06/23/2010

Correlation Issues Plague Commodity Funds

Persistent correlation between commodity and equity markets has contributed to wild performance swings for some of the top operators of commodity hedge funds, including Aisling Analytics, BlueGold Capital and Clive Capital.

Returns of commodity-trading advisors usually are uncorrelated with broader financial markets, which is what makes them appealing to managers and investors alike. Since the economic downturn, however, the markets have moved largely in unison, confounding investment strategies - and marketing efforts - employed by many commodity hedge funds.

"Everything's being dominated by macro variables, everything's correlating to an unusually high degree, and it's unclear how long that will last," one manager said. "The good [funds] are down 3%, and the bad ones are down 15-18%."

Aisling, a giant Singapore commodity-trading advisor, has had a particularly difficult year so far. The firm, which trades mainly in "soft" agriculture and energy futures, was up 9% in January but is now down around 15% year to date.

BlueGold started out the year with an 11% loss in January, prompting the London firm to send a letter to investors quashing rumors that it was unwinding. It turned things around in February and March, then suffered another sharp loss - of 12.5% - in May. London-based Clive fell 6% in May - its worst monthly decline since 2008.

The woes of each firm can be blamed at least in part on ill-timed trades and other portfolio missteps. But market players see broader macro-economic factors changing the dynamics for commodity-trading advisors generally.

Historically, commodity prices have correlated with the broader markets only during recessions, which clearly was the pattern in late 2008 and early 2009. Witness the S&P 500 index versus the Goldman Sachs Commodity Index: In the years leading up to the financial crisis, they often moved in opposite directions. But since late 2008, they've been in lockstep.

Most commodity portfolio managers expected their market would uncouple from the stock market beginning in late 2009 or early 2010, but that hasn't happened. Indeed, during the past six weeks or so, commodities have been more closely correlated with equities than at any time during the past eight years, with the exception of June 2009, according to hedge fund services firm Newedge Group.

Some market observers fear that pattern is here to stay. Why? In a word, uncertainty. Across most asset classes, managers have been preoccupied with the same set of macroeconomic trends, including Europe's sovereign-debt crisis and lingering concerns about the strength of the global economy and governmental responses to the last credit crisis.

"There's been tremendous connection between markets that in the past have been entirely unconnected," another manager said. "Things that should have very little relationship to one another are getting caught up in it."

The upshot: The market has become significantly harder to read for commodity managers. Newedge researcher James Skeggs said quantitative traders have had a particularly difficult time.

One portfolio manager said the past six months have been "the rockiest, most testing months I can remember."

Persistent correlation also is raising concerns among investors that have long seen commodities as a hedge against the broader financial markets. "The reason some people wanted to be in commodities was the diversification," the same manager said. "If you believe that 2008 and 2009 is the new norm, then there is no diversification story anymore."

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