A Way to Look at Commodities—And It Is Not Quantitative
Several new specialist managers are making sector, relative value, and fundamentals-based trades to take advantage of current market dynamics.
Reported by Bailey McCann
Commodities prices have been on the rise in recent weeks. Cocoa, oil, and metals have all seen significant price volatility as world markets react to extreme weather and ongoing geopolitical concerns.
As a result, commodities funds are building on the positive momentum they have had over the past few years. The HFRI Macro: Systematic Diversified Index, which tracks quantitative commodities funds, rose 9.4% in the first quarter. The HFRI Trend Following Index also saw gains of 8.1% over the same period.
That momentum is drawing interest from investors. Systematic Diversified CTA strategies, one style of commodities trading, saw inflows of approximately $28.1 billion in the first quarter according to data from HFR.
There is also a growing crop of specialist commodities managers that have launched funds that are not strictly quantitative. These funds make sector, relative value, and fundamentals-based trades to take advantage of the current environment. Sources say that macro trends, including climate change and ongoing geopolitical concerns, are having a significant impact on commodities markets. Those impacts are likely to persist which could lead to a robust opportunity set for commodities funds.
Rethinking Commodities
Nishant Gupta, founder and CIO at Kanou Capital, an industrials fund focused on the energy transition, says that commodities funds have gone through several phases over the past handful of years, resulting in structural changes to how investors think about these funds and what is available to investors that want commodities exposure. Gupta recently formed Kanou Capital after a stint at Lansdowne Partners where he was focused on the energy transition. He notes that many commodities funds closed during the mid-2010s when commodities as a whole struggled to perform. That took a lot of specialist managers out of the sector and concentrated much of the activity into quantitative strategies. Now things are changing again.
“Prior to 2019, there was very little happening with the energy transition,” Gupta explains. “There was growth in solar and a bit in wind but nothing at the scale that we need to power the transition. Then from 2019-2021 we went into a very ESG phase where clean energy became the focus and there was a bubble around the clean names. Now we’re in a new period where there is a backlash against ESG. Other factors like where interest rates are, post-Covid inflation, and the Ukraine war have negatively impacted clean names and fossil fuels and other dirty stocks have done better.”
As a result of these dynamics, Gupta says, many investors are rethinking their exposures and looking for investment strategies that are going to be responsive to competing market demands.
“Institutional investors are taking a more nuanced view of the transition overall,” he says. “For example, there’s a realization in some countries, like Germany, they might have to use dirtier fuels for a temporary period so they can transition away from Russian dependence. So, companies that deal in those fuels are probably going to do well for a bit longer. But investors don’t want to miss out on the clean transition just because clean names are underperforming right now. That’s leading to a demand for strategies that are going to balance both realities because at the end of the day their focus is long-term capital appreciation.”
Gupta says there are a number of competing policy objectives at play, which is why he looks across sectors including industrials, utilities, metals and mining, in addition to energy, as part of his strategy. “The cycle is different because what we are observing is a lack of supply-side response, primarily due to decarbonization efforts. Consequently, it will likely take longer to transition away from fossil fuels than most anticipate, and the costs will be higher because these trends are highly inflationary,” he says, adding that in this context sectors like industrials, which provide essential tools and services, can be helpful diversifiers. Decarbonization and electrification will all require support from companies in the industrials, utilities, metals and mining sectors.
This holistic approach was recently outlined in a letter from five Dutch pension funds to lawmakers in the Netherlands calling for increased public-private investment in the energy transition.
“We want to join forces with the government and offer our joint (financing) strength and expertise to make an important contribution to the energy transition in the Netherlands,” a translation of the letter stated. “To really give energy to the transition, cooperation between pension funds, municipalities, network companies and other government agencies, under the strict direction of a national investment institution, is necessary.”
Supply-Side Concerns Grow
Supply-side issues are not only impacting the energy transition, they are also impacting the metals and mining markets. This month, the London Metal Exchange alongside the Chicago Mercantile Exchange announced new sanctions on metals arriving from Russia. The rules prohibit the import of Russian-origin aluminum, copper, and nickel into the United States and the use of Russian metals on global metal exchanges and over-the-counter derivatives markets.The announcements led to price volatility in the immediate aftermath and over the following weeks traders including Trafigura and Glencore reportedly figured out a potentially lucrative workaround involving the supply of metals in the LME’s warehouses. That led to an announcement from the London Metal Exchange on April 23, saying it would impose new rules on how metals are moved through its warehousing network to limit traders’ arbitrage opportunities. The London Metal Exchange acts as a global benchmark for a number of metals products.
Gerardo Tarricone, founder and managing director at commodities firm Arion Investment Management, was not philosophical about the new rules. He noted that markets saw delivery of Russian metals at the start of the year and there were dislocations in price as a result of the increase in supply from a sanctioned country. But he adds that even with the sanctions, those metals are likely to end up somewhere.
“The recent sanctions mean uncertainty, which brings volatility in flat price, calendar spreads and arbitrage relationships between different locations and exchanges. This creates opportunities for players that can trade relative value and arbitrages.” he says. “We anticipate volatility is here to stay.”
Tarricone adds that as the need for metals grows, geopolitical concerns are likely to have a bigger impact. “Governments are having to take a closer look at markets for these critical metals and where they originate. That might mean things like repatriation of assets, as they can only rely on supply on aligned governments, and potentially even opening new mines, which can take years to action. There are going to be a lot of opportunities as this all works itself out,” he says.
For investors looking for funds to take advantage of this and other opportunities, they may be surprised by how short the list of options is, Tarricone says. “We’re seeing more fund launches. I think there is a recognition on the manager side that there is a longer-term opportunity here. And we’re seeing it with investors as well, they want to customize their exposures based on where they see the opportunities now.”
Adam Davis, founder and CIO at Farrer Capital Management, agrees. Farrer launched at the beginning of this year, following Davis’ departure from Merricks Capital where he was previously head of commodities. Farrer focuses on agricultural markets.
Davis says he’s seeing interest from investors who want specific exposure to agriculture apart from what they might get in a more traditional multi-strategy fund. “Over-the-counter markets have expanded so much in over the past five to ten years, managers have a lot more options for customizing trading strategies,” Davis says.
Davis explains that like seemingly everything else, agriculture is going through a transition as the environment responds to climate change. That can result in surpluses in new markets and scarcities in others. “We think the hedge fund model is well placed here because hedge funds tend to be long cash and can apply capital where it is scarce taking advantage of dislocations and wait for the appropriate time to cash out,” he says. Right now, those opportunities are not very crowded because there are few funds focused specifically on agriculture.
“It’s a very good time to be in these markets,” Davis says. “We’re seeing trading opportunities from a fundamentals perspective and from a relative value perspective—so that’s very encouraging. It feels a little like the heyday of 2007-2009 when relative value and arbitrage worked really well.”