Hedge funds investing in commodities have long championed active management over passive, index-based products. With stratospheric oil and precious metals prices pushing commodities to the forefront of asset allocation, one firm is making its case.
FINalternatives recently spoke to David McCarthy and Philip Smith of Martello Investment Management, an $850 million fund of funds and advisory shop, about its recently launched Resources Fund and why it thinks now is the time for investors to embrace active management within the space. McCarthy is the firm’s founder and chief investment officer, and Smith serves as the new fund’s co-manager.
FINalternatives: Tell us about your funds and their historical returns.
McCarthy: Our flagship fund, Martello Diversified Trading, launched in May 2002, returned 11.17% last year, and is managing about $55 million. Our Institutional Fund and Diversified Trading Fund gained over 11% last year. From October 2007 to the end of January, they were up around 7% while the equity markets were down about 9%. This is what we hope for in periods of financial market dislocation. It doesn’t always happen and we can’t promise it, but that’s the kind of opportunity that happened in 2002 and 2003, and is happening again today.
FINalternatives: What does your investor base look like?
McCarthy: Martello’s investor base is largely institutional and 65% non-U.S. There is a longer history and a greater comfort within the overseas institutional investor group in the global macro/CTA arena than there is in the U.S. That’s beginning to change quite significantly, and the current environment gives that change further impetus as well. As a result, we’re actively beginning a more aggressive effort right now to raise onshore assets.
FINalternatives: Tell us about the new fund and the idea behind it.
Smith: It became clear to us with the growing involvement of institutional investors in the resource space that the investment community was still on version 1.0 in resources investing because of their limited expertise or due to internal investment policy constraints. Their default allocation was typically through a long-only, passive index approach. It’s our belief that it’s time for version 2.0, in that an active and non-long only approach is really what the institutional community needs to migrate toward.
The new fund is built upon a combination of long/short managers in the resources-equity space with systematic managers dealing in commodities contracts. It is our experience that most sector-focused long/short managers have an inherently long bias as their commitment to the sector frequently means that they like the sector and believe in it. Consequently, when a particular sector goes down, the typical long/short manager tends to suffer somewhat because of their long bias.
By combining systematic managers with long/short managers within a portfolio, the systematic managers frequently provide a return stream that may be uncorrelated to the long/short managers in down-trending markets, thus offering diversification to their long bias. And by being invested in equities, our long/short managers can touch parts of the resources universe for which there aren’t listed, liquid futures contracts such as alternative energy, steel or carbon credits.
FINalternatives: Where are the commodity markets going?
Smith: We certainly do not know if this resources bull run is over or whether it’s going to continue. But I think it’s safe to say that it won’t be a one-way directional move up. Thus, an active approach that is not long-only is really more suitable for investors. Clearly, the risk profile of a passive, long-only strategy is worrisome in markets that aren’t exclusively—and continuously—in a bull trend.
FINalternatives: What do you look for when you’re performing due diligence on managers?
McCarthy: With respect to our allocations to quantitative managers, we look for someone who has learned to not simply trust optimized results at face value. The most important factor across all of our discretionary managers is trading experience. Although these traders take a lot of small losses, they make a lot of money on a few trades. The experience and discipline of taking those small losses and being around to take advantage of the large opportunities when they do exist is an essential factor in the success of discretionary global macro managers.
FINalternatives: How important is transparency?
McCarthy: We don’t require transparency, but what we do get from most of our managers is a risk framework to help us understand what risks they’re taking and how they’re taking them. What we do is compare the risks they’re taking at any point in time against the risk they’ve taken historically and against their peer group. We’re very much focused on their risk reports rather than their individual positions.
FINalternatives: Under what circumstances will you redeem your investment with a manager?
McCarthy: We understand there are startup risks for new firms, especially if the firm is cobbled together by people from different firms. We invested in a firm started by two guys who had known each other but had never worked with each other. Within eight months, it was clear that the two partners were not seeing eye-to-eye on how to operate that business. When that became apparent, we simply got out.
FINalternatives: In addition to your fund of hedge funds, you also have an advisory business.
McCarthy: A lot of the managers we meet contact us directly because we’ve been around the industry for a long time. And because we have been around for so long, there are people who come to us and say, “We’re thinking of doing this, can you help us think it through?” For example, a very large European global macro firm, which started a few years ago, approached us a year before they decided to launch a fund and asked us to help them think through how investors would look at their fund because they were within an institution.
On the buy side, my partner, Neil Loden, in our London office was recently in Brazil meeting with managers we know there. He brought along the CIO of one of our largest clients who was not as familiar with Brazil and wanted to meet with some of the managers, using our introduction as a way of doing that. That consultative element to what we do has benefits to us as well.
by Hung Tran