NEW YORK -- A new commodities-based hedge fund attempts to capture upside returns while providing downside protection against the wild swings typically associated with the asset class.
Officials at Nikko Securities Co. International Inc., New York, hope to raise $750 million from institutional investors for their Absolute Return Commodity Hedge Fund, which combines a two-part bond portfolio with a call-option strategy.
Some think the time is right to invest in commodities. Since their low in July, commodity prices had surged 11.4% through Dec. 22, largely on the back of rising metals and oil prices.
Richard Seamans, managing director of Seamans Capital Management, a Concord, Mass.-based bond manager, said commodities have reached a 60-year low in real terms.
"My view on commodities is we are at an important juncture," he said. "The last low was reached on July 13, 1999; the last time we were there was Aug. 16, 1939."
Over the past 210 years, stocks have bested commodities roughly 200-fold, he said. "However, every 60 years, sometimes every 30 years, you get a significant retracement," he said. In those periods, commodities beat stocks by four- to seven-fold.
For institutional investors, the problem with commodities is the extreme volatility of returns. Every decade, a five- or 10-sigma event -- such as the 1990 Gulf War or a drought -- affects commodity prices, said Mr. Seamans. Statistically, such events should occur only every 100 to 1,000 years on a normal statistical distribution.
When such dramatic events occur, there's a "doubled-barreled effect" on the value of the option, said Louis Margolis, general partner at Pine Street Associates LP, New York. Both the assets underlying the option go up and the implied volatility of the options dramatically expands, increasing their value, he explained.
It's cheaper to purchase call options during periods of stability, because they reflect near-term volatility and not unanticipated events, said Mr. Margolis, who is considering investing in the Nikko product on behalf of Pine Street clients.
By investing in both commodities and bonds, which are inversely correlated, the ARC fund is designed to get upside returns from the commodities basket while generating positive returns from bonds when commodities perform poorly.
Said Mark Kenyon, president and chief executive officer of Union Bancaire Prive Asset Management LLC, New York: "I haven't seen anything like this," noting the fund is uncorrelated to traditional investment markets. The fund-of-funds manager intends to be "a significant investor" in the Nikko fund.
Basically, the fund builds on the technology used in Call Option Linked Trust, a commodity-linked strategy that Andrew Weisman, now chief investment officer at Nikko, developed for Cargill Financial Services, Minneapolis. The strategy uses a zero-coupon bond combined with an optimized commodity call-option basket.
Nikko officials have taken the technology and "created a hedge fund version of that for institutional investors who want to smooth out or improve risk/return characteristics," said Mr. Weisman.
The ARC fund offers far more flexibility than the COLT, in which the investor is locked in to the zero-coupon bond when the bond market tanks.
With the new fund, Nikko officials can lengthen or shorten the duration of the bond portfolio depending on market conditions.
"We have made a distinct effort to focus on being long on the item which is going up the most," said Enrico de Alessandrini, president of Stonebrook Advisors, New York, which is marketing the fund.
The ARC's bond portfolio is split in two: 50% of the fund is invested in U.S. 10-year exchange-traded interest-rate futures; and 43% is in a long/short bond component that invests in developed market exchanged-traded futures based on long-term and short-term trend-following system. The remaining 7% is invested in a long call options basket executed through Cargill.
The commodity calls are invested in a basket of 17 commodities drawn from four groups: energies; metals; and agriculture, which is split between grains and non-grains.
When interest rates are on a long-term secular rise, the U.S. bond component goes from long to cash, de-leveraging the fund and letting commodities dominate the returns.
The strategy also addresses a key concern many institutional investors have with hedge funds.
Typical arbitrage strategies are oriented toward short-term volatility, Mr. Weisman explained.
In effect, these strategies assume global trends haven't changed, he said. These funds typically rely on a strategy based on buying a cheap security and selling an expensive one, based on the assumption that prices will revert to the mean.
That works fine when market volatility decreases, but not when dramatic changes are occurring in the market. "When a massive flight to quality occurs, that all breaks down at once," Mr. Weisman said.
Nikko officials attempt to avoid this problem in two ways. First, they use a volatility hedge program developed by a sister company of Stonebrook that has been successfully used as a stand-alone product. Second, research into the risk of extreme events is used to limit the bond portfolio's exposure when losses reach 6% of assets.