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Hedge Funds

Losses to trigger move to active commodity investments

LONDON (Reuters) - Disappointment with returns on widely used commodity indices and worries about higher losses because of a change in the structure of the market are expected to trigger a move to more actively managed strategies.

Institutions such as pension funds have typically used commodity indices such as the S&P GSCI .SPGSCI and Dow Jones AIG .DJAIG, which use nearby futures contracts.

Collapsing commodity prices have meant the two indices last year slumped 46 and 35 percent respectively.

“We suspect the recent sell off ... will encourage more investors to consider actively managed strategies that have the scope to profit from both rising and falling commodity prices,” Richard Cooper, a partner at consultants Mercer, said.

Active management could include hedge funds, which make directional trades using supply and demand analysis.

But a more viable alternative for pension funds -- many of which are restricted by their mandates on the amounts they can invest with hedge funds -- could be indices that look for value in contracts across the whole maturity spectrum.

“Traditional indices for investing in commodities are clearly broken,” Adam Robinson, director of commodities at U.S.-based fund manager Armored Wolf, said.

“Index investors want to express a medium- to long-term view in commodities and they are doing it using the shortest term contract ... It makes no sense.”

Analysts estimate money linked to the S&P GSCI and Dow Jones AIG at about $40 billion (27.85 billion pounds) and $20 billion respectively.

RETHINK

A major problem is the changed structure of the market.

As demand collapsed many commodities moved into contango, a discount for nearby futures contracts against longer dated contracts, compared with a premium for at least the first half of last year.

That means a negative roll yield -- receiving a lower price for selling a maturing contract than that paid for buying the next contract -- and larger losses to come.

“Traditional indices are going to have to rethink their approach,” Robinson said. “Enhanced indices could become much more popular this year.”

A Deutsche Bank index -- the DBLCI-Optimised Yield index -- launched to solve the problem of contango -- aims to maximise positive roll yield and minimise negative roll yield.

Other indices that use futures across the maturity curve include the JPMorgan Commodity Curve Index and UBS’s Constant Maturity Commodity Index.

“There is a move toward more active strategies ... Partly driven by deficiencies in returns,” Douglas Hepworth, director of research at Gresham Investment Management, said.

BROKEN PREMISE

Many pension funds have in recent years invested in commodities as a way to diversify because commodity returns have little or no relation to those earned on equities.

But that premise has broken down in the face of what is expected to be one of the worst global recessions in history.

Many investors also watching growing instability in the banking sector have turned to exchange traded commodity funds, particularly those backed by physical gold used as a hedge against financial uncertainty and inflation.

The rush to gold can be seen in holdings of the world’s largest exchange-traded fund, the SPDR Gold Trust, which hit a record high above 1,028 tonnes last week.

Barclays Capital estimates money invested in exchange traded commodity products (ETPs) rose to nearly $52 billion in January from nearly $41 billion at the beginning of last year.

“What we have been seeing over the last few months is a surge in inflows into energy ETPs and of course gold,” the bank said, adding that commodity-based medium-term notes had suffered because of contango and reduced liquidity.

“Issuance in January 2008 was $688 million, while in January 2009 it was $309 million, one of the lowest ever.”

Medium-term notes or structured products often use swaps, which buy and sell commodities now for different dates in the future. If a price rises the buyer gets the difference, if the price falls the buyer makes up the difference.

Liquidity in the commodity swap market has fallen because some providers have left the market. Worries about counterparty risk have also damaged new issuance.

Editing by Sue Thomas

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