I co-authored this for Inside Supply Management magazine.
WEATHER BOOSTS PRICES OF CORN AND SOYBEANS
by Stanly, Foreman, & Nicholson
Inside Supply Management
September 2005
Dry weather in the eastern half of the corn and soybean belt has been the principle element in sharply boosting grain and oilseed prices over the course of the summer. From planting-time to mid-growing season corn prices rose 13 percent, while soybean prices saw 15 percent appreciation. Now, however, temperature moderation accompanied by much-needed rainfall has tempered the markets, settling them down to the price levels of last May. Through this time period large speculators or hedge funds, as they are commonly referred to, have built long or ‘buy’ positions in both markets, further supporting prices. And, with declining stocks-to-usage ratios, corn and soybean prices are both expected to be about 20 cents per bushel higher in the 2005-06 crop year which is now beginning, than they averaged in the past 12 months.
Corn Supplies Lower But Adequate
Despite an advance to 81.6 million planted acres, corn production for the 2005-06 crop year is now projected to be 10.03 billion bushels, down sharply from last year’s 11.81 billion bushel record. Average yields are set at 135.4 bushels per acre with projected reductions expected in 29 of the 33 corn-growing states. Last year’s yields were 160.4 bushels per acre. Nonetheless, there are ample supplies, with a total supply of 12.26 billion bushels this coming year, compared to supplies of 10.58 to 12.78 billion bushels in the past five years. Improvement in exports will take a bite out of these supplies and offset the dip in domestic usage driven by lower animal inventories. Corn usage in ethanol production has doubled in the past three years, and will claim about 15 percent of all 2005-06 production. These dynamics should leave stocks of 1.42 billion bushels at the end of the coming crop year, which is certainly adequate for the commercial pipeline.
The USA’s key competitor in the global corn trade is Argentina, whose production is likely to be 10 to 14 percent lower this year. Another key factor in the global market is China which, at 127 million metric tons of corn production, is again consuming more than it produces. These factors deserve monitoring, as does global coarse grain stocks which may approach historic lows this coming year.
Buying Strategies Driven by Technical Factors and South American Production
While the crop has been damaged by extreme heat and dryness through a large portion of the central and eastern corn belt, the risk premium for production well below 10 billion bushels has evaporated. With harvest about to begin, seasonal pressure may hold rallies in check. Buyers may expect December corn futures to find support in the $2.15 to $2.20 range. Longer-term, buyers should expect stronger export demand, tightening USA and global ending stocks, and a smaller Argentine corn crop to support prices this fall and lead a seasonal recovery through the winter and into the spring.
While most coverage for the October through December quarter should be in-place, there is not a pressing need for buyers to cover into calendar 2006 at this point.
--- ---
USA Soybean Production Lower But Not Problematic
We have seen the lowest planted acres to soybeans this year since the 1998-99 crop year. Accompanying this are yields, while good at 38.7 bushels per acre, are no better than the upper-end of the range of the past 10 years. Last year’s yield of 42.5 bushels per acre was a record. Production in the 2005-06 crop year is projected to be 2.78 billion bushels, contrasted with 3.14 billion bushels in 2004-05, and 2.45 billion bushels in the 2003-04 crop year. The story behind this year’s numbers is the dryness in the Midwest. The key growing state of Illinois received only 60% of its typical early and mid-growing season rainfall this year and faces some of it’s poorest yield prospects since 1988. Beginning stocks for the coming 2005-06 crop year are a healthy 263 million bushels, which aids in moderating the effect of strong domestic crush, pegged at 1.70 billion bushels. The good flow of exports, at 1.05 billion bushels, have been buoyed by weakness in the dollar as compared to the currencies of key USA soybean customers. Exports were recently running about 25 percent ahead of last year’s pace.
Global competition to USA vegetable oils produced from soybeans has surfaced from sunflowerseeds, which are projected to rise in 2005-06 to a near record 27.2 million metric tons of production. And, world output of rapeseed, forecasted to be 43.1 million tons due to good crop conditions in the EU and Canada, will also weigh on market prices. These improvements are offset somewhat by the 3.2 percent soybean planting reduction in Brazil, the second-largest global producer of soybeans. Overall, global vegetable oil production is growing at 6.94 percent per year, just keeping-up with consumptive growth of 6.88 percent.
Some Soybean Coverage Is Now Warranted
The soybean market of late has had difficulty in finding direction. A key question is whether late-season rains were enough to help yields or was it “too little too late”. It may be the latter, but at least those rains stabilized the condition of the crop and prevented further deterioration. Technical market analysis suggests that the soybean market is currently in a $5.65 to 6.50 per bushel range. Buyers could cover their October-December quarter needs at the lower-half of this range, and pursue covering up to one-third of their needs into 2006 on opportunistic ‘buys’.
September 29, 2005
August 23, 2005
Hedge Funds Situation and Outlook
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.”
“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.”
May 30, 2005
Jeff Hawkins on Applying Entrepreneurism
Jeff Hawkins
Founder of Palm and HandSpring
Stanford Technology Ventures Program
Hawkins does a great job of cutting through the clutter and looking at things very pragmatically, though at the same time very intelligently. He had two key points in his presentation, one being that entrepreneurism is not a life or a job, it’s merely a tool. That is, entrepreneurism is a temporary ‘thing’ to start something; it’s a last resort; and, it’s for progressing a passion. And that’s the second point he made, you need a passion in your life.
A few of his comments were unsurprising, while a few were actually counter-intuitive. With that as a base, he posited these rules for successful entrepreneurialism:
1. Find a passion and follow it.
2. Use the fastest and surest way to succeed. Everything else will fall in place if you have a passionate goal and a plan.
3. Use entrepreneurism as a last resort; it’s a desperation move.
4. Work smartly, not necessarily harder. You have to have a life.
5. Try to have fun, and do so by following the goal.
A final comment was that a start-up really does require a lot of process—an employee manual, a hiring plan, etc. It’s very important in a start-up to have process.
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