayments remaining structurally low, leading to attractive pay-offs from IO strategies. Corporate health remains strong with record levels of cash on the balance sheet which should assure continued interest in the Event Driven space. Higher input prices will affect companies that cannot pass on prices increases and should lead to decent performance in the Long Short Equity space where having a short book may finally be beneficial.
Commodities and correlation | Ernest A. Scalamandre | AC Investment Management LLC
Observations Regarding Commodity Correlations
Ernest A. Scalamandre Founder | AC Investment Management LLC Commodities have historically demonstrated a very low to negative correlation to more traditional asset classes, such as equities. In normal market environments, there is an economic reason for this. However, during times of extreme market uncertainty, this relationship has proven to break down as correlations between unrelated instruments increase. In this paper, we will discuss a few of the previous periods of high commodity and equity correlations, as well as address why today’s environment might be different.
Commodities and equities are distinct asset classes, influenced by a similar set of factors, namely global GDP, but in different ways. Commodities tend to perform well in times of inflation, as increasing natural resource prices typically cause product prices to increase. Periods of inflation are generally accompanied by rising interest rates, which control the inflation that generally creates a challenging environment for equities. Conversely, periods of low interest rates and low inflation or deflation are normally bullish for equities and bearish for commodities. In times of extreme panic or market distress however, commonly during or following periods of recession, the correlation between stocks and commodities tends to increase as investors decide between risk-on or risk-off attitudes, as opposed to fundamentals.
swissHEDGE 11
Commodities and correlation | Ernest A. Scalamandre | AC Investment Management LLC
itical unrest (Iran-Iraq war in particular) as well as an unpredictable supply of crude oil to developed economies. Interest rates were cut steeply to tame record high inflation, ultimately creating a bullish market for equities that saw the S&P 500 approximately double from 1979 to 1985. During this period, investment interest in commodities such as gold and crude oil greatly increased, which caused prices to rise further. At the same time, the economy experienced significant employment and demand growth, which also proved to be supportive of commodity prices. Following this period of growth and investment interest in financial assets, commodity investments faded as investment capital fled to equity markets, creating a substantial long-term decorrelation between the asset classes until a brief period in the mid 1990’s. There is little consensus as to which single event precipitated the Asian Financial Crisis. However, the first tangible domino to fall occurred as Thailand de-pegged its currency to the USD. Shortly thereafter, robust economies were subdued as the Southeast Asian “bubble” burst. Most important among the directly affected economies was Japan, which was the world’s second largest economy at the time. Inopportune policy decisions in the attempt to stifle the ongoing crisis served to exacerbate the situation and contributed to a growing sense of apprehension among speculative
The purpose of this article is to examine the current state of commodities as an investment. In order to accomplish this goal, a review of commodities’ recent history is necessary, which would allow one to put today’s extreme market behavior in perspective. The first period under examination occurred in the early 1980’s, in the wake of the Second Oil Crisis. Next the late 1990s is considered, a time period during which the Asian Financial Crisis played a significant role in determining the general market sentiment. Finally, we examined the most recent recession and the circumstances surrounding the current market environment, which is particularly unique as a result of a dynamic set of factors. To demonstrate this change in correlation, we have compiled monthly returns on both stocks and commodities from 1975 onwards. We used the Continuous Commodity Futures Price Index, a revised version of the Commodity Research Bureau (CRB) Index as our basis for commodities returns. It provides an equally-weighted geometric average of commodity price levels between 17 commodity futures contracts. For equity returns, we used the S&P 500 Index. With this data, we calculated a rolling monthly correlation from January 1975 to the present. As exhibited below, in the past 35 years, there have been three occurrences of high positive commodity and equity correlations; the early
Correlation between stocks and commodities
Hi: 0.6358
Correlation 0.4361
0.60 0.4361
0.40
0.20
0.00
-0.20
-0.40
-0.60 Low: -0.6746 ’75
’76 ’77
’78 ’79 ’80
’81
’82
’83
’84
’85
’86
’87
’88 ’89
’90
’91
’92 ’93
’94
07-Apr-2011 19:06:21 ’95
’96
’97 ’98
’99 ’00
’01
’02 ’03
’04
’05 ’06
’07
’08
’09
’10
’11
Source: Bloomberg
1980’s, the mid 1990’s, and the late 2000’s. Each of these occurrences has been accompanied by broader economic events that may have caused markets to move in unison. The early 1980’s were marked by uncertainty due to geopol-
swissHEDGE 12
investors. This perceptual shift did not only apply to Asian economies, but to all emerging markets and risky investments in general. In the minds of investors, the true nature of Asian investments was exposed, which led to a massive
Commodities and correlation | Ernest A. Scalamandre | AC Investment Management LLC
withdrawal of speculative capital and ultimately concluded with Russia devaluing their domestic debt in August 1998. As is always the case with contagion-type panics, the loss of confidence in one general type of investment spilled over to create doubt in other asset classes. With a sense of fear undermining clear-thinking, the relationships between asset classes shifted and led to a tangible increase in correlations. Following a period of slightly negative correlation in 1997, the correlation between commodities and equities soared by 1999. Had this crisis been worldwide, it is fair to assume that the spike in correlations would have been even more dramatic – as evidenced by the events of the past five years. In the mid 2000’s, correlations between financial and commodity asset classes began to increase once again. We would argue that the extremity of the most recent rise in
“inevitable” deterioration of other markets. Additionally, the massive devaluation of the real estate market created a considerable need for liquidity, which exacerbated the effect. Fear and irrational behavior, coupled with structural shifts in financial markets, became the dominant factors as all markets, including commodities, began a steep sell-off. Correlations were driven even higher in recent months as optimism has been restored driving the equity markets higher, while key components of supply and demand have led to commodities prices reaching all-time highs. Additionally, unlike previous periods of high equity and commodity correlation, the correlation between commodities themselves is also at elevated levels. In our view, this is primarily caused by the previously mentioned influx into the commodities asset class. To illustrate, below is a corre-
Institutional and retail commodity AUM
Intra-Commodity Correlations
Institutional and retail commodity AUM
1975–2011
350
DJUBSA
1.00
0.17
0.34
0.26
0.64
0.07
DJUBSE
0.17
1.00
0.25
0.15
0.10
0.09
DJUBSI
0.34
0.25
1.00
0.28
0.31
0.10
DJUBSP
0.26
0.15
0.28
1.00
0.24
0.01
DJUBSS
0.64
0.10
0.31
0.24
1.00
–0.05
DJUBSL
0.07
0.09
0.10
0.01
–0.05
1.00
DJUBSA DJUBSA DJUBSE
Issuance of commodity medium term note Exchange traded commodity products Barcap estimates of commodity index AUM
280 210
$bn
2000
420
140
1995–1999
70
DJUBSA
1.00
0.14
0.01
0.14
0.50
0.05
DJUBSE
0.14
1.00
0.01
0.11
0.10
–0.04
0
DJUBSI
0.13
0.01
1.00
0.18
0.09
0.05
DJUBSP
0.14
0.11
0.18
1.00
0.06
0.02
DJUBSS
0.50
0.10
0.09
0.06
1.00
–0.05
DJUBSL
0.05
–0.04
0.05
0.02
–0.05
1.00
DJUBSA DJUBSE
2002
2004
2006
2008
2010
DJUBSI DJUBSP DJUBSL
Sources: Bloomberg, ETP issuer data, Barclays Capital
DJUBSI DJUBSP DJUBSS DJUBSL
2005–2011
inter-asset correlations is the result of a number of factors, quite dissimilar to prior periods. For one, previously distinct markets are far more connected and interdependent today as a result of globalization and electronic trading, which facilitated the spreading of financial contagion in 2008. Additionally, material increases in passive investment via indices and ETFs have played a crucial role in driving correlations higher as similar investors influenced by similar psychological processes were now getting involved in previously inaccessible markets. Excessive speculation in real estate markets, fueled by easy credit and rising asset prices, precipitated the ensuing crisis. Other markets would follow suit. Consequently, speculators began liquidating assets in an attempt to avoid the
DJUBSA DJUBSE
DJUBSI DJUBSP DJUBSS DJUBSL
DJUBSA
1.00
0.46
0.50
0.37
0.71
0.14
DJUBSE
0.46
1.00
0.49
0.37
0.40
0.14
DJUBSI
0.50
0.49
1.00
0.41
0.42
0.14
DJUBSP
0.37
0.37
0.41
1.00
0.31
0.03
DJUBSS
0.71
0.40
0.42
0.31
1.00
0.15
DJUBSL
0.14
0.14
0.14
0.03
0.15
1.00
Source: Bloomberg
lation analysis among a sample of commodities sub-sectors in the Dow Jones UBS Commodities Index. We used the Agriculture, Energy, Industrial Metals, Precious Metals, Softs, and Livestock subsectors. With these subsectors, we ran a monthly correlation between 1975 and 2011 to show the long-term correlation, and a weekly correlation
swissHEDGE 13
Commodities and correlation | Ernest A. Scalamandre | AC Investment Management LLC
between 1995 to 1999 and 2006 to 2011 to examine the periods in question. There are a couple of trends worth noting in observing the monthly intra-commodity correlations between 1975 and 2011. The majority of relationships between the major commodity sectors do not exhibit statistically significant correlations. With the exception of the DJUBS Agriculture index and DJUBS Softs index, no pairing possesses a correlation over 0.34. Though Agricultural and Soft commodities serve different purposes, their supply chains are similarly affected by weather events, which accounts for the relatively high correlation between the two. In comparison, the intra-commodity weekly correlations for the period between 1995 and 1999 were less significant across the entire spectrum. The inverse of this trend occurred between 2005 and 2011, as intra-commodity correlations rose to higher than normal levels. This increase from normal levels can be attributed to the increased levels of capital currently involved in the commodities markets as can be seen from the chart above. This has put a positive price pressure on commodities in general and has linked many seemingly unrelated commodities. Additionally, huge demand growth, primarily from the BRIC countries, has amplified this affect. This confluence of factors has set the stage for a truly unique market environment; one that may endure for a longer period than has been previously seen. The process by which unrelated asset correlations increase can be partially understood by examining the circum-
swissHEDGE 14
stances surrounding previous incidents. There were several similarities detected in the three periods in question. Each period was preceded or accompanied by some sort of financial turmoil or crisis. In the early 1980’s, the world was still trying to come to terms with the realities and potential effects of the second Oil Crisis. In the late 90’s, the world was shocked by the Asian Financial Crisis. Most recently, developed nations across the world have been mired in a huge slump borne out of the slowdown and eventual bursting of the housing bubble. These events served to skew the perception of investors, but they do not tell the whole story. Key decisions made by policymakers across the world served to reinforce and extend the trends that naturally arise in times of uncertainty. Moreover, in the 2000’s, substantial inflows into commodities have skewed the market’s traditional supply and demand price discovery mechanism and have created an instinctive correlation between the markets. What does this mean for investing in commodities today? The increase in correlations serves to reduce the attractiveness of investing in commodities as a source of diversification; however, it should not serve as a deterrent to investing in commodities in general. With volatility having accelerated and expected to continue, the conditions are ripe for an investment in an actively managed commodities portfolio. Nimble managers who are capable of navigating various market conditions should be able to thrive under the current set of circumstances.
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Commodities trading | David Skudder, Global AG, LLC | David Zelinski, Opus Futures LLC
Crossroads, Risks and Opportunities in Trading Feed Grains and Oilseeds David Skudder Trading Principal, Global AG, LLC David Zelinski Trader, Opus Futures LLC The USDA provided surprises in the Quarterly Grain Stocks report released on March 1. The report provided a corn stock estimate below trade expectations, and soybean acreage below those of last year, and well below market expectations. Furthermore, wheat will be a follower after this report due to a much higher than expected spring wheat planted area and a bearish stock estimate.
swissHEDGE 16
There is indeed a long term story for commodities, particularly in the agricultural space. We are the first to admit, we do not hold ourselves out as experts on the fundamentals of industrial metals. Intuitively, we know that copper is a finite resource and at the current pace of global industrialization, world copper supplies will tighten to critical levels at some point in the future. The job of the market is to find a price that effectively rations copper usage until either more copper resources are found, or technology provides a suitable substitute for some portion of its demand, or supplants its primary use all together. The key here is how fast does technology provide the relief? Will it be three years, five years, ten years, or longer? Is there a product on the horizon that can be substituted for the billions of feet of
Commodities trading | David Skudder, Global AG, LLC | David Zelinski, Opus Futures LLC
copper wire pulled in residential/industrial construction on an annual basis world-wide? We are looking at a similar situation in the grain and oilseeds markets; the current pace of economic development in Asia has generated a steady stream of above average year on year demand growth. Additionally, the ever increasing mandated inclusion of biofuels in the global energy pool has created grain demand that is, for the most part, price inelastic. Add to this the current environment of rising energy prices, forecasts of world population growth, Indian economic development, and global political instability and you have got one extraordinary and dynamic story. There is one major difference, however; unlike copper, grains and oilseeds are renewable resources and agricultural technology is moving at an incredibly fast pace. Seed technology coupled with far better herbicides, fungicides, and agronomic practices are providing shocking yield benefits that we are realizing every year. Surprisingly, these advantages are yet to be recognized by the vast acreage pool in less developed cropping areas of the world. As the price of agricultural commodities rise, this economic signal is being sent to every corner of the globe and profit-seeking companies worldwide will insure that these signals are embraced. Here again though, will technology keep pace with demand and at what pace will the less developed world be able to embrace these advances? Prices of corn, wheat, and oilseeds have risen substantially over the past six months. This price rise was warranted and necessary as two major production problems in the world created a less than adequate supply of feed grains and to a lesser extent, oilseeds. It is noteworthy that we have yet to reach the all time high price for any of these feed/food commodities reached in early 2008. However, a quick glance at world balance tables shows that while corn is definitely tighter, wheat and oilseeds are not, thus allowing for some of the world’s acreage to shift to corn in an effort to alleviate the tightness. Certainly we are living on the edge, but once again it would appear the southern hemisphere is going to rise to the occasion and provide the world with very good crops. For now, USD 350 per ton soymeal prices and ever increasing DDG supplies appear to be rationing some portion of its demand, not only in the US but in Europe as well. The price of corn has livestock companies at maximum inclusion rates on substitutes, which makes a difference but is not a lasting solution. In addition, to say those of us in the financial/speculative side of the agricultural commodity business are leaning to the long side is a major understatement. The visible length
in corn futures is astounding, and we can not forget the “invisible� off-exchange (OTC) length which we imagine is quite large as well. Having arrived at such historically high price levels, many in the financial/investment community are likely looking to take pause and reconsider the amount at risk, especially considering the volatile global environment. The world has witnessed major changes in the politi-
swissHEDGE 17
Commodities trading | David Skudder, Global AG, LLC | David Zelinski, Opus Futures LLC
cal and social environment in the Middle East and North Africa, and that situation is evolving daily. In addition, Japan was rocked by an unbelievable series of tragedies (earthquake, tsunami, nuclear contamination threat). Uncertain times mean investors look to get their money a little closer to home, and that sparked a massive wave of selling pressure in the agricultural commodity sector through the first half of March. However, a funny thing happened during the break in prices. While speculators were liquidating (selling) commodities in earnest, the worlds’ end-users were stepping up to the plate and buying what they needed. Major livestock companies hedged feed costs through the end of the fiscal year, and foreign buyers stepped up their purchases of US grains/oilseeds. Specifically, the world’s largest end-user of commodities, China, finally stepped up to purchase several cargoes of US corn. News of the Chinese corn purchase, along with private analyst forecasts for 2011 summer crop acreage, have since propelled markets back near their previous high prices. Some analysts claim the world needs to realize that the agricultural markets are looking at a “new-normal”, saying high prices are here to stay. However, it is simply human nature to ignore the inputs that do not support our bias. As mentioned before, we must remember that outside of the worlds’ “western” economies there are agricultural advances yet to be implemented that will create production and consumption efficiencies. Improved seed genetics, chemical applications and treatments, mechanization, modern irrigation, and animal genetics can be applied to a vast portion of the world. As “exciting” as these high prices may be, we must remember not to lose sight of the fact that “price” does work, rationing does take place, and production responses to price tend to surprise us by their magnitude. Look for the grain and oilseed complex to remain a very volatile affair in the weeks/months ahead. We are about to embark on what might be the most important US summer growing season in recent history. With corn stocks at very low levels, the US and world needs strong production. Seed genetics aside, we are all at the whim of Mother Nature. A Quick Note On 2011 Acreage & Production Prospects: March 31, 2011 was quite a day. The USDA issued two of the most anticipated reports in recent history, the March 1 Quarterly Stocks report as well as the 2011 Planting Intentions report. The implications of the acreage report are obvious even to the casual grain/oil-
swissHEDGE 18
seed market observer. A higher level of planted area means prospects for higher production and potential to ease the tight supply/demand situation. The USDA is estimating that the corn area is up roughly 4.5% from last year at 92.2 mn acres, which if realized would be the second highest planted acreage in the US since 1944 (only behind 2007). Soybean planted area is estimated at 76.6 mn acres, down roughly 1% from last year, but still forecasted to be the third largest on record. The industry had, for the most part, anticipated figures near these levels and this has not produced an exaggerated market reaction. However, it is important to remember the key word in the title of the report, namely “intentions”. Intentions can change, and most certainly will, based on new economic incentives down the road. The Quarterly Stocks report, however, turned out to be quite a wake-up call. The report showed much smaller than anticipated stocks for corn, essentially telling the market it has not yet done an adequate job of rationing demand. The response has been immediate and severe, with prices rallying very sharply following the report. The market’s “job”, as described above, is to find a price where consumption slows to ensure adequate stock levels and encourage improvements in production. What the March 31 report showed the market is, to this point, prices had not met that level yet. Feed demand has not slowed significantly, ethanol production continues at a steady pace, and as mentioned China is now in the market for corn imports. In the days/weeks following this report, the market has to figure out a way to slow the pace of consumption. Prices will become even more volatile into the spring planting season, when the fluctuations from one weather forecast to the next will push prices around dramatically. Supply is tight and we need a little luck from Mother Nature – will she deliver? Important to remember is that the grain and oilseed markets are continuously changing. By the time this article is in print and has been circulated, many things will have changed. It could be a change in a weather pattern in the US or elsewhere in the world, or it could be a political or social change in a major importer/exporter. We do not know what will change, only that the world is continuously evolving. New opportunities can present themselves without notice, and we must remember to always keep an open mind and remain receptive to new thoughts and ideas.
Thank you
Emerging markets and the world of tomorrow | Karthik Sankaran | Covepoint Capital Advisors LLC
Emerging Markets and the World of Tomorrow
Karthik Sankaran Managing Principal | Covepoint Capital Advisors LLC The last few years have seen an upsurge of interest in the theme of the so-called “emerging markets” (EM). For most of the past decade, sentiment towards EM has been generally bullish, but there are moments when perceived excessive euphoria leads to talk of “bubbles” and the like. This happened to some degree ahead of the first Fed rate hike in 2004, and it happened much more dramatically in the aftermath of the global financial crisis of 2008. This year, the combination of unrest in the Middle East and worries about the impact of commodity price-driven inflation have led to the underperformance of EM versus developed markets (DM) amid renewed talk of bubbles. Now,
while it is only natural for asset managers to focus on asset prices, focus must instead be on the tectonic shifts that have occurred in the world over the last decade. These epochal changes underpin the importance of EM to the global economy and global investment strategies. The single undeniable fact about EM is that they already account for a significant portion of the world economy. According to the World Bank, as of the end of 2009, all EM accounted for about 38% of global GDP as measured at current nominal exchange rates. That percentage is probably closer to 40% by now. However, when considered by Purchasing Power Parity (PPP), the share of GDP by EM is even larger. As of October 2010, the IMF put the emerging markets share of global output at 50% at PPP. (In keeping with the convention of FX markets, the newly industrialized Asian economies will be considered, including Korea, Taiwan and Singapore, to be EM countries.) There are two obvious conclusions from this. The first is
swissHEDGE 19
Emerging markets and the world of tomorrow | Karthik Sankaran | Covepoint Capital Advisors LLC
that an investment strategy that is focused solely on the developing markets makes about as much sense as an advertising strategy for toothpaste that is focused only on one sex. It might do for a niche producer, but not for anyone with a genuinely global vision. The second point is that we, as foreign exchange traders, tend to be wary of PPP as a trading tool. Nevertheless, we believe that the 10% spread between the global weight of EM as measured in PPP terms and in current dollar terms will close over time – in other words, that emerging markets currencies as a group will outperform. Strong Growth and Strong Balance Sheets However, from the point of view of investors, what matters even more than the current importance of emerging markets is the likely scale of their future outperformance. That EM can be expected to outperform in terms of their growth outlook is not surprising. Countries that have embarked on “catching up” might well be expected to grow more strongly, and this has indeed been the case. What is more striking, however, is how superior the balance sheets of emerging markets are to those of developed markets. For those who remember the tumultuous decades of the 1980s and 1990s when emerging markets were plunged periodically into crisis by fiscal or current account imbalances, this is a remarkable turnaround. While there are pockets of vulnerability, the good health of emerging markets in aggregate is very clear, particularly when compared with the poor health of the developed markets. Attached are tables that show the broad indicators of growth, fiscal and current account indicators for a broad range of countries below, but even just the aggregate numbers are striking. According to the IMF, in 2011 advanced economies are expected to grow by 2.2%, while the emerging economies are projected to grow by 6.4%. These growth differentials might not be surprising, but the scale of EM outperformance is still noteworthy. What is even more extraordinary is simply how much better EM balance sheets are, both in terms of stocks as well as flows. According to the IMF fiscal monitor published in November 2010, the gross general government debt/GDP ratio of the G7 economies will be 122.5% in 2015. Against this, the EM members of the G20 are expected to post a gross debt/GDP ratio of 32.7% in 2015. Insofar as a key component of debt sustainability is the cyclically adjusted primary balance (the gap between revenues and non-interest expenditures abstracting from shortterm developments in the business cycle), it is hardly surprising that developed markets come off as poorly as
swissHEDGE 20
World Growth Indicators Country
Growth 2011
Current Account 2011
US
2.3
– 2.6
Japan
1.5
2.3
Eurozone
1.5
0.5
Germany
2.0
5.8
France
1.6
– 1.8
Italy
1.0
– 2.7
Spain
0.7
– 4.8
UK
2.0
– 2.0
Switzerland
1.7
10.3
Australia
3.5
– 2.3
Canada
2.7
– 2.7
New Zealand
3.2
– 4.4
Argentina
4.0
1.2
Brazil
4.5
– 3.0
Chile
6.0
– 2.0
China
9.6
5.1
India
8.4
– 3.1
Indonesia
6.2
0.1
Korea
4.5
2.9
Malaysia
5.3
13.8
Mexico
3.9
– 1.4
Philippines
4.5
3.4
Poland
3.7
– 2.6
Russia
4.3
3.7
Saudi Arabia
4.5
6.2
South Africa
3.5
– 5.8
Taiwan
4.4
9.5
Thailand
4.0
2.5
Turkey
3.6
– 5.4
Advanced Economies
2.2
Emerging G20
6.4
Source: IMF World Economic Outlook, October 2010
they do. According to the IMF fiscal monitor, the underlying primary deficit of the G7 economies in 2011 will be –5.9%. For the emerging members of the G20, it will be –1.2%. The picture that emerges from these statistics is clear and disturbing. The developed world in aggregate entered into the crisis with an excess of leverage and lower growth rates than the emerging markets. Indeed, the excessive leverage might itself have been the result of a desire to shield citizens (and their consumption prospects) from the consequences of a structural decline in growth rates. To put it in financial terms, excessive leverage was a way to maintain constant return on equity at a time when the return on assets was falling. Whatever the reason, large portions of the developed world (particularly the US, the UK and the periphery of the Eurozone) face a future of continued deleveraging that will put pressure on growth and be reflected in a recov-
Emerging markets and the world of tomorrow | Karthik Sankaran | Covepoint Capital Advisors LLC
ery that is weak by historical standards. Conversely, the emerging markets in aggregate will face less pressure from deleveraging and consequently can enjoy higher growth. Higher growth in turn translates into lower countercyclical fiscal outlays as well as reduced pressure of deflation. Together, these factors imply less pressure on private and public balance sheets. For the emerging markets then, the interaction among growth and balance sheets forms a selfreinforcing virtuous circle. The implications of this virtuous circle may be gleaned from a fascinating publication issued by Standard Chartered Bank entitled “The Super Cycle Report,” according to which 68% of the world’s growth until 2030 will come from the emerging markets. According to the same report, in nominal terms, today’s emerging markets will account for about 65% of world nominal GDP by that date (up from
Fiscal and Current Account Indicators Country
Gross Gen. Gov. Debt/GDP 2015
Primary Balance 2011
Reserves (USD bn)
US
110.7
– 8.0
48
Japan
249.1
– 7.2
1030
Eurozone
90.0
– 3.5
213
Germany
75.6
– 1.5
37
France
88.3
– 4.6
37
118.8
0.4
36
Spain
82.0
– 4.7
14
UK
83.9
– 5.2
53
Switzerland
35.9
0.2
221
Australia
21.3
– 2.1
29
Canada
71.6
– 2.8
60
New Zealand
33.3
– 2.2
15
Argentina
48.9
– 0.1
47
Brazil
64.8
3.2
315
Italy
Chile
5.3
– 0.7
28
China
14.0
– 1.4
2850
India
69.6
– 4.0
273
Indonesia
22.9
– 0.1
100
Korea
23.9
3.3
298
Malaysia
59.2
– 4.0
99
Mexico
43.7
– 1.1
122
Philippines
38.8
– 0.4
54
Poland
60.9
– 3.5
86
Russia
14.6
– 2.9
458 450
Saudi Arabia
6.3
6.0
South Africa
35.1
– 1.5
Taiwan
37 391
Thailand
44.8
– 1.4
173
Turkey
38.8
0.7
83
122.5
– 5.9
32.7
– 1.2
G7 Emerging G20
Sources: IMF Fiscal Monitor, November 2010, and Fiscal Monitor Update, January 2011, Bloomberg
about 40% now). Global GDP is expected to at least double in real terms and to quintuple in nominal terms by that date. Implications for Asset Markets If this is indeed the case, what are the implications across asset classes? If nothing else, it suggests that ignoring the emerging markets as just a fashionable fad would be little short of investment folly. To reiterate, this is a universe that comprises one half of world GDP (at PPP) today and is expected to provide about two-thirds of global growth over the next two decades. Even today, the impact of the emerging markets on world asset markets is immense – this is particularly evident in the commodity markets, but it is also true of foreign exchange markets, where the emerging world’s reserve banks and sovereign wealth funds are key players. This impact can only be expected to grow. In terms of allocation decisions between developed and emerging markets, we would suggest that the higher growth and stronger balance sheet positions of EM have important consequences. The relatively strong fiscal positions of emerging markets (and the corresponding deterioration of fiscal positions in the core of the developed world) suggest that the notion of risky and risk-free assets might need to be reconsidered. Meanwhile, the combination of higher trend growth rates and a significantly lower threat of a debt-deflationary spiral is likely to result in higher equilibrium interest rates in EM. The combination of higher interest rates and reduced fiscal risk premia argue for increased participation in local currency debt markets in EM. These factors also signal a potential for currency appreciation (which would also be justified by the undervaluation of EM in aggregate on the basis of PPP). More generally, we would make the case that investors are very likely to be underallocated to fixed income assets in emerging local markets. This might be due to market restrictions or due to worries about taking on local currency risk. It might also reflect the greater liquidity of core developed world bond markets. However, it seems to us that this is an instance in which considerations of size mask deeper vulnerabilities. Liquidity is after all but a euphemism for supply. Simply put, larger and more liquid debt markets are a symptom of the greater indebtedness of the developed world. Meanwhile, a recent piece of research from the McKinsey Global Institute entitled “Farewell to Cheap Capital” points out that the rising investment needs of the emerging markets could actually lead to a significant rise in global interest rates over the next two decades as the excess of global
swissHEDGE 21
Emerging markets and the world of tomorrow | Karthik Sankaran | Covepoint Capital Advisors LLC
savings over global investment shrinks. In turn, this could exacerbate the problems of those portions of the developed world that have in the past “benefited” from abnormally low global interest rates and have channeled their command of those excess savings into unproductive assets. Differentiating within the EM Universe The case has been made above that emerging markets offer superior growth and balance sheet metrics to the developed markets. But as we pointed out, we are also speaking in aggregate. The question then becomes one of how to judge among different emerging markets. Rather than go through a list that evaluates every single country, we would rather lay out some of the criteria that we use to differentiate among different markets. At various times in the cycle, different factors might become more important in determining the attractiveness of one EM versus another, or one EM asset class versus another. One basic criterion is to differentiate between closed and open economies. During the immediate aftermath of the crisis, it became clear that the large relatively closed quasicontinental economies like India and Indonesia enjoyed better growth than the very open economies like Singapore that were very susceptible to swings in developed world demand. Another obvious criterion for differentiation is that between current account deficit and current account surplus economies. Within the group of deficit economies, one ought to pay a lot of attention to the quality of current account financing – whether it is financed by relatively sticky direct investment flows or by relatively flighty portfolio flows. Exchange rate regimes and central bank reaction functions are important in all countries, but the credibility of the central bank is an especially important variable in countries that are dependent on portfolio capital to finance current account deficits. The nature of the export mix is also a key variable in differentiating among countries. Insofar as the pattern of growth among EM is likely to be very commodity intensive (reflecting their desire to use their ample financial resources to build out more sophisticated physical infrastructure), there could be persistent upward pressure on commodity prices. This in turn translates into a positive terms of trade shock for emerging and developed commodity exporters. While the growth and currency implications for the exporters of commodities might be quite positive, the status of the commodity importers requires closer examination and interpretation. How will their central banks react to a shock from imported inflation? Are they current account surplus coun-
swissHEDGE 22
Emerging Markets and The US Country
Energy Usage per Capita
Hospital Vehicles/ Beds/1,000 1,000 population
US
7,770
3.3
China
1,433
2.4
780.0 35.7
Brazil
1,184
2.4
140.0
Indonesia
803
0.6
34.7
India
510
0.9
13.2
Sources: IMF Fiscal Monitor, November 2010, and Fiscal Monitor Update, January 2011, Bloomberg
tries that can react to such a shock by reducing reserve accumulation and accommodating currency gains to fight inflation? If not, what is the willingness to sacrifice growth to maintain credibility in the fight against inflation? After recent developments in the Middle East, considerations of political risk – which were once the paramount consideration in dealing with EM – have once again returned to center stage. This is, of course, justified. In considering political risk, we would pay attention to factors such as institutional flexibility and legitimacy as well as the interaction between these institutional factors and economic outcomes, measured in both aggregate and distributional terms. In thinking through these political issues, we
Emerging markets and the world of tomorrow | Karthik Sankaran | Covepoint Capital Advisors LLC
would argue that broad-based growth can allow governments to have degrees of policy freedom that are denied to those facing growth constraints or more straitened economic horizons. This is another dimension to keep in mind when comparing EM with today’s developed markets, where politics might actually become more intractable in response to more difficult economic circumstances. How much Room to Grow? A final question has to do with whether EM is capable of generating enough demand to make up for the potentially depressed spirits of the developed world consumer for some time to come. We do not deny the difficulty of reorienting economies towards domestic consumption (and this issue really applies primarily to China rather than to India, Indonesia or most of Latin America). But even in this case, the sheer scale of unmet needs suggests that any argument based on an absolute insufficiency of EM demand makes little sense. The research from Standard Chartered Bank points out that real per capita income in China today is roughly the same as real per capita income in the US in 1878, and real per capita income in India is one fourth that in China. More granular figures make this even clearer.
The statistics on motor vehicles (from the US department of energy) are roughly in line with the time scale suggested by the Standard Chartered research. As of 2008, the degree of motorization in Brazil was comparable to that of the US in 1923, while the degree of motorization of China and Indonesia was comparable to that of the US in 1917, and that of India to that of the US in 1913. This is an extraordinary divergence that has only just begun to close. Of course, the emerging markets have always had these enormous needs. What is different today is that they have the financial capacity to meet these needs. And as they proceed down the path of faster development, the consequences for the world economy and world politics will be truly immense. Whatever else, the EM story simply cannot be ignored. The impact of emerging markets on patterns of global growth, commodity demand, inflation, interest rates, exchange rates and risk premia is already large and only going to get larger. Thus, knowledge of emerging markets trends is not going to be the concern solely of dedicated EM investors. A genuine global macro strategy has, by definition, to incorporate a deep consideration of the impact of emerging markets on every asset class in the world.
swissHEDGE 23
Roundtable Discussion 1st Half 2011
Roundtable Discussion
swissHEDGE regularly invites reputable individuals to take part in a roundtable to discuss the topic of
the semi-annual publication. For this issue, we have invited three prominent industry professionals to share their views on the hedge fund industry – today, and going forward.
swissHEDGE: How has the opportunity set changed for your strategy and what are the implications for investing in the short and longer term? CENTAURUS: The risk arbitrage opportunity set has increasingly become more global. This trend is being fuelled from a number of sources: 1) western companies seeking geographic expansion in pursuit of emerging market growth; 2) Asian and Latin-American companies seeking to deploy cash and to diversify out of their home markets, 3) sovereigns, such as China and India, acquiring natural resources and western technology and know-how, and 4) in-market consolidation of fragmented industries and the modernization of old fashion family and corporate holding structures. We view places like Asia and Latin America similarly to Europe in 1990’s or the US decades earlier; and believe we are in the early years of a multi-decade corporate finance led revolution. In general, after a few quiet post-crisis years, we expect opportunities throughout the event-driven
swissHEDGE 24
spectrum to accelerate in 2011 and the years that follow. Key drivers for our strategy are improving macro visibility and business confidence, attractive valuations versus historic levels, opening of credit markets and the cash rich private equity and corporates starting to deploy their historically high cash balances. RWC: We have been managing funds in European equities for over ten years and previously in the private equity markets. The market is continually changing; although we have seen uncertainty from a macroeconomic/geopolitical standpoint, it has normalized since 2007–2009. We are now seeing companies returning to long-term planning, and going “back to basics” of company execution. Over the last three years, equities have been a tough place to make money, but the focus on valuation and earnings has allowed us to do so, and we believe the current environment is a good one for stock picking. WestSpring: The market opportunity is changing all the time. What one needs is a systematic way of assessing the opportunities available, and choos-
ing those with the most compelling risk/reward relationship. We have managed positive returns every year by adjusting our portfolio bias to the opportunities presented. In the short to medium term, we believe the opportunity in the dispersion of credit spreads will provide attractive risk adjusted returns. Depending on the pace of the recovery, this opportunity may only last for 6–12 months. Longer term, a continued understanding of the US economic cycle, in the context of potential global shocks, will be the key to consistent, uncorrelated returns. How do you differentiate yourself from your peer group? WestSpring: Our proprietary analytic
framework and tools provide our most significant competitive advantage. Developed over nearly ten years, these systems and processes help us find and analyze inefficiencies in the credit markets. By understanding how economic variables impact specific firms through intensive econometric studies, we have historically generated non-consensus
Roundtable Discussion 1st Half 2011
Centaurus Capital Risk Arbitrage Fund Representative: Randy Freeman/CIO
RWC Partners Ltd. Representative: Ajay Gambhir/Portfolio Manager of the RWC Samsara Fund WestSpring Advisors, LP Representative: Eric Phillipps/Principal
views on assets that are trading below their intrinsic value (or in the case of our short investments, above). This approach allows our team to focus on the market sectors where value can be extracted as efficiently as possible. This analysis alerted our team to the knockon impact of the mortgage crisis on financials and then consumer related firms in 2008 and 2009. CENTAURUS: The most important competitive advantage in risk arbitrage is experience and the relationships which created and nurtured over time. We have more than 17 years of direct event-driven investment experience and have invested in over 1,500 risk arbitrage transactions in 60 countries during this period. In general, we look for investments that are overlooked by the market, often smaller deals in more remote geographies. Having our funds sized conservatively is crucial in order to effective exploit trades in the small and mid-cap market sectors. We also have a successful history of proactive investing, having a successful trackrecord in negotiating better terms for
shareholders in announced deals and/ or instigating competitive offers. We are always searching for hidden optionality in our investments; such as competitive bidders, discrepancies in time to closure, hidden value in spin-off shares and imbedded call/put options in how some deals are structured. Overriding our investment approach, are an active trading mentality and a robust risk management process. RWC: Our differentiating factors are the strong focus on investment performance for our clients, the consistent application of our process (in particular our “value” discipline and the ability to identify/avoid “crowdedareas”) and the passion we have for markets. How have the following factors impacted your trading: volatility, liquidity, competition? RWC: Through the cycle, the market
does trade differently and one needs to be aware of how this should be managed. We generally invest in liquid stocks and we predominantly trade electronically with brokers at minimal
costs. We have taken advantage of the changing landscape to reduce trading friction. WestSpring: We manage our volatility exposure through the market risk component of our risk management framework. Generally, we see volatility as advantageous to the fund, as it typically allows for a higher number of attractive entry points into investment targets. Liquidity risk can drive trading activity. WestSpring maintains strict guidelines with respect to the liquidity tenor of all assets in the portfolio. We actively match the liquidity of our capital base with the liquidity of our assets. Although competition in this industry is always high, the reduced number of market participants has been a benefit to currently active managers, including ourselves. However, since our strategy typically leads us away from crowded trades, we feel we are generally unaffected by changes in the competitive landscape. The nearly ten years of experience and proprietary systems we have built should sustain our competitive advantage through the long-term.
swissHEDGE 25
Roundtable Discussion 1st Half 2011
CENTAURUS: Volatility only impacts
our strategy in extreme situations. After a major economic or market shock, spreads tend to widen, but since risk arbitrage is premised on trades that either break or converge back to parity, these extreme periods of spreads widening are generally short-lived. Liquidity (alongside downside protection) is a key risk management criterion for all our funds and has an important influence in how we size our positions. Each and every investment is sized based on conservative criteria in order to be able to liquidate the entire position within the liquidity constraints imposed on all of our funds. How do you manage fat tail risk?
invest thematically or in high momentum, crowded trades. WestSpring: WestSpring’s robust risk management framework is three tiered, accounting for market risk, credit risk and liquidity risk. Fat tail risk is managed through the credit risk tier, as this framework quantifies the worst case scenario of a given trade construct at inception. However, potential tail risks can change over time and a fund manager needs to be constantly vigilant for these changes. In 2008, liquidity risk was the fat tail risk, and our management of this then dominant risk, given client’s growing need for liquidity, allowed our team to manage through this difficult period with exemplary performance while meeting all liquidity needs of our investors, with no exceptions.
CENTAURUS: In dislocated and vola-
tile markets, we seek tactical hedges around our risk arbitrage positions as well as cost-effective overlay portfolio hedges. By selecting strong conviction hedges different to those in classic allstock merger arbitrage situations (where only the acquirer is shorted), we attempt to maximize profitability while protecting downside. In general, cash deals remain unhedged at the position level, although at portfolio level, hedges may be applied. Share deals generally are fully hedged using the acquirers’ equity, although competitors’ equity or other instruments may be applied. Other corporate actions are hedged at the position level. Positions and hedges are traded actively. In addition to this, the portfolio are regularly stress tested to estimate portfolio downsides in various market scenarios. RWC: We manage fat tail risk by simply having a well diversified portfolio of directly held companies on both the long and the short side. We minimize counterparty exposure and do not
swissHEDGE 26
Are you concerned with inflation and to what extent is it incorporated into your strategy through individual trades or hedging? WestSpring: Inflation is a risk that
needs to be monitored and managed like any other. We position our portfolio to take advantage of the effect of future inflation expectations on market instruments. In general though, WestSpring’s strategy is fairly insulated from the effects of inflation, due to our use of CDS and hedging. CENTAURUS: Event-driven investing and in particular risk arbitrage, is one of the most market neutral hedge fund strategies and hence remains generally de-correlated with macro events. The exception being in short periods around large volatility events, such as the recent situation in Japan or Lehman in 2008, where risk arbitrage spreads tend to widen, but have historically normalized in the short-term. In fact, major market disruptions can create interesting opportunities for us to grow positions in safe risk arbitrage invest-
ments where the spread has temporarily widened as risk capital is being taken off the table. In general, risk arbitrage investments are not materially effected by inflation, but we are always mindful about the overall macro picture. RWC: Most definitely, inflation is on our radar as a variable creating investment opportunity. If one can manage to stay objective, there are a multitude of opportunities developing on the short side for those companies that are experiencing input cost inflation and minimal price control to the end consumer. We have to be realistic, we are at the beginning of the rate tightening cycle and we factor into our analysis how sensitive our companies will be to this environment. There seems to be a polarisation of opinion on whether inflation is entrenched or short term. Our view is that inflation will stay at a higher level than “generally accepted” this year which could lead to a further correction in the equity and bond markets. What are your capacity constraints? At what level would that be reached? RWC: The greatest myth of capacity is
that it is predictable. We manage our funds to perform but equally to be scaled within reason. We will close the strategy if there were signals that in extremis it may become impeded, and we were able to demonstrate the efficacy of this discipline by returning all capital upon request during the credit crisis. We did this without gating, sidepocketing or seeing a market/performance impact. WestSpring: We believe our capacity is in excess of USD1bn. Our proprietary analytics and trading can be continually optimized to fit the level of capital available to the fund at any discreet time.
Roundtable Discussion 1st Half 2011
CENTAURUS: The M&A market is a
multi-trillion dollar market, to put this in perspective, even during the postcrisis years of 2009 and 2010, global M&A levels exceeded USD2tn in each year. We have purposely chosen to conservatively cap the size of our funds in order to allow our portfolio to remain flexible enough to investment in all deal sizes and in most countries.
Our funds are very active in the emerging markets where many of the deals havemarket caps below EUR500mn. Do you think about who is on the other side of your trades and how the opportunity set may decrease as a result of fewer market participants? CENTAURUS: Fewer market partici-
pants improves our opportunity set and the risk/reward profiles of our trades. As a result of the credit crisis, many small and mid-sized eventdriven funds were either forced or chose to close their businesses; and the number of new entrants to the market was significantly reduced. There has been a major dislocation with our other main competitor, bank proprietary
swissHEDGE 27
Roundtable Discussion 1st Half 2011
desks, many of which ceased operations or significantly curtailed the quantum of capital they invest. These factors have left a less crowded eventdriven investment space, especially in Europe and Asia, where many of the event-driven funds have been closed or are currently restructuring and many of the large US-based multi-strategy hedge funds have either closed their satellite offices, and retrenched back to the US, or have severely reduced their staffing levels. These factors have provided us with better opportunity set, as there is less capital and investors competing for investments, resulting in wider arbitrage spreads. We always think about who is in the same trade as us. We try to avoid crowded trades and always dynamically size our downside risk on individual positions taking into account many factors, including a “crowdedness” factor. RWC: It is a key part of our strategy to avoid areas that have become expensive
swissHEDGE 28
or “crowded”. This reflects our belief that we don’t blindly follow price momentum into heavily bought areas that will eventually suffer from significant downside should they disappoint. Many hundreds of billions of USD chasing simple value/momentum factor models have been withdrawn from the markets over the last couple of years which may explain why value strategies have not performed so well in recent years. Stylistically, our approach is to understand real intrinsic value and how earnings are behaving to find opportunities. From this perspective, less money chasing simply cheap P/E’s allows greater upside and more rewards for really good companies found through thorough (rather than blunt) assessment of a company’s valuation and earnings. WestSpring: Fewer market participants should increase the available investment opportunities for those market participants that remain. We
see consolidation in the investment space as a net positive for our investors. What is your biggest challenge today? WestSpring: Our biggest challenge has always been determining the optimal way to allocate capital among the many attractive investment opportunities we see in the market. Over time, we believe we have developed a systematic way of monetizing gains on existing positions and rotating into new investments that provide the best riskadjusted upside for our investors. CENTAURUS: Exploiting investment opportunities that have interesting risk return rewards and avoiding deal breaks is our main focus. Over the years, we have been good at picking winners and most importantly avoiding deal breaks (which fortunately have historically comprised a very low percentage of investments). Our conservative sizing of positions (dependent
Roundtable Discussion 1st Half 2011
on downside and liquidity of the position) has allowed us to never lose more than 3% of the equity in any of our funds in any single investment in our 17 years of experience. RWC: Maintaining the culture of our company as it grows, which I think we are succeeding in doing. How has increased government regulation (or potential regulation) impacted your strategy? How do you think it will impact your strategy going forward? RWC: Although, we have to be aware of
regulatory change in relation to issues such as short selling, our strategy has not been affected directly. Of more interest to us is how regulation affects the companies within which we invest, such as the banks. At the point where there is regulatory uncertainty we are circumspect as the outcome is binary and unpredictable. As legislation develops, we are able to more effectively understand the impact on earnings and how this may provide investment opportunities. We tend to avoid risk to our clients’ capital on outcomes that are not predictable. Broadly, we see government intervention on UK banks and to some extent Swiss banks, making them less commercial and less focused on shareholder value. WestSpring: In short, we do not expect the increased government regulation to impact WestSpring’s strategy materially. We foresee some potentially positive forces resulting from increased regulation pressuring proprietary trading efforts out of the large banks and creating a more level playing field. We also see potential regulation related to credit default swaps (i.e. central clearing, higher transparency) as a positive dynamic, as it should decrease bid-ask spreads and counterparty risk.
CENTAURUS: We have seen a clear
acceleration in politically motivated government interference in recent years – as political risk has probably become the key impediment to M&A deals since the credit crisis. At times, it seems difficult to disentangle political from regulatory issues, however, after studying carefully the deals that have broken or ran in trouble recently, it appears underlying political agendas were to blame rather than regulatory/ economically-led logic. Subsequent to the credit crisis, the world has been plagued by fragile coalition governments, electoral uncertainty and populist fervor which have conspired to increase nationalist sentiments and xenophobia. Trying to take of positive view of recent political trends, uncertainty tends to shake out complacency and brings with it complexity, which widens arbitrage spreads (albeit with increased volatility). One area where we have periodically seen invention is with regards to short selling. We have seen during various recent crisis periods a variety of temporary bans on short selling, these bans have run the gamut from complete bans on all stocks in a particular jurisdiction to specific industries and even individual names. These temporary bans are disruptive to the efficient operation of the market, however, in the very unlikely event of an absolute ban on shorting coming into place, we would not (as most other hedge funds) be able to run our strategy. Do you provide greater transpar-
100% of the portfolio in a very detailed manner; including all positions, all hedges, and all exposures. We want investors to understand exactly what we do and what they own. We want to give our funds the “look and feel” of managed accounts by providing greater transparency and liquidity RWC: Within reason we are happy for our investors to have any information that ensures they can validate where we make our money from. We have seen an increased need for investors to source this data from our third-party prime brokers and administrators which has been the major change for us. We only use tier one third parties and are very comfortable with our clients interacting with them directly. The move to managed accounts has not been as great as the managed account providers would have you believe. There are potentially huge distractions for both investors and portfolio managers within the set-up and management of additional accounts. We do run a small number of managed accounts, but we would never take on additional managed accounts to increase assets under management at the expense of strong corporate governance or the ability to maintain the performance focus. WestSpring: WestSpring has always strived to provide the most transparency possible to our investors, without negatively impacting the portfolio. It is our philosophy that our best partners are investors who fully understand and are confident in our strategy, and why it has been successful for so many years.
ency to your clients than in the past? Have you considered managed accounts as a path to higher transparency? CENTAURUS: Yes, we do. Prior to
2008, we disclosed our top 20 holdings on a monthly basis. Today, we disclose
swissHEDGE 29
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