Futures hassles push funds into buying real commodities

Commodity Funds Get Physical

By Gregory Meyer
Financial Times, London
Friday, December 4, 2009

http://www.ft.com/cms/s/0/41c44bc2-e107-11de-af7a-00144feab49a.html

The retired civil servants of San Bernardino County could soon be in the livestock business.

The public pension fund in the county, the largest by area in the US state of California, has agreed to place $30 million with a fund manager who is considering using some of the money to raise cattle.

"A potential strategy will be to buy calves, put them on feed, and then sell them," says Brian Long, investment officer at the San Bernardino County Employees' Retirement Association.

Financial marketers have in recent years cooked up a smorgasbord of products aimed at making the messy, complex business of investing in commodities as neat and efficient as buying stocks. But big costs inherent to commodity futures markets, along with threatened regulations, are now pushing some investors to get their hands dirty and own the actual raw materials themselves.

Commodities have sucked in record amounts of money this year as ultralow interest rates make riskier assets attractive and stir fears of inflation. Inflows are approaching $55 billion, according to Barclays Capital.

Many long-term investors in commodities have been burned, however, by a pattern in which commodities to be delivered months or years ahead cost more than commodities available today. This has essentially meant selling low and buying high each month as investors freshen up expiring futures contracts, eating into returns.

For investors, the easiest way to get a piece of the action has been through exchange-traded products, which trade on stock exchanges like equities. A popular ETP that tracks the Dow Jones-UBS Commodity Index has been running television advertisements showing a person crushed by an oil drum, grain sheaf, and cow. "How about a convenient way to hold commodities?" they ask.

Some of these index products have proved disappointing because of the cost of holding futures contracts. The United States Oil Fund has gained 18 per cent in 2009, far short of the 72 per cent rise in US crude futures, for example.

As a result, some groups catering to larger investors are now pursuing far less convenient strategies -- buying so-called "physical" commodities and incurring all the risks and headaches that go with them.

From an office in a Manhattan neighbourhood full of cheap perfume and jewellery shops, Vermillion Asset Management manages stores of corn and soyabean holdings stored in grain elevators around rural areas of the US.

It also owns stockpiles of aluminium in Europe and South Korea. Crimson, a Vermillion fund launched in July, at some point may also buy tankers loaded with oil, says Chris Nygaard, who co-founded the company.

Vermillion is not the only hedge fund to enter the "physical" commodities game. AAA Capital Management Advisors, a Houston energy trader, this year began a physical natural gas and petroleum fund. Red Kite, a UK hedge fund, trades physical metals such as copper, sometimes storing the metal in warehouses, while M2M Management, a shipping hedge fund based in London and Athens, invests in actual vessels to profit from freight costs.

Bankers also report new interest in physical commodities, not only because of the cost of trading futures but because of potential regulations limiting investors' footprint in the market.

"The number of inquiries from the investor community with regard to alternative ways to invest in commodities, including physical, has increased substantially in the last several months," says John Redpath, global head of oil and agriculture trading at Deutsche Bank in New York.

Trading physical commodities is in many ways riskier and more complex than derivatives markets. Vermillion has to negotiate individual storage rates with the warehouse operators with which it does business.

The cost of holding a commodity in a warehouse is built into futures prices, and may not be cheaper than futures.

Mr Nygaard, a former trader at agribusiness giant Cargill, says Crimson buys real commodities only when it is cheaper to pay for storage costs than to trade in the futures market.

He and other traders involved in physical commodity trading also claim it gives them an information edge, maintaining access to operators of grain elevators, river barges, and export terminals, for example.

"Any commodity hedge fund out there is going to get research from his broker. Very few are going directly to the source," he says.

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