Marc Maisonneuve* is the CEO of a large, TSX-listed firm in the industrials sector. A portion of his compensation is stock options; his salary is $5 million. His wife, Julie Lapierre, is president of a top university, so she’s also making seven figures. They qualify as accredited investors and take advantage of the alternative investments this status gives them access to.
*This is a hypothetical scenario. Any resemblance to real persons is coincidental.
Adrianna, the couple’s advisor, is well versed in the alternatives space. She knows there’s an alternative strategy for virtually every client—from conservative, hedged strategies targeting modest growth to aggressive plays shooting for double-digit returns.
During the KYC process, Adrianna determined Marc and Julie have the financial ability to absorb losses, as well as the psychological capacity to handle risk and volatility. This allows Adrianna to consider more sophisticated ways to access commodities, which often exhibit price volatility that can rattle the nerves of clients—even those with tens of millions to invest.
Short of storing stockpiles of physical commodities in a warehouse, the purest exposure Marc and Julie can get is through futures. Adrianna wants a strategy that can earn the couple outsized returns, but that still has robust safeguards built in.
CEO and portfolio manager at Blackheath Fund Management in Toronto
Marc and Julie have a 35% allocation to alternative strategies, of which 75% is market-neutral funds, private equity and a fund of hedge funds. The remaining 25% of the alternative allocation is in commodities strategies.
One of the commodities strategies is a fund that uses long or short futures bets to exploit divergences between market sentiment and price trends. A recent bet, wound up last November, was a long position on the cocoa market. Christopher Foster, CEO and portfolio manager at Blackheath Fund Management, explains how it worked.
The cocoa market had been trending higher over a multi-year period. “There were corrections, stagnation periods, sell-offs and rallies. But over pretty much any timeframe you could measure, the market was advancing,” says Foster.
Despite this, most speculative investors showed no appetite for cocoa. Foster knew this because he gets weekly data from the U.S. Commodity Futures Trading Commission showing who’s buying, who’s selling, and what. The data does not give specific names, but it indicates the category of investor playing the market (see “Commodity trader categories,” page 7). So, if it’s a consumer of commodities that removes physical stockpiles from the market for production purposes, Foster will know. If it’s speculators buying and selling futures contracts, the data will make that clear. A slew of neutral or bearish research reports on cocoa during this period contributed to speculator indifference. “It’s fascinating to see that kind of research because it can’t be right,” says Foster. If cocoa’s fundamentals were in as bad a shape as these reports suggested, then in the absence of speculative buying—which, if present, would’ve pushed the price up—the commodity’s price should go down. But it was going up.
That’s Foster’s signal to make a bet. If a commodity’s price is trending upward in the absence of broad speculative buying, “you can infer the fundamentals are positive,” he says. That’s the long side of the book. On the flip side, a commodity may be trending downward, but market participants as a whole are bullish and betting long. If the price is falling despite all that speculative long money flowing in, the commodity’s fundamentals must be in rough shape. That’s Foster’s cue to go short.
All investments can lose money, but if you’re on the wrong side of a commodities trade, the potential for loss is much greater—and can happen quicker—than with run-of-themill equities or bonds. This is why it’s important to leave commodities-related calls to specialists who live, eat and breathe this space. And even for them, notes Foster, making money is much harder than it may look.
Importantly, a clear uptrend or downtrend isn’t enough to trigger a bet. The trend must be broadly unacknowledged by speculative investors. “The most dangerous kind of uptrend to get aboard is one that’s buoyed by speculative money,” says Foster. The price increase is artificial in the sense that it’s not supported by strong fundamentals in the underlying commodity. And speculators aren’t like commodity consumers, such as Mars or Nestlé in the case of cocoa. Mars buys cocoa and takes it off the market to make chocolate bars, he explains. Speculators always buy with the intention of selling.
If they all run for the exit at the same time, he adds, the price will drop quickly since fundamentals don’t support the price.
Cocoa’s elusive fundamentals
The fundamentals of this delectable commodity are notoriously difficult to get reliable information on. Often it’s only possible to infer they are strong or weak, because the price is going up or down without the influence of speculative money.
“The most volatile component in cocoa’s fundamentals is the supply side,” Foster says. About two-thirds of global supply is grown in West Africa. “We’re talking countries like the Ivory Coast and Ghana, which are essentially lawless.” The borders are also extremely porous: “You can go to the border between Ghana and the Ivory Coast and it’s just a field. How much makes it out of the ports in Ghana versus the Ivory Coast probably depends on which way a farmer wants to go. Crop numbers are very hard to come by.”
Complicating this is the fact that cocoa-consuming companies like Mars and Nestlé have a vested interest in keeping important information under wraps. “It’s a competitive advantage to know what’s going on in the cocoa market, so they’re highly secretive,” says Foster.
Then there’s the weather. “When hot winds sweep across West Africa, cocoa rallies. It rallies on a weather event even if it’s not clear that event will actually have an impact on the crop.” Foster says he doesn’t factor weather into his own calculations. “By the time I know what the weather is and how it’s impacted the crop, it’s already moved the market. Guys on the ground from the big cocoa-consuming companies have satellite data, and they’re buying out of fear. […] If they’re worried the crop isn’t going to come in, they have to buy up all the cocoa they can to protect their inventory.” No inventory, no chocolate bars.
Foster says, by November 2015, speculators finally clued in that cocoa was the real deal. So, they piled in with long bets, bringing the commodity to new highs. “That, for me, was the signal to exit, and I did.”
That trade went well, but you can’t win them all. That’s why Foster has strict risk-mitigation protocols in place. The main one is a 3% limit on losses for any given trade: once losses dip below 3%, he has to close out the position.
“If you take a very large position, it only has to come down a little to create a 3% loss. So we try to take moderate-sized positions.”
He has three to six bets (long or short) running at any given time.
Marc and Julie are sophisticated clients who understand the importance of having uncorrelated assets. They’re comfortable with the risks involved in a niche play like cocoa, and are comforted by the 3% stop-loss built into the strategy. It was a bad year for the TSX, so this part of their portfolio helped pick up the slack.