Our on-going analysis of funds examines the short-term impacts of fund trading on commodity prices via funds position-to-price correlations; price elasticities of changes in funds’ positions with commodity prices; and, vulnerabilities of market price levels to neutralization or ‘evening-up’ of funds’ open positions. The funds’ influence on market prices over the five years we have studied it has been significant. And, we anticipate that this influence is going to increase. Therefore, we are looking more deeply into just who the funds are, how they trade, and what the growth prospects are for this industry that will increasingly effect the commodity prices which you manage.
“The next new thing is--things.”
Reviews of current literature, new trade seminar offerings, and industry conferences echo this quote from Jim Rogers, former George Soros partner and author of several investment guides including the current best-selling Hot Commodities, that the coming years will be a bull market for basic commodities, or at least a bull market for the commodity trading or commodity fund industry. The underlying thesis is that global commodity producers steadily reduced capital investment during the 1997 to 2004 period, and are now faced with reduced production capacity in the face of rising global raw materials demand. Others look at long-term cycles (e.g. 18-years) that suggest that commodities and stocks outperform one another in alternating cycles, and they posit that we have entered the long-term bull market cycle for commodities. Such cyclical shifts attract money, in the form of funds.
Given the historical, current, and projected impact that financial investment trends will have on prices, a buyer of agricultural commodities should be quite knowledgeable of who the funds are, how they function, and how they may react to and trade fundamental or technical situations.
Just who are ‘the funds’?
The funds. Hedge funds. Commodity funds. Managed futures. CTAs and CPOs. The large ‘specs’. Private equity funds. Commodity mutual funds.
Each of these entities can be defined with differentiation or at least subtle variations, but given the common participants, their common trading styles, and common financial engineering roots, we aggregate them broadly, as most of the trade does, as simply, ‘the funds’.
Their genesis was 1949 research by Alfred Winslow Jones which led to the formation of a market-neutral investment pool or fund. The long positions in Jones’ under-valued equities would be off-set by short positions in others. This “hedge” by the fund would allow for greater leverage, and if structured as a limited partnership, allow it to operate with less regulatory constraints than imposed by the Investment Company Act of 1940, which regulates market pools such as mutual funds. Through the years a number of funds emerged, copying elements of what Jones had started. Then, Nobel Laureates Markowitz, Miller, and Sharpe codified risk diversification and non-correlated returns techniques in their work in modern portfolio theory, spawning still more growth in this nascent sector. Years later, a 1966 Fortune article was credited with coining the term “hedge fund”.
Today, one could define ‘a fund’ as an unregistered, privately-offered, managed investment pool of capital from high net-worth investors. There is reasoning behind each of these descriptive attributes which will be explored below. Central to the funds’ reason-for-being is to exploit market inefficiencies, while providing asset diversification; non-correlated, leveraged returns; and, long-term capital gains.
“Hedge fund” is not a uniformly, legally defined term in the commodity and securities industries or among the bodies that exert regulatory authority such as the Securities and Exchange Commission (SEC) and National Association of Securities Dealers (NASD), and the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA). These are the governmental bodies and the related, industry self-regulatory organizations for the securities and commodity futures industries, respectively. While subject to the laws and exchange policies as is any other trader, funds do operate in a less-regulated environment than do other such pools, such as mutual funds.
The Hottest Area in the Financial Industry
Such a less-regulated environment has in itself led to a cottage industry in the financial sector in merely tracking industry size, growth, and major participants, as much hedge fund data is self-reported. Most analysts place the number of funds at some 7,000 to 8,500. (For context purposes, this compares to 7,000 mutual funds operating in the USA today.) Nearly 1,500 funds directly take positions in futures and options, as indicated by commodity pool operator (CPO) registration figures from the CFTC and NFA. There are an additional 800 firms which advise others on futures and options trading as commodity trading advisors (CTA), and still more that participate in futures and options--including agricultural commodities--via off-exchange or over-the-counter swaps and other derivative instruments.
Over the past year there have been about 400 new fund start-ups along-side 250 to 300 closures. The life-cycle for many funds is just a few years due to time-worn or duplicated market strategies or simply fund manager burn-out. In fact, only one-fourth of 600 funds analyzed in a 1996 Princeton University and Analysis Group study are still operating today. For purposes of familiarization, reference, and further research we have assembled Table 1, as to who are among the leading funds in the market today.
Table 1
General Reference: A Who’s Who Among Funds
(Doane has not assessed the financial situation or merits of any of these firms or funds,
and this is not intended to be a complete or exhaustive list)
More notable, general fund managers
Top-performing agricultural commodity funds of 2004
Campbell
Caxton Associates
Citadel
Dunn
Highbridge Capital Management
John W. Henry
Maverick Capital
Moore Capital
Renaissance Technologies
SAC Capital Advisors
George Soros funds
Paul Tudor Jones funds
AgTech Trading Company
Bell Fundamental Futures (Standard)
Commodity Capital, Inc.
Crow Trading, Inc.
DEC Capital (Ag. Institutional)
Fundamental Futures (Lone Star)
FuturesOne (Spec. AG)
Kottke Associates (Ag-Spread)
Lawless Comm.(60% Max Drawdown Acct.)
Range Wise Inc
Strategic Ag Trading (Grains; and Inter-market)
Venture I (Grains)
Publicly-traded commodity index funds
Specialty mutual and equity funds driven by commodities and raw materials
Oppenheimer Real Assets (QRAAX)
PIMCO Commodity Real Return Strategies (PCRAX)
Rogers International Raw Materials Fund
AMEX Gold Bugs Index (HUI)
Credit Suisse Commodity Return Strategy (CRSAX)
Invesco Energy (FSTEXA)
iShares Dow Jones US Basic Materials (IYM)
iShares Goldman Sachs Natural Resources (IGE)
Merrill Lynch Real Investment (MBCDX)
Oil Service HOLDRs Trust (OIH)
Permanent Portfolio (PRPFX)
Scudder Commodity Securities Fund (SKNRX)
Select Sector SPDR Materials (XLB)
T Rowe Price New Era (PRNEX)
Van Eck Global Hard Assets (GHAAX)
Vanguard Energy (VGENX)
source: Barclay Trading Group; Morningstar; Doane Economics Group
Most industry analysts state that capitalization of the funds industry is now approaching $1 trillion, up from less than $400 billion in 1998, $500 billion in 2000, and about $800 billion in 2003. It is possible that upwards of $250 billion in pension fund monies could move into the funds arena as a result of widely-touted strategies among even more traditional investment advisers to diversify portfolios, and to seek-out volatility and add risk:reward exposures via commodities.
Of the 7,000 to 8,500 operating funds in the industry there are typically just 250 to 600 of them with open positions in each of the CBOT agricultural commodity markets (see Part I of The Funds) at even given time. And, we estimate that initial margin on the funds’ share of open interest currently held in CBOT corn, wheat, and soybeans and its two products, is only about $300 million. Those are small numbers given the massive capitalization of the funds industry and the number of participants. There is plenty of room for upside growth, so one can see that the potential impact which funds may have on core, agricultural commodities in coming months and years is very substantial.
Fund Operating Principles Shaped by Regulatory Environment
Funds have been able to thrive in their minimally-regulated environment. This has been nurturing for the funds, as the general constructs of the funds’ business has been driven by a desire to operate in a secretive, competitively-secure fashion, shielding the trading methodologies from the public, from competitors, and in many cases even from its investors. This has been for a good reason, as once many of the more widely-used trading approaches are copied, market efficiencies tend to dilute profit potentials. Stated differently, market inefficiencies can become efficient over time due to funds’ intervention. The market reaches equilibrium.
Funds use a combination of trading methodologies, utilizing
· information asymmetry or proprietary, closely-held knowledge;
· relative value arbitrage or mis-pricing between commodities or commodity locations;
· projected volatility shifts or cycles;
· illiquid, low-transparency but rapidly-maturing markets;
· exhaustive examination and back-testing of technical timing, momentum, and directional studies; and,
· event-driven or anticipatory price shocks.
Often, funds will require a four to five year commitment or ‘lock-up’ from an investor so that they can pursue long-term capital appreciation trading strategies. During this time only financial results, without detail of the trading strategies involved, may be shared with the fund’s investors. The number of investors is typically limited to 99, with the fund manager acting as general partner. In so doing, the fund will not fall within the definition of an investment company as defined by the Investment Act of 1940, and is thereby relieved of many registration, disclosure, reporting, and recordkeeping requirements. Further, the fund then retains the right to invest in many markets, seeking different, sometimes aggressive levels of leverage. These features are not available to firms regulated by the Act, and as a result, mutual funds have tended to be homogeneous, while one finds much more variation in emphases, styles, time horizon, and risk exposures from fund-to-fund.
The benefits of forming as a limited partnership, as many funds do, is its flow-through tax treatment and the limited liability for limited partners. While interests in a limited partnership are generally considered securities, most funds avoid securities registration by claiming that their investments are via ‘private offerings’, not available to the general public.
Long a standard in the industry, many funds operate with an annual management fee of 2% of invested assets per year, plus 20% of profits.
Operationally, the funds will use futures, options, swaps, and even cash market instruments to enter positions; tend to focus on trading non-correlated assets--the ‘hedge’ part of what they do; and, use bonds, popularly, TIPS (Treasury Inflation-Protected Securities) for non-invested capital maintenance and collateral purposes.
The Commodity Exchange Act of 1974 (CEA) imposes CFTC and NFA registration requirements for funds or funds activities which may be considered CTAs or CPOs. The Commodity Futures Modernization Act of 2000 relieves CPOs and CTAs of many regulations if their futures usage is minimal and if their investors are high net-worth, experienced investors. Such investors are referred to as Accredited Investors or Qualified Eligible Participants (QEP). While a number of funds are registered as a CPO and/or a CTA, many are exempt because of the limited number of clients they serve or the QEP status of those clients.
Funds Positions a Current Regulatory Topic
The CEA directs the CFTC to limit excessive speculation as it could cause “sudden or unreasonable fluctuations or unwarranted changes” in prices. Knowing this, some market-watchers have looked at the recent, record high shares of total open interest accumulated by funds in the Chicago Board of Trade (CBOT) agricultural commodities with concern (see Part I of our Hedge Funds analysis). Therefore, we examine here the speculative position limits, position reporting, and hedging requirements within the exchange policy and regulatory environment, so as to better understand if this is an issue for commodity buyers and traders.
The CFTC sets speculative position limits for corn; soybeans, meal, and oil; wheat; oats; (see Table 2) as well as cotton, while limits for all other commodities and financial futures contracts are set by the various exchanges in accordance with specific CFTC guidelines.
Table 2
CFTC-prescribed Speculative Position Limits, per Trader (in number of contracts)
CBOT Commodity (includes mini-contracts)
Respective data:
Net, all months combined
Net, any single month other than spot
Spot month
Wheat
4,000
3,000
600
Corn
9,000
5,500
600
Soybeans
5,500
3,500
600
Soy oil
4,000
3,000
540
Soy meal
4,000
3,000
720
source: CFTC
The CFTC goes further in attempting to limit excessive speculation via its speculative position aggregation and reporting requirements. The Commission and the exchanges do view multiple market positions which are subject to common ownership or control as if they were an individual trader. The rules are applied so as to aggregate related accounts. So, a funds investor with a 10% or greater interest in a partnership must aggregate the entire position of that partnership, not just their fractional share, together with whatever positions they may hold separately from the partnership. Further, a fund comprised of many investors is allowed to hold positions only as if it were a single trader. This is quite limiting to building very large speculative positions.
However, there are key exceptions to this aggregation rule. Limited partners and fund participants with no knowledge of or control over trading in the fund can be exempted. And, given the nature of many funds, this is quite often the case. Secondly, CPOs and CTAs may be exempted if the market positions in their fund is independently-controlled, even if it has common ownership. Such would be the case if a CPO (a fund) pools money from a group of investors, segregates it into several funds, and has several CTAs, independent of one another, trade an individual fund.
Exemptions to position limits are granted to those who meet Commission rules of bona fide hedging. Commission Rule 1.3(z) is intended to define hedging in a traditional sense--as a substitute for transactions to be taken later in the cash markets. It is conceivable, though unlikely due to CFTC regulatory practices, that a fund could ‘hedge’ a cash-market, over-the-counter (OTC) swap in the futures market. In so doing a large speculator could, at least in theory, be considered a hedger or a commercial. Generally, the CFTC classifies a trader as a commercial upon their completion of CFTC Form 40, stating that they are “…engaged in business activities hedged by the use of the futures or options markets”. The CFTC does monitor, on a monthly basis, traders’ positions so as to determine if they have a sufficient cash market position to justify futures and options positions in excess of the speculative position limits. And, the CFTC may, at its discretion, reclassify a trader from commercial to non-commercial.
Note that reporting levels, referred to here, may be changed by the CFTC from time-to-time so as to balance the need for adequate data for analysis, with reporting burdens upon the industry.
While we see that there are means by which a fund’s speculative position could be mischaracterized or enlarged beyond regulatory limits, current CFTC mechanisms would appear to be adequate to maintain market integrity
The Road Ahead Leads to High Growth
The biggest challenges of the funds in recent years has been low interest income on non-invested capital; other firms employing many of the same trading techniques, thereby diluting potential profits; and, quite importantly, the war for talent--recruiting, developing, and retaining the brightest managers for the funds. However, the interest rate rise of recent quarters will help. And, the continued, sizeable inflow of funds should, in itself, obviate some of these problems as funds are better able to invest heavily in technical and fundamental analysis as well as advanced applied mathematics, and can better afford to attract talent to this corner of the financial sector.
We expect little in the way of new regulation or regulatory restrictions that would impede fund industry growth.
So, for the commodity buyer, increased research on fund industry trading styles and patterns, and close, weekly monitoring of their positions must become part of the weekly routine. Even for a seasoned buyer, “The next new thing is --funds.”
