Ask John Bailey of Spruce Private Investors what the future holds for the U.S. economy and he’ll give you his “base line” scenario: moderate economic growth, rising interest rates (starting in 2012) and low inflation (until 2013, after which, he says, higher inflation is “almost inevitable”).
Ask him how to invest in such a climate and he’ll tell you: focus on real assets, in particular, long/short commodities.
Ask him how he reached that conclusion and he’ll offer an explanation that begins in 1971: to decide what investment strategy would be most effective in a rising-rate environment, Spruce Private Investors looked at how 18 broad asset classes or strategies in four major categories performed during the eight such periods they identified between 1971 and 2010.
To do this, they used standard indices where possible and created backfill proxy returns from other liquid market data where necessary. What their research revealed, Bailey told FINalternatives during a recent phone interview, was that different strategies prevailed during different periods. As rates rose in 1974, for example, long/short commodities were king; in 1988, CTAs came out on top; in 1995, REITs prevailed. But when you averaged them out, he said, one strategy stood out: long/short commodities.
The secret, says Bailey, is consistency: “When you look at, for example, long-only commodities, you have massive volatility, so you can have an enormous gain, you can have an enormous loss.” Whereas, he says, “the largest loss you had in the long/short space was 1%, so you’ve had fairly strong gains in ’74 and ’04; modest gains in ’95 and 2007 and 2008, but you didn’t really have large negative numbers.”
“But if you look at the other categories,” he says, “REITs have had two periods of losses—down 3.5% and down a little over 5%—commodity equities had the really large loss in ’08, CTAs haven’t really had those large losses either, but their gains have not been as strong.”
With long/short commodities, he says, “you still get much of the benefit of the inflation protection but you get a much more consistent return stream and you have volatility of about a 7 or 8, is what we’ve seen, versus 25-30 for the index. So, it’s dramatically less volatile—it’s one third…to a quarter the volatility.”
But what if the baseline scenario isn’t what the future looks like? Bailey says Spruce also considered a scenario where “the risk to inflation is higher than you think, number one, and number two, that you…have an oil spike.”
In fact, Bailey thinks an oil spike within the next three years is almost a foregone conclusion:
“With [what’s going on in] Libya, 3% of the oil market is off line and you’ve got the Saudis pumping out maximum output right now…In the last 70 years, there’s never been a single year, even through the worst economic crises, where global oil consumption went down, never a year. So oil consumption will continue and if you look at the emerging markets coming online, it’s just unbelievable the impact that they will have, yet we don’t have a lot of excess capacity and we’re not discovering huge amounts of new reserves either—the one off Brazil is the only major one we’ve had since the 1970s. So the likelihood is that you will see this economic growth continue, you will see it surpassing supply and what happens then is price rises dramatically. That then starts to dampen demand and that just resets the whole thing.”
What Spruce’s research shows, says Bailey is that in situations where the price of oil spikes or situations of high inflation, long/short commodities and CTAs perform best. Bailey is quick to qualify that as “competent” CTAs and says his firm (which advises on assets worth about $3 billion) both invests with—and has reservations about—them.
“CTAs fulfill a real role within a portfolio for an investor,” he says. “Basically, commodity trading advisors, these are hedge funds following quantitatively oriented trend-following models, so they invest with momentum. If something goes up, over a certain period of time, they’ll buy that security. If it goes down, they’ll short that security….The commodities markets have been very prone to momentum signals. There is a momentum to that market. They go up for an extended period of time and when they go down they go down for an extended period of time…You can gain an attractive measure of return even when markets are going down, assuming there is a trend—that’s why CTAs have been diversifying to a portfolio. For example, in 2008, CTAs had a very strong up year. But conversely, if markets are trending higher they can also profit from the rise.”
“They have two weaknesses. There’s a weakness at the turn—let’s say markets have been very strong, and they just get over-bought, and you have a dramatic sell-off and the sell-off is material, well, the CTAs will likely get hurt in the turn…Number two, when you get markets that are very choppy and don’t really have a true momentum to them or a trend…these guys get hurt in those environments and they will probably underperform because they may be buying or selling just a little bit behind.”
Bailey, clearly, favors long/short commodities managers, but that doesn’t mean just any long/short manager will do. Spruce, he says, has “very specific criteria” it applies when evaluating managers.
First, he says, a manager must have “relatively real-time” supply and demand information. “They can’t be relying on Bloomberg or government releases,” says Bailey. “Everybody gets that information and it’s six months old or a quarter old or a month old.” As an example of the type of information a manager should be privy to, Bailey speaks approvingly of a Brazilian manager who, during a visit to a coffee plantation, was “literally counting the number of beans on different trees as a way to compare to past harvests.” It’s an approach that’s painstaking, he says, but worthwhile.
Next, he likes a manager who is skilled at structuring trades and managing risk. “What I mean by that is, you can have a great fundamental view of the marketplace, but you can have…some technical issue or geopolitical issue that completely overwhelms your investment thesis and so you need to be able to anticipate the likelihood of these events. Even if you don’t know the specific event, you have to be able to say to yourself, ‘Well, I might need to unwind this trade, therefore, do I have enough liquidity? Do I know how large a part of the market I am? Do I know who the other players in the market are?’”
Third, he says, is personnel. “There’s got to be a team, it’s got to be a deep team of people, it can’t just be a guy trading positions.”
And finally, the manager has to have a verifiable track record, preferably at least three years although Spruce has no hard and fast number.
At the moment, Bailey says, Spruce has about 12% of its portfolio in absolute return strategies, almost two-thirds of that is in macro and CTA strategies, and 12% in real assets—all long/short commodities.
Bailey says their long/short commodities bets have returned 11% per annum since they started investing over three years ago. That result, he says, is better than stocks, better than bonds, better than funds of hedge funds. And, he adds, that result has been achieved during a low-inflation period.
“We’ve been getting paid to wait on the inflation picture,” says Bailey.