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Opalesque Futures Intelligence

Founders Q&A: Commodity expert George Zivic allocates to niche managers, but he also trades. Read about where he sees opportunity in commodity markets.

Tuesday, July 27, 2010

George Zivic

Investing in Commodity Niches

George Zivic, chief investment officer of Almanac Capital Management, discusses the finer points of commodity investing. Mr. Zivic started his commodity trading career in 1999 at Enron, where he participated in the development of weather derivatives. He has contributed to a book on the subject—Weather Risk Management: Markets, Products and Applications.

After Enron, he worked for commodity hedge fund Takara, reinsurance company XL Capital and Dutch bank Rabobank. Before founding Almanac Capital in 2007, he was a director and the head of commodity allocations at Credit Suisse, where he selected commodity hedge funds.

Almanac Commodity Fund made 15.4% in 2009

While our universe is much smaller than long/short equity, there are interesting managers in niches. But first you have to establish which niche you should participate in.

Opalesque Futures Intelligence: How did you get into commodities?
George Zivic: It was at Enron, where I helped start the weather derivatives business. We looked at interrelations between the weather and certain commodities and set up a commodity correlation trading book. I learnt how dynamic and interrelated commodity markets are. A group of us left Enron to start a similar business at XL Capital. Later at Rabobank I worked more directly on agricultural commodities, which was a very useful addition to my experience. Then at Credit Suisse I helped build a commodity fund of funds.

OFI: Is Almanac a fund of funds?
We are not a traditional fund of funds allocator. I think of Almanac as a multi-strategy commodity fund that predominately uses outside managers. With our background in the trading and risk side of the business, we take a trader's approach to building the portfolio. The commodity space is extraordinarily complex. Information flow is far more important in these markets than in just about any other market. This is our expertise. We have a view of what's going in specific commodities and where the opportunities are.

OFI: How do you identify the opportunities?
We develop a macro outlook and also look to get a sense of market psychology—meaning what the market believes is going to happen. The key question is how the macro outlook will drive movements in specific markets. That creates opportunities in areas like volatility. We pick managers to extract value in specific trades that are promising.

OFI: Do you trade yourself?
Up to 10% of the portfolio we trade ourselves, like an in-house hedge fund. We pick shorter term trades based on the best ideas that are in line with our macro view.

OFI: Given you trade yourself, why do you allocate to outside traders?
The goal is to make sure the portfolio is diversified across commodities. This is different from the typical fund of funds approach, which starts with a statistical analysis of manager returns and picks managers on that basis. To determine the right strategy for the environment, we analyze the implications of market psychology and our macro view for every market. For instance, if I expect a market to be exceptionally volatile, then I'll hire a volatility trader. If we expect a market to be very upward trending, we may hire a long-biased manger for that market.

OFI: Do you get outside managers that focus on specific sectors?
I invest in pure commodity funds and 80% of my exposure is in funds that trade a single commodity. Currently our portfolio has an agricultural trader, a base metals trader, two natural gas traders, a power trader and a weather derivatives specialist. In effect, together we constitute a multi-strategy commodity portfolio. While our universe is much smaller than long/short equity, there are interesting managers in niches. But first you have to establish which niche you should participate in.

OFI: How do you know what the outside managers are trading?
I spend much of my time studying commodity markets from a trading perspective. It makes me a much better allocator in this space, in contrast to someone who knows almost nothing about commodities. Because we trade capital in-house, we're very connected with the markets our managers are in. I compare what the managers and performance and risk measures are telling me with what I see in the market Our job is to align markets with managers, not just to pick managers. Having an outlook and an understanding of the markets, we make better decisions when we deploy capital. Our expertise and direct market participation also allows us to communicate better with managers.

OFI: Why would investors go with an active manager when they can just buy commodity ETFs?
Pensions and endowments want to buy commodities because they expect commodity prices to go up when inflation goes up. But commodity markets have much less liquidity than the traditional markets institutions invest in and have physical characteristics like no other market. Because of liquidity constraints and other specific characteristics, the downside deviation and volatility is very high in commodities. Historically, commodities traded at 30% to 40% volatility; natural gas has traded as much as 120% volatility. Long-only commodity investments lost heavily in 2008—those losses compounded investors' pain as equity and credit markets went down.

OFI: Are all commodity investments subject to high volatility?
There is another way of trading commodities that is not price dependent. Commodities have life cycles—think of corn all the way from the seed being planted to when it becomes ethanol or food and is delivered to end users. This life cycle is generally very inefficient and specialists trade different stages of the life cycle to take advantage of inefficiencies. Our focus is on the inefficiencies rather than price dependency. We look to where the inefficiencies are and how they will be affected by macro trends. That way we can capture much of the upside but protect ourselves against downside price movements. Many investors don't understand the inefficiencies that drive commodity trading opportunities, such as physical and curve constraints, so instead they go for index investments.

OFI: Are there many inefficiencies at any one time?
The beauty of commodities is that there are many related but distinct markets. Oil in the US is different from oil in Europe. High protein wheat is not the same market as low-protein wheat. There may be not enough of one but too much of the other. An expert will arbitrage that inefficiency by buying the first one and selling the other. These strategies can be executed in futures or options.

In gold and oil there is a great deal of noise masking the supply and demand fundamentals.

OFI: Is Almanac different from a traditional commodity trading advisor?
We are not a systematic CTA but a discretionary commodity trading firm that does in-house trading and allocates to outside managers who may specialize in a single commodity. Most CTAs have only a 20% allocation to commodities proper and the ones in commodities are typically biased to gold and oil because those are the more liquid markets. We try to limit our exposure to gold and oil, which tend to be dominated by large macro hedge funds, CTAs and index investments. In gold and oil there is a great deal of noise masking the supply and demand fundamentals—prices move for reasons other than the life-cycle inefficiencies we look for.

OFI: So you don't like gold and oil?
We have very little exposure, but I might look for a volatility-based oil trader. While prospects for oil are bullish in the long run, in the current environment there are contrary macro views that we expect will lead to high levels of volatility in a non-trending market, which is more conducive to volatility trading. Eventually demand side changes will turn that market around and trending strategies may become more appropriate.

OFI: Which commodities do you like?
Agriculture has many characteristics I like, but it is a small market. During the growing season there is weather-based volatility in agricultural prices. A manager who can take advantage of short-term volatility using an options-based strategy is promising. From a long- term view there are a couple of strongly bullish markets in the agricultural space because of demand trends in emerging markets over the next five to 10 years. So I do have a manager with significant agricultural exposure and a long bias.

OFI: Why do you have two managers trading agricultural commodities?
These managers have two different strategies, one using options and focused on short-term volatility, the other using outright futures and focused on long–term trends. They capture alpha from markets in different ways. Correlation between these two funds is very low.

OFI: Are weather derivatives an attractive investment?
Weather derivatives have evolved a lot in the 10 years I've been in the market. There are more participants, like utilities hedging their snowfall and rainfall risk. We have a manager that trades only weather derivatives.

OFI: What's your outlook?
In many commodities we do not think demand will grow as much as expected, which is what we thought in 2009 as well. We expect volatility to continue through 2010 and probably 2011, or at least until a consensus view is established on the demand picture for commodities. People with long-only investments will be very frustrated, not only by price behavior but also by a bearish (contango) curve structure. There may be a reallocation of commodity exposure from passive to active strategies. Long term, I see greater opportunities for us in markets like carbon trading, shipping and weather derivatives. These markets are not huge right now but will grow in time. There are interesting trades already, such as a shipping arbitrage that makes US soybeans more attractive to Chinese importers, compared to South American soybeans.

OFI: Will Almanac be affected by regulatory changes?
GZ: Those will have much more of an influence on the dealer network and possibly on multi-billion-dollar funds with large positions in the market. Our exposure is to smaller managers who trade very narrow markets with high turnover but not high volume. I don't expect a significant impact from regulatory changes.

This article was published in Opalesque Futures Intelligence.
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