Family offices searching for high sea returns

The original “carrying trade” had nothing to do with going short yen and long Icelandic krona. It was, wrote economist Adam Smith, “purchasing goods in one foreign country in order to supply the consumption of another”. Given that 90 per cent of the world’s goods are transported by sea, surprisingly few investment funds focused on this real carry trade are open to outside investors. One trailblazer, Tufton Oceanic’s Oceanic Hedge fund, which has traded long-short shipping and oil services equities and some freight forward agreements (FFAs) since August 2002, recently closed to new money having reached $500m (?370m). November 2003 saw Castelia Partners launch its Castelia Straits fund, active in long-short shipping equities; and more recently its Castelia Springs fund for FFAs. And in May 2006 shipping broker H Clarkson & Co launched the Clarkson Shipping Hedge Fund, which also trades long-short equity and FFAs. “It’s a fairly small and distinguished band,” notes Steve Rodley, joint managing director with M2M Management. M2M’s fund, Global Maritime Investments, is part of that band, boasting one vital differentiator: half of its portfolio is made up from actual ships – currently 11 panamax vessels – hired for 1-3 years at a cost of $40,000-$50,000 per day. Once delivered, the fund pretty much has carte blanche for sub-letting or using them to transport cargo (shipping radioactive material or dynamite is not allowed, and visits to North Korea are out). An increasing number of players – including those shipping hedge funds, ship owners, commodity producers and investment banks looking for statistical arbitrage opportunities between energy and commodity derivatives and FFAs – source profits from just one or two sectors of the shipping market, maintaining the inefficiencies which sustain M2M’s truly market-neutral strategy. The fund steers clear of tankers, which is a more efficient market thanks to the predominance of the oil majors, and trades exclusively in dry bulk. Taking a cab “I’m sure they make good money, but in our world they are only trading one part of the market, and that creates opportunities for us,” says Mr Rodley. For one example among many, let’s consider the asset owners. A Greek ship owner profits by buying and selling ships: in the meantime he wants to generate yield by hiring them out for as long as possible. But a mining company moving cargo only wants a ship for a matter of months. “It’s like only having a car hire company available for someone who just wants a taxi,” observes Mr Rodley. “Maybe you can hire the car, charge someone else a taxi fair and cut yourself a margin.” Let’s say M2M offers to move six cargoes at $30/tonne on a particular route in 2008 for BHP Billiton. The risk premium comes from not knowing how much ships will cost to hire in 2008. That “long” exposure (i.e. ships) is hedged out with short exposure via FFAs, removing the shipping market beta and leaving the alpha spread between hiring a ship and transporting a cargo. FFAs are based on the average value of daily Baltic Exchange quotes for the costs of freight across four global routes. That means that to get a perfect hedge against your ‘longs’ you need a portfolio of ships that is completely diversified geographically – and that is generally the fund’s default position. But the fund sometimes concentrates to exploit a little geographical basis risk. At the beginning of this year the fund went ‘overweight’ with ships in the Middle East (while being ‘underweight’ in the Atlantic and Pacific). Why? In the first quarter of each year China’s steel industry negotiates one-year iron ore contracts with the major mining firms exporting from Australia and Brazil. This January those firms were looking to put up prices, so the Chinese feigned lower demand by spurning the Australian and Brazilian iron ore spot markets. “The fact is Chinese demand is strong – and we know it is,” explains Mr Rodley. “Now, the only other place you can realistically source iron ore is India, so we wanted to put on a position for that very small period of time before the monsoon season shuts down the Indian market, to reflect that there was going to be spike in demand for iron ore out of India relative to Australia-China and Brazil-China. “Our portfolio as a whole during that period had an equal number of ship ‘longs’ and paper shorts, but within that we had a concentration in the Middle East, and a little bit of calendar risk as well, short Q1 and long Q2. The big thing for us is that we are not gambling on whether ‘the shipping market’ is going up or down tomorrow or next week.” Although it is early to extrapolate from the fund’s dataset, risk manager Phil Drew observes that correlation with the Baltic Panamax Index has been just 8 per cent and negative against the CSFB Tremont Hedge Fund Index and major equity indices. The double layer of diversification should be of interest to investors, as should the barriers to entry to the strategy. With no two panamax ships being the same, knowing which is the most efficient vessel for a particular job requires specialist experience – so those investment banks have neither the skillsets nor the appetite to bundle in and arbitrage all the spreads away. Mr Rodley was manager of panamax freight operations for BHP Billiton, where he was allocated risk capital to “commoditise freight;” while M2M’s other joint managing director, Stuart Rae, traded freight derivatives with GMT Shipping and founded a freight trading company with a prominent Greek shipping concern. The fund has compounded 19.6 per cent since inception, which is 31 per cent annualised from 3.7 per cent volatility. The Sharpe ratio is currently 7.0. The target return is 15-20 per cent per annum from volatility of 7-8 per cent, with an estimated Sharpe ratio over three years at 2.5-3.0. Redemptions are quarterly with a six-month notice period, and there is a 25 per cent gate. Since launching with $10m in October 2006, the fund has attracted $84m from 16 funds of funds and family offices, and only one investor with a shipping connection. It is just beginning to see institutional interest from Scandinavia, the US and South Africa. Private banks have proved a little harder to crack: M2M has to explain its very esoteric strategy, starting with “the A-to-Z of shipping”, before the banks themselves can sell it. But there has been interest in the diversification benefits, and also the fund’s proven ability to smooth out some of the shipping sector’s inherent volatility – often from private banks which have had important clients independently asking them to examine the fund.

Rodley: it is a small and distinguished band