Originally a family office with around £1 bn assets under management, at the end of May, Castlestone also launched its first UCITS III-compliant commodity fund: the Dublin-listed Aliquot Active Commodity Index (UCITS) Fund.
The fund will mirror the exposure provided by the Aliquot Commodity Fund, but will also offer the flexibility to change exposure to individual commodities.
Q: We spoke to Castlestone’s founder and managing principal Angus Murray and started by asking him what was the motivation behind setting up the commodity funds?
A: "In December 1996 I started Castlestone Management with the backing of a European family from Austria just outside Vienna. For the first five years we ran fund of funds and single manager hedge funds. Then at the start of 2001 we added two asset classes that hedged against inflation."
"There were three possible assets to hedge against inflation that we could have bought into: property, commodities, and art. Property was very interesting but it was being distorted by bank lending practices and gearing. With regard to commodities in it was easier to invest in gold and precious metals and energy than it was to add in wheat or live cattle or natural gas, but nevertheless they were real assets. We bought some direct physical metal – gold, silver and platinum – and we also bought some swap contracts over the GSCI and Dow Jones RG Commodity Indices.
"The other real asset we bought was art. Art is an irreplaceable unleveraged real asset. We bought nine pictures and three sculptures.
"In March 2002 we opened up a number of funds to allow our investors exposure to commodities. And since August 2005 we have been actively managing those portfolios and offered exposure to wheat, aluminium, crude oil, natural gas, aluminium, or to copper.
"We felt that it was much easier to control the level of risk inside the portfolios through active management via the use of options, stock losses, or weighting towards one commodity over another, than it was to just buy an overall swap contract. And remains the principal reason why we are still involved in commodities today."
Q: And moving forward to the recent fund launches?
A: "We had been running a broad, diversified portfolio called the Aliquot Commodity Fund since March 2002 that has been actively managed since August 2005. Prior to that date it was a passive holding of indices with risk management built around it."
"Given the significant increase in investor demand for agriculture based funds, and the hard closing of the Schroders Agriculture Fund, a number of our investors wanted us to use the same risk management systems and disciplined research-driven approach that we had been doing with commodities in general in a new fund.
"On 18 April 2008 we launched the Aliquot Agriculture Fund which includes agriculture, water, alternative energy and livestock. It is a long only unleveraged fund in terms of its exposure in dollars, euros and sterling. The fund’s assets had exceeded $100m by the end of May.
"We are currently in the launch period, which runs from being 31 May to 30 June, of the Aliquot Active Commodity Index UCIT Fund. It a fund that we have been working on since late last year, and it is designed to allow investors in the UK and Europe to buy into commodities in a meaningful way.
"One of the problems with many of the UCIT funds that are in the UK market at the moment is that they have been put together very simplistically. They tend to buy one or two commodity indices and that is all they do. There is no genuine ambition to have diversification or any attempt to limit or control the risk on the downside. UCIT law, under the European directives, allows quite comprehensive although complicated risk management systems inside the portfolios which enables the fund manager to limit the downside of the portfolios.
"The intention is to have a broad diversified holding to commodities using individual transferrable securities – and that is an exchange-traded fund or an exchange- traded commodity – and complement it by commodity indices. Rather than it being an indices-first fund, which is one way to get commodities exposure, or indices plus ETCs and ETFs - which is another - we have tried to give as much diversification and individual exposure to individual commodities.
"It is worth noting that you cannot buy an individual futures contract over a commodity under UCIT law. You have to buy an ETF or an ETC. There are a set of laws that limit the investor with regard to that in terms of diversification. We have signed up with a number of counterparties with a number of products that we have had approved by the Irish regulator. We believe that is the principal way to get the maximum exposure to commodity indices. That gives better diversification. It gives better targeting of individual commodities and better risk control and is therefore much better for investors."
Q: Why do you think other companies haven’t been doing what you are doing?
A: "I believe that there will be plenty of them soon. In the past the demand has not been there from the retail investor in the same meaningful way that exists today. Even institutions such as fund of funds, for example, have not had the demand from their clients to buy these types of products. So they have taken a while to be developed."
"In order to gain the individual transferrable security exposure that we think is applicable for running a fund, instead of just getting exposure to industrial metals through the S&P, GCSI non-energy index, for example, we want to use the ETFs nickel contract, ETFs zinc, ETFs aluminium, ETFs copper or the IShares S&P Commodity Index.
"I believe that many other managers will be developing this type of fund. This is just a much more complex way of delivering to the clients what they want. Banque Paribas has recently released an agriculture exposure fund but they only bought one or two indexes. I can understand why they have taken a product and created a regulatory product around an index, but it’s not adding a lot of value for the client.
"We’ve waited until we’ve been able to add value to the client in terms of exposure and risk control and then we’ve released the product. This will be a daily traded Irish stock exchange listed product but it will be dollar, euro and sterling."
Angus Murray, founder and managing principal, Castlestone Management
Q: Can you expand on your attitude to risk management?
A: "On the risk management side it has really been about a team working together to a set of disciplines that we have had in place since inception in 1996. To be granted a license by the Irish regulator there is an enormous amount of regulation and compliance that has to be done on a risk basis, particularly with regard to the daily value at risk reports."
"We take that a step further because we believe that it is important to look at the correlation risk between individual commodities or individual sectors. If for example energy and precious metals are becoming correlated to each other and their correlation has moved towards a 1 or a negative 1, then there is much more likely to be risks within a portfolio even if it includes a diversified number of commodities. We spend a lot of time looking at the correlation risk within the individual commodities and within the individual sectors compared to value at risk.
"The investment management is done by three individuals, myself, Leon Diamond and Matt Sena. Matt, who came from Goldman Sachs, is based both in Chicago and New York. He also writes our research reports for the individual commodities.
"We are a long only, unleveraged commodity fund, and are employed by our investors to give them exposure to commodities but as an investment manager we are trying to knock out as much risk as possible because we are paid a performance fee. If we lose money then we have to make that money back up before we are paid again.
"What we aim to do is limit the downside inside the portfolio and gain the upside. But we are employed to be long only so if commodities generally rise by 20% over the next year we will generally rise by that much. The only time we can really get a chance to see whether our risk management is working is during a period of a drawdown.
"The last time we saw a substantial drawdown period was August 2006 through to December 2006. This is the track record of the Aliquot Commodity Fund which is a British Virgin Islands actively managed fund. It has more flexibility than a UCITs fund. It is allowed individual futures exposures to individual commodities, whereas a UCITs fund is only allowed transferrable securities, ETFs, ETCs and commodity indices.
"During the period from August to December 2006 we lost 3% of the value of our total portfolio, but during that period the GSCI declined by around 30%. That was just using option strategies and knocking out the risk in the portfolio. We showed that during a drawdown we were able to use our expertise in the risk management systems that we have in our portfolios to limit investors’ downside."
Q: So if there is a shift away from commodities generally that is that what you would expect to happen?
A: "We would hope that generally given what has happened in the past that our risk management systems should be able to limit the downside. We can’t make money when it goes down. That is not what we are programmed to do but if we can limit the downside then we should be able to substantially improve returns for investors."
"I am assuming that commodities will have one of the best months and one of the worst months sometime this year.
"Looking at the individual commodities and starting off with energy, I remember when Goldman Sachs published their first report and stated that crude oil would go to $105 a barrel, and most people thought they were exaggerating. Well, it did.
"I’m not necessarily saying just because Goldman Sachs say something is going to happen that it will, but Goldman Sachs recently published a report saying for fundamental supply reasons that crude oil could hit $150 - $200 a barrel sometime over the next six to twenty four months. I certainly think that is feasible. That price rise is being based on fundamental supply and demand.
"Turning to agriculture; prices have some way to go before they peak. If we go back to the end of the Second World War the population grew and people started to get wealthier. They consumed more food because the population was growing and diets improved but at the time there was not a lot of new seed technology. There wasn’t a lot of available arable land. As prices rose throughout that period it took a while for the new seed technology to be developed. Humans being pretty productive it was of course. They brought on new farmland, developed seed technology, better irrigation systems, better fertilisers and they started to produce more than was demanded and prices began to fall.
"The situation today is that because prices have been so low for such a long time there has been no new seed technology developed. There is not a lot of available arable land to be turned into productive land today. It is a bit politically insensitive to burn down another rain forest or plough up a national park but it will catch up and seed technology will improve.
"Along with the ever increasing world population the consumption of meat per capita is rising as diets improve. The number of calories that are taken from higher quality and more diversified grains are improving. In addition there has been a huge demand for biofuels and ethanol – which is sugar and corn - and alternative energies and it is unlikely to end soon. We will eventually get more productive land and better seed technology and Europeans will eventually accept genetically modified crops because they are good for productivity. Demand will remain constant, supply will increase and prices will come back down again but that could be a number of years away.
"Industrial metals are naturally linked to supply and demand which is directly linked to the economy, copper in particular. Nickel has come down from highs of around $54,000 a tonne last year down to under $25,000 a tonne today. That is because of its use in production of steel and slightly lower levels of demand. By cutting interest rates from 5.25% to 2% the US Federal Reserve has begun to improve the economic outlook of the US. It will go through a natural slowdown, which is a healthy thing. After a slowdown you get a bit of an improvement – and you only need to see a shift from 0% growth to 2% growth and a number of these industrial metals (where this is very little stockpiles) will see price rises. We’ll see a pickup in demand and prices could easily be 20 – 40% higher over the next twelve months.
"To summarise: with regard to energy I still feel that the outlook – although it may have a bit more volatility in it – is pretty favourable. Agriculture, I think, is a long term trend. There is nothing particularly complicated about it – it is in a long term up trend. You will continue to see volatility in individual commodities but the trend is going to be positive.
"With regard to industrial metals, when economic growth comes through because they are directly related to economic growth there will be an improvement. Precious metals I think are predominantly the hedge against inflation and G8 political risk. The case of platinum illustrates what happens whenever there is a supply disruption with prices rising 40% following supply disruptions in South Africa associated with electricity. That just shows you how sensitive these commodities in general are to any supply disruption.
"Livestock is a little difficult. There are probably too many animals alive in America at the moment. We need to allow life cattle prices to increase. The farmers are destocking and when they complete that process – and it takes a while to restock – the farms will get much more pricing power back in their hands. We know that the cost of labour, production, insurance, transport and refrigeration has all gone up. At some point in time that pricing power will shift when the farmers destock and life cattle will look much more interesting.
"Over the next twelve to eighteen months we are going to be favouring increasing our weightings towards livestock and industrial metals, which being inside a UCITS fund and given the flexibility of the instruments we are able to use, means that we will be able to achieve much better than buying a one-off or one or two indices.
"We have already seen a substantial interest in the UK for a UCITs based product because of the active management and diversification. It also helps that we are a manager that has been business since 1996 and have proven to be able to knock out risk on the downside. There are not a lot of alternatives if people want to invest in these types of products. When we open on June 30 I imagine that the compliance departments of our investors alone will be very happy to invest in a fully compliant product."
Q: Have you any fund growth predictions?
A: "From the initial conversations we have had with people we have already been allocated $180m, but I imagine that will grow as our clients gets to see the documents and the presentations behind the marketing, and see the flexibility we have over other products."
"We are also acutely aware there will be a substantial number of other products like this coming on to the marketplace, but given the stringency of the regulations it still may take them a further eighteen months to come fully on board. It is an expensive process to go through to set up the risk management process, and get the right personnel in place. It is not so easy. You have to understand UCIT law, you have to have a compliance officer that feels comfortable with that, and put the trading systems and risk management in place.
"We have been doing this for the last twelve months. We have invested heavily to make sure that we were in a position to make sure that we ran the fund properly for our clients. We’ve taken on two more analysts, and have developed our compliance side. We became fully regulated with the Irish regulator. We’ve had to take on six more people in our back office to make sure that they can process trade conciliation and operate the cash management systems. All of that needed to be done before we could even contemplate opening this fund. But we needed to do it primarily in a way that was flexible enough to offer our investors something that was pretty unique; that is the flexibility to own ETFs and ETCs in a meaningful way inside the portfolio and not just rely on commodity indices."