Commodity Hedge Funds Escape Full Force Of Credit Crisis

Date: Tuesday, October 7, 2008
Author: Gregory Meyer, Dow Jones Newswires

Market upheaval hasn't spared hedge fund managers specializing in commodities, though unique circumstances have so far armored them against some of the harshest effects of the credit crisis.

Managers of commodity-oriented funds say investors are clamoring to cash out profits from their funds to cover losses elsewhere. Their flight may aggravate the steep drop in oil, agriculture and other commodity prices of recent months.

An index tracking a category of hedge funds known as commodity trading advisors was up 0.5% in September, according to preliminary estimates from Barclay Hedge Ltd. The fund tracker's index of broader hedge fund performance was down 4.9% in the same period. So far this year, CTAs are up 7.6% while the broader index is down 10%.

Poor performance this year has bruised many hedge funds, lightly regulated pools of capital with wide latitude in making investment decisions. Many borrow heavily to juice returns, a strategy that has hit the rocks as credit markets seized up.

Fund investors struggling to cover losses elsewhere have dipped into their commodity profits to raise money, fund managers say. With stock and credit markets reeling, some investors are staying out of commodities for now. The Standard & Poor's GSCI, an index tracking 24 commodity futures, is down 5.3% so far this year.

The Dow Jones Industrial Average, in comparison, is about 26% lower year-to-date and broke below the psychologically significant 10,000 level Monday, the first time it's been below that level since October 2004.

"We're the first place of resort when people need liquidity," said Georgia Nakou, head of business development at Altis Partners, a $1 billion commodity-focused hedge fund in the Channel Islands that's up 15% this year. "If people lose money in their other funds, they might come to redeem here to get their hands on cash."

Scaling Back

Most funds claim a unique trading strategy, and many commodity trading advisors trade as much in financial contracts - foreign exchange futures, for example - as in contracts for delivery of crude oil or live cattle. Some take positions on the volatility of commodity prices, not their direction, or use commodity bets to offset positions elsewhere.

Still, there's evidence the funds are reducing commodity holdings amid widespread risk aversion and a souring outlook for global consumption of raw materials. The number of open contracts for crude oil futures, the world's most actively traded commodity, last week fell to its lowest level since July 2006 on the New York Mercantile Exchange, a unit of CME Group Inc. (CME).

"It has very little to do with the fundamentals, and everything to do with the credit situation - forced selling, margin calls, deleveraging and everything else tied to credit problems," said John Hummel, president of Wilton, Conn., hedge fund firm AIS Group, whose funds include a $400 million portfolio that invests in equity, fixed income and currency markets as well as commodities.

Dighton Capital USA, a California hedge fund with about $300 million in assets, was up 48% year-to-date through September, said Chief Investment Officer Alex Moisseev. But investors still redeemed 2% of the fund's assets last month.

"That's huge for us," said Moisseev, who said his fund last month bought Nymex crude below $95 a barrel and then sold it at $100 for an easy gain. "Looks like some investors were liquidating whatever they could, especially if it was on the profitable side."

Hedge funds are famous for deploying borrowed money to amplify returns, a strategy that's difficult to maintain with credit in paralysis. Commodity futures are naturally leveraged, as traders need only put up a small percentage, known as the "margin," of the cost of the position to begin trading it. The margin on Nymex crude is about $10,000, for example - less than 15% of the cost of a 1,000-barrel contract. Light, sweet crude for November delivery was recently down $5.55 at $88.33 a barrel, down more than $55 from its peak in July.

To the extent they've got sufficient cushion to cover margin calls, or demands for more collateral, commodity funds may not fall victim to the same kinds of credit pressures affecting other hedge funds as they don't have to take out bank loans to pay beyond what margin rules require. To buy and trade shares in equity markets, investors put up some of the money themselves and borrow the rest from banks.

"(Commodity trading advisors) use leverage, but they do not have to borrow the money, they don't have to pay interest on the money, and they're not dependent on lines of credit," said Sol Waksman, president of Barclay Hedge.

Still, with markets volatile, the prospect of margin calls is forcing some to pull back. Hummel said he has gradually cut back trading positions to keep leverage consistent, a situation he will reverse if credit loosens up again.

Betting On A Comeback

Some high-profile commodity hedge funds have run into trouble this year. A month ago, Ospraie Management LP decided to close its biggest fund after taking short positions on commodities futures and long ones on resource equities, a move that backfired when stock prices tanked and commodity prices didn't fall far enough. A commodity-focused fund run by oilman T. Boone Pickens was down 84% through August.

Easing supply and demand strains for physical markets have also driven prices lower. Morgan Stanley commodity research head Hussein Allidina noted that every commodity in the GSCI besides gold posted negative total returns last month, amid poor U.S. and European economic data. In oil, demand in the U.S. is down more than a million barrels a day from last year, and a recession in the U.S. could calm raging demand growth in Asia.

Still, commodities remain a more tangible bet than exotic credit instruments whose markets have frozen up, getting large swaths of the global financial system into trouble. It's precisely because commodities bets have largely been profitable that they've suffered at the hands of investors scrambling for cash.

With investors still groping to assess a value to once popular asset classes such as mortgage-backed securities, many managers still see value in trading raw materials.

"I just think we're in the middle of a huge secular bull market in commodities, and this is an interruption," said Hummel, adding that his multi-asset portfolio returns are essentially flat this year after surrendering earlier profits. "Once the credit chaos is out of the way, I think people will be surprised at how quickly commodity prices come back."

-By Gregory Meyer, Dow Jones Newswires; 201-938-4377; greg.meyer@dowjones.com