Commodities-focused hedge funds are proving irresistible to institutional investors — especially public-pension plans — hungry for an inflation hedge, investment gains and downside protection.
Rather than risk the volatility of a long-only strategy that tracks a commodities index or uses an enhanced indexed approach, industry experts said that institutions increasingly are opting for the long/short protection that hedge funds and hedge funds of funds can offer.
Among the pension funds that recently have invested in dedicated commodities single-strategy hedge funds or hedge funds of funds:
• The New Jersey Division of Investment, which committed $200 million to Rock Creek Group-RC Woodley Park Fund, a dedicated commodities hedge fund of funds managed by The Rock Creek Group LP. The division manages investments for the $72.9 billion state pension system.
• The Colorado Fire and Police Pension Association, which invested $100 million of its $3.3 billion in assets in a dedicated commodities hedge fund of funds managed by K2 Advisors LLC.
• The Arizona Public Safety Personnel Retirement System, which committed $25 million to the LD Commodities Alpha Master Fund Ltd., managed by Louis Dreyfus Investment Group. This year, trustees of the $7 billion fund committed up to $40 million to another commodities-related hedge fund, the Red Kite Fund, managed by RK Capital Management LLP.
• The $300 million Fairfield (Conn.) Joint Retirement Investment Board, which gained its first commodities exposure through a direct investment of $9 million into Brevan Howard Asset Management LLP's Commodities Strategies Master Fund Ltd.
“Hedge funds as a group offer better risk management on the downside and uncorrelated returns, and commodities hedge funds add an interesting dimension to the current debate — which is not over — about the extent to which a rise in inflation is likely,” said Goran Hagegard, principal of Greenwich Associates LLC, which provides consulting services to money managers.
“If you believe that a rise [in inflation] is likely, commodities would be of interest as an inflation hedge. Commodities hedge funds combine some of the aspects of real asset strategies and risk control, and that is attractive to institutional investors,” Mr. Hagegard said.
“Hedge funds historically have done a good job of hedging risk, meeting the demand for equity-like returns with fixed-income-like risk.”
VOLATILITY SCARES SOME
Although rising inflation would further inflate the price of commodities, benefiting investors with long-only exposure, “the wide gyrations in the volatility of the asset class are too much for many investors,” said Stephen L. Nesbitt, chief executive of alternatives consultant Cliffwater LLC.
“Using a hedge fund for commodities investment is a little like having your cake and eating it, too. The fund should be able to produce alpha and control volatility through a long/short strategy,” Mr. Nesbitt said.
History supports his opinion. For the five-year period ended April 30, commodities hedge funds produced more-modest returns than the major investible commodities indexes but experienced much lower downside volatility.
The HFRX Commodity Index returned 4.85% for the five-year period with semivariance (estimate of the average loss that can occur) of 0.29%. By comparison, the Dow Jones-UBS Commodity Index Total Return returned 1.92% with semivariance of 5.92%, and the S&P GSCI Total Return Index returned -3.69% with semivariance of 11.03%.
All returns are annualized.
Commodities have an added advantage for many investors because they are “another play on emerging markets. Consciously or unconsciously, everyone who is considering commodities is thinking about the emerging-markets aspects of the asset class,” said Kweku Obed, a principal at Mercer Investment Consulting Inc.
The infrastructure changes and growth of emerging markets are expected to be very strong over the next 30 to 40 years, said Afsaneh Beschloss, chief executive and president of Rock Creek Group. That long time horizon “matches very closely to that of many institutional investors.”
Rock Creek Group managed $7.3 billion as of April 30 in customized and commingled hedge funds of funds, including dedicated commodities, natural resources, global macro and emerging-markets strategies.ADDED DIVERSIFICATION
For Colorado Fire and Police, the K2 specialty-commodities hedge fund of funds adds diversification as the third and final component of the fund's absolute-return or hedge fund program, said chief investment officer J. Scott Simon.
This year, the system also gave $100 million each to hedge-fund-of-funds managers GAM Fund Management Ltd. and Aetos Capital LLC to manage in global macro and long/short equity strategies, respectively.
“The commodities fund of funds will help balance the other two absolute-return approaches,” Mr. Simon said.
There is no good gauge of the size of institutional investment in commodities overall or how much is invested through hedge fund and long-only strategies, industry observers said. But they agree that the pace of investment is quickening.
Greenwich Associates' annual survey of the 1,000 largest U.S. defined-benefit plans saw a 3-percentage-point gain in the proportion of executives saying that they invest in commodities, to 15% as of June 30, 2010, up from 12% two years earlier, Mr. Hagegard said.
“The public plans have been most active in stepping up their commodities investing, as they are reaching for returns to meet their obligations, since taxpayers are not inclined to further fund public pensions,” he said, noting that corporate-plan executives, on the other hand, are “de-risking” their DB plans as part of asset liability matching.
“Institutional interest is very strong. People we've been talking to for three years suddenly want to invest,” said Michael S. Reeves, managing director at commodity specialist Vermillion Asset Management LLC.
About 70% of the $2.2 billion Vermillion manages is from institutional investors. Half the firm's assets are managed in an alpha-generating hedge fund strategy, Viridian Fund, while the rest is managed in its long-biased beta strategy, Celadon Commodities Fund.
Mr. Reeves said that when Vermillion opened in 2005, it offered just the hedge fund strategy but opened the beta fund at the request of an institutional client that wanted long-only exposure. He would not name the client. Unlike a 100% long-only commodities strategy, managers of the Celadon fund use various overlays to “mitigate volatility that definitely is present in the strategy,” he said.
Reporters Douglas Appell, Timothy Inklebarger and Robert Steyer contributed to this story.
Christine Williamson is a reporter at sister publication Pensions & Investments.
