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Advent Software’s Brian Stableford: Industry Insider Focusing on commodities hedge funds HAMLIN LOVELL


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he Hedge Fund Journal contributing editor Hamlin Lovell talked to Advent Software Solutions Consultant, Brian Stableford, who provided grassroots insights based on his daily on-the- ground interactions with participants in the industry. Stableford’s prior career incarnations


have included commodities trading, so he is well positioned to opine on the challenges facing a beleaguered hedge fund strategy that has lately suffered a number of conspicuous closures of names that were once to be conjured with. Stableford helps hedge funds to find solutions for their front, middle and back offices and he keeps a close eye on regulatory developments.


A tough backdrop – but with pockets of opportunity Advent’s Brian Stableford has seen commodity funds hit by “leverage in the face of redeeming flows from the manic crowd rotating to safe-haven investments with yields as QE III comes to an end.”


Late last year Barclays identified $36 billion of net outflows from commodities funds and said it estimated assets under management in the space were down by $88 billion. Stableford finds that “the knock-on effect of outflows is poor performance, and worst case closure if the client base is not diversified.” He thinks commodity funds are particularly vulnerable to redemptions because


Table 1 Contract types Legacy


Agricultural Contracts


Source: Advent


CBOT Corn (C) CBOT Oats (O) CBOT Soybeans (S) CBOT Soybean Meal (SM) CBOT Soybean Oil (BO) CBOT Wheat (W) ICE Futures US Cotton No. 2 (CT) KCBT Hard Winter Wheat (KW) MGEX Hard Red Spring Wheat (MWE)


Non-Legacy Agricultural Contracts


CME Class III Milk (DA) CME Feeder Cattle (FC) CME Lean Hog (LH) CME Live Cattle (LC) CBOT Rough Rice (RR) ICE Futures US Cocoa (CC) ICE Futures US Coffee C (KC) ICE Futures US FCOJ-A (OJ) ICE Futures US Sugar No. 11 (SB) ICE Futures US Sugar No. 16 (SF)


Energy Contracts


NYMEX Henry Hub Natural Gas (NG) NYMEX Light Sweet Crude Oil (CL) NYMEX RBOB Gasoline (RB) NYMEX NY Harbor ULSD (HO)


Metal Contracts


COMEX Copper (HG) COMEX Gold (GC) COMEX Silver (SI) NYMEX Palladium (PA) NYMEX Platinum (PL)


“selling positions you do not want to hurts overall performance.” In particular he points out that as commodity contracts can be thinly traded, “forced sellers are catching a falling knife.”


The headline closures in recent years of Chris Levett’s Clive, Jennifer Fan’s Arbalet, John Arnold’s Centaurus, Fortress’s commodity fund, Neil Shear and Jean Bourlot’s Higgs Capital and Pierre Andurand’s (albeit reincarnated) Bluegold are, Stableford surmises, “mainly due to a static investment process crippled by redemptions as Quantitative Easing approaches its perceived expiration which underpins any dollar-priced asset.” In contrast, he says that the “successful commodity hedge funds in our present environment are smaller, nimble, disciplined traders focused on relative value trades rather than trending markets.”


Some such relative value commodity strategies have been more resilient, Stableford has found – particularly when they are using little or no leverage. Typically these funds are doing spread trades, which might be intra-market trades such as Brent Crude Oil versus West Texas Oil, and which could include “crack spreads” like heating oil against crude oil, inter-market substitution plays such as copper vis- à-vis aluminium, or calendar spreads expecting the term structure to steepen or flatten.


Stableford also suggests that investors need to drill deeper to identify the differences between commodity funds. For instance, hard commodities can behave very differently from soft commodities – and even within the soft commodities space, individual products can follow their own path. The two best performing commodities of 2014, when we spoke in late February, were natural gas and coffee. Both price rises were weather-related but had very different drivers: cold weather for natural gas and droughts for coffee. Stableford thinks “a thorough understanding of the investment process of funds is essential,” and also argues that “allocations should be appropriate for the aggregate portfolio.”


Shifting commodity market dynamics There is a long-running debate over whether commodities are an asset class. Stableford argues,


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“Broadly speaking, commodity futures were never intended to be an asset class. They exist to facilitate commercial hedging by producers and consumers, and speculators grease the wheels by providing liquidity.” He states, “The presence of large investors such as pension fund giants (CalPERS or APG), not to mention some of the big hedge funds (Paulson & Co), can distort thin commodity futures markets, disrupting the commercial hedging practices.”


Stableford also thinks these markets can become prone to manipulation via “front running, and people working in cahoots.” The links between speculation and commodity prices are the subject of academic controversy. Speculative activity can, Stableford reckons, “also aggravate commodity price inflation as we saw in 2008 and to a lesser extent in the shortages to triggering global recessions in response to oil price shocks.” Then, wider macroeconomic repercussions are felt as central banks will often respond to a speculative surge in commodity prices by raising interest rates, slowing GDP growth in the process.


The origins of this vicious circle date back to around 2007, Stableford thinks, “when investment banks and other financial institutions started mainly promoting tracker funds, which were mostly long only. Flows inevitably pushed prices of raw materials considerably higher, creating commodity price inflation, which reached a peak in July 2008. The process was repeated following the credit crisis crash, leading to another expensive bubble peak in 2011, which had little to do with a surge in consumer demand but a lot to do with long-side commodity speculation.”


Stableford explains: “With the advent of tracker funds in commodities, institutional participation in this sector has mushroomed from near zero to hundreds of billions of dollars. This largely one-way flow has inevitably boosted prices for a number of resources, not least crude oil. In the meantime, it is unintentionally compounding economic problems, not least in terms of commodity inflation.”


However, he suggests that this investment approach became a victim of its own success – by steepening the term structure. “The short- sighted investment institutions which purchased commodity futures tracker funds did not do very well because every three months they were hit by contango and transaction costs when their expiring futures positions were rolled forward,” he observes.


Now it seems the pendulum may be swinging back away from passive investment, as Stableford notes: “Fortunately, that fashion faded and the unwinding of tracker fund positions and ETFs in


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