Brief Business Profile:
Institutional clients regularly include Commodities into their portfolios. Whenever they do, the business is either high volume or bespoke and profitable. RD is experienced in commodities products for institutional clients and has a track record with sovereign funds, asset managers and pension funds, particularly in Australia and South East Asia .
RD’s work would include educating asset managers about client commodities products and creating bespoke indices to hedge specific portfolio risks. For example, the largest Australian investor focuses on hedging geopolitical event risk with commodities. Another investor has hedged inflation.
RD would also negotiate optimal pricing for vanilla solutions and aim to capture maximum client wallet by providing excellent value-added service. For example, asset managers and pension funds have focused on reducing vanilla product fees in 2015. Maintaining high fee income required solutions that added new value to clients.
Business Metrics:
Revenue: 10 000 000
Estimated RoE: depends on scale
Regional expertise: Australia & South East Asia
Product requirements: one common sense core beta index, one core Risk Premia (alpha) strategy
Recent highlights: First commodities index deal with QIC at Morgan Stanley
Where is the Opportunity?
During periods of severe market stress, the Institutional Commodities Business is in demand and can be profitable.
Dislocations in commodity markets open opportunities for long-short strategies (“alpha” or “risk premia”) to deliver solid sharpe ratios.
Should markets cyclically reverse (ie. equities down, commodities up), long strategies (“enhance beta”) would hedge equities core positions and deliver returns.
Inflation scenarios are also putting commodity indices in demand.
Commodities are also used in bespoke geopolitical hedges for institutional clients.
Unfortunately, the Exit of many market players from institutional commodity products, leaves a vacuum for quality client service and products.
Regional Focus:
Opportunity distribution:
Product demand:
REP is an attractive business in Australia and Asia because Commodities exposure forms part of almost every diversified institutional portfolio – under the section: Alternatives.
Beta exposure to Commodities makes sense in cyclical long term reversals and rallies. We might be at the cusp of such a cyclical reversal in which case Commodities allocations will increase dramatically.
But strategic and dynamic institutional investors are good in seeing the cyclical big picture. The real value comes in form of understanding the micro-inefficiencies in commodity markets.
Commodities are extremely inefficient because arbitrage trading requires access and expertise in extremely fragmented and regionally diverse physical marketplaces. Large institutional investors do not participate in these markets at all. Yet persistent inefficiencies and dislocations in commodities structurally, regionally or in terms of liquidity or volatility, can make for attractive sharpe ratios.
Alpha products (Risk Premia products) are created on this premise and allow for systematic (non-discretionary) trading rules. There are also specialist funds focused on Discretionary execution of arbitrage trading in specific markets (e.g. Chinese base metals or East-West fuel oil arbitrage).
Be it discretionary or rule-based, products should fulfill a specific portfolio purpose – e.g. as a volatility overlay or tactical addition – and exhibit a sharpe ratio around 1.3-1.5.
