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Energy Hedge Fund Investors And The Growth Of Fund Of Funds

For the past year, the Energy Hedge Fund Center (www.energyhedgefunds.com) has researched energy-oriented hedge funds and, recently, we have detected the emergence of several funds of funds in the natural resources segment.

For the past year, the Energy Hedge Fund Center (www.energyhedgefunds.com) has researched energy-oriented hedge funds and, recently, we have detected the emergence of several funds of funds in the natural resources segment. This signals that energy and green hedge funds are now in vogue for investors.

We have found over 330 energy hedge funds, over 100 of which are commodity trading the energy complex. This year, many new commodity trading hedge funds are entering the sector in both North America and Europe. One obstacle, however, is the tremendous competition for senior and experienced energy trading talent by investment banks means there is too much mediocre talent available for trading energy commodities.

Why is that so? Because over the past dozen years, many companies unwound their hedge positions as energy prices were moderate, and fixed price deals could be offloaded to the fuel supplier to manage price risk. Today, good oil traders are hard to find. The only stalwarts in the energy trading complex have been multinational oil firm BP and investment banks Morgan Stanley and Goldman Sachs.

This leads us to the present situation where multibillions of dollars are piling into the energy trading complex. Some of the investors are funding poor business plans and mediocre trading talent. Fund of funds is another way to play the energy complex with less risk. The other option that is emerging is exemplified by the investment of Lehman Brothers in energy hedge fund Ospraie and Merrill Lynch into Pequot. Their high-net-worth and institutional clients are clamoring for more exposure to the energy complex since we are in the middle of the greatest natural resource bull market ever.

 

What's Been Going On Since Enron Went Down?

When Enron and the energy merchants collapsed in December 2001, many hedge funds investing in energy equities shorted the sector and moved on. After that, while the hedge funds had made money, they had little capacity to place it in the energy sector in 2003. In fact the August 14, 2003 Northeast Blackout only served to exacerbate that conundrum as there was plenty of capital available for investment but few energy investment ideas to pursue.

In late 2003 and early 2004 a handful of energy commodity hedge funds began to surface, initially trading crude oil and then migrating into other areas such as petroleum products and natural gas. By the end of last year, our research had discovered many new funds both in the US and Europe trading both commodities and equities and sometimes the arbitrage between both. A significant trend had also emerged in the form of green hedge funds, which trade sulphur dioxide, nitrogen oxides, renewable energy credits and carbon dioxide emissions.

 

What Is The Capacity Of Energy?

The increasingly volatile and higher priced energy markets for oil, gas and coal have brought new investors into the market. In our view, lower energy prices are not coming back and there will be no mean-price reversion in energy markets. We expect to see continued higher prices for energy commodities despite recent price drops from previous highs. However, the issue for investors will become one of capacity. Just how many new hedge funds can realistically come into this sector?

Energy is only a USD2 trillion financial market in notional value according to Global Change Associates' estimates, compared to the greater than USD200 trillion notional value of the more mature foreign exchange and interest rate derivatives markets. The physical energy markets are over USD4 trillion and growing. The second question is how well will all these new funds perform? Funds of funds solve some of those issues as they find the winners among all the noise.

 

Funds Of Funds

The fund of funds approach has been extremely popular in the hedge fund industry and provides a number of potentially significant benefits for investors that include:

* Providing investors with access to a professionally managed and diversified portfolio of hedge funds;

* Reducing individual fund and manager risk;

* Outsourcing the due diligence and monitoring of multiple hedge funds to a single manager;

* Providing easier administration of diversified investments across a large variety of hedge funds;

* Providing exposure to hedge funds that otherwise may be unavailable as a result of high minimum investment requirements;

* Obtaining access to a wide variety of hedge fund strategies for a modest investment.

A fund of funds manager will usually be looking for a portfolio of relatively uncorrelated hedge funds to invest in and, as such, performs the necessary fund monitoring and constant due diligence of funds on behalf of the investor. It is this latter point that causes difficulties for funds of funds that desire access to the relatively high returns being obtained by energy hedge funds. The issue is that many energy hedge funds have little track record and very few have more than a 12-month track record by which to gauge the fund's success. As a result, the fund of funds manager will need to take a view on the individual fund manager and style that is not necessarily supported by historical success.

Fund of funds are also often a popular vehicle for institutional investors as a result of its more stable and supposedly lower risk approach. From our meetings with both investors and hedge fund managers, the vast majority of energy specialist funds currently being launched are backed by private or family investor money. The emergence of funds of funds in energy would also suggest more institutional money is now finding its way into the sector, or at least looking to invest in it.

 

The Emergence Of Natural Resources Funds Of Funds

We have observed this new trend both directly from hedge fund announcements and indirectly from interest created by our energyhedgefunds.com website and speaking engagements. In the latter case, during 2005, we have seen a large number of inquisitive fund of funds professionals and investors looking for information on the state of energy hedge funds. In the former case, in the last two months, the number of fund of funds reported in the Energy Hedge Fund Directory has tripled from less than 5 to around 15. Their strategies are diverse, and include managed futures, commodity-focused fund of funds, energy and more general fund of funds that have diversified in to a small number of energy hedge funds trading natural gas, crude oil and other commodities. Some are interested in the immature green trading space but it appears that the business model here is also changing.

The emergence of broader based natural resources fund of funds represents a significant maturation point in the rush to energy. It brings institutional money as well as more conservative investors looking to benefit from the upsurge in energy prices and interest in everything energy and/or environment-linked.

The issue for fund of funds managers remains the relative youth and immaturity of the hedge funds focused on the energy industry and their lack of a track record except for a handful of funds who got in early. On the other hand, there are a small number of energy specialist funds with greater than 12-months and highly positive track records, as well as a larger number of more established macro or broader-based hedge funds that have exposed more of their assets under management to energy for them to choose between. In the longer term, the rush to invest in energy both through traditional investments and via the alternative universe begs the question about capacity mentioned above. How much money can come into the sector and still deliver a better than average return? While the answer to that question may not become apparent for a while, it is readily apparent that natural resources funds of funds will be a winner for more conservative investors wishing to diversify their investments into the extremely volatile energy complex. Expect more funds to enter the space this year and next.

This week's Learning Curve was written by Peter Fusaro, chairman, Global Change Associatesand Dr Gary Vasey, vice president, UtiliPoint International who formed the Energy Hedge Fund Centrein November.

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