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?
GZ: 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?
GZ: 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?
GZ: 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?
GZ: 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?
GZ: 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?
GZ: 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
GZ: 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?
GZ: 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
OFI: Are there many inefficiencies at any one time?
GZ: 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
In gold and oil there is a great deal of noise masking the supply and
OFI: Is Almanac different from a traditional commodity trading advisor?
GZ: 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?
GZ: 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?
GZ: 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?
GZ: 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?
GZ: 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?
GZ: 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
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