Monday, 2 April 2012

Dumb and Dumber

As either a pension fund or a wealthy private individual seeking to chase the hottest financial fad in the last three years, the opaque and illiquid commodities market, which your private and investment banking advisors have pushed hard, due to the large fees they can earn, you may have considered and invested an increasing portion of your cash in commodities long only plays and supposedly more savvy long-short commodity hedge funds. As a consequence, the wallet size and market influence of commodity funds has continued to increase dramatically at the detriment of western consumers. And within commodities, oil focussed hedge funds have seen the most dramatic growth. It is worth asking then, amidst the hoopla, what has been their performance as a group to date? When compared with every other type of hedge fund (L-S equity, RV, global macro, etc), over the last three years volatility of returns of oil hfs have been the highest (~30%), the beta with the underlying asset class has been close to 1 and Sharpe ratios one of the lowest (~1). These metrics tell us, oil hedge fund returns have broadly tracked the direction of oil prices over this period, but provided no real decrease in volatility of returns when compared with the long only play. At the same time returns have been poor (-ve or low single digits for most funds). Originally, long only commodity investments were sold as a means to hedge out the performance of traditional assets in a financial portfolio composed primarily of equities and bonds (as an inflation hedge). That mythical diversification has been debunked by three years of returns which have been highly correlated with every other market. So a strategy which diversifies further through specialised oil hedge fund managers makes a modicum of sense but the results do not appear to hold up to even modest scrutiny. It is often said passive, long only money is the dumb end of investment. And that certainly may be truer today for those still tempted to enter into oil markets at the very elevated levels they have reached. However when you look closely at the performance of commodity and oil funds, it may a case of one investment being dumb and the other even dumber.

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