Liontamer’s new fund invests with the benefit of hindsight. In this article Liontamer Head of Investment Solutions, Janine Starks, explains how the fund was created.
Friday, October 20th 2006, 2:24PM
by Janine Starks
Liontamer’s new fund invests with the benefit of hindsight. In this article Liontamer Head of Investment Solutions, Janine Starks, explains how the fund was created.
When we enter the product development phase for a new capital protected fund, one of the most important questions we ask ourselves is this: “What features suit the current investment climate?”
Liontamer have led the way in the NZ market with two previous funds and it’s important that we continue to offer opportunities which are untapped by others. We felt it was important to take a fresh look at commodities and offer investors a fund positioned for the current climate.
On a recent product development trip to Europe, we analysed a wide variety of possible structures. We looked at momentum strategies, trends based strategies and even considered a particular CTA/hedge fund strategy. One very important sector discovery was that soft commodities were gaining attention due to their use in the bio-fuel sector (corn and sugar to ethanol) as well as substantial demand from emerging economies with rising wealth.
Our conclusion was that commodities markets are still being driven by very powerful macro economic factors. The fundamentals are still in place, but the returns from different sectors could be far more diverse. Our fund needed to take advantage of the outlook, but with added flexibility. If there is a retraction in a particular commodity sector, we want to limit our exposure to it.
Capital protection allows us to limit our risk to the overall asset class, but we also wanted to ensure one bad egg in a sector didn’t severely affect our returns.
Our desire was to re-engineer the fund’s returns, by over-weighting the winners and under-weighting the losers. One of the most powerful features we wanted to put in place was a commodities index that could completely drop the worst performing component (i.e. give a 0% weighting).
To accommodate this, we came up with the ‘rainbow’ feature, which is also referred to as ‘perfect hindsight’. The concept is very simple (another important consideration for investors). The taste-test is being able to explain it in one sentence.
Here's the short of it:
"To calculate an investor's return at maturity, we wait until we've seen the performance of the commodities and then allocate more money to the best performers and less or no money to the poorest performers."
Here's the extra bit of detail:
A chart tells the story (see below). There are 5 commodities in the basket and 5 fixed weightings. We have the luxury of allocating 30% to each of the top 3 performers, 10% to the 4th performer and we exclude the worst performer from the basket.
The rainbow feature gives investors a great deal of extra comfort. Take the market for oil as an example. Investors want the opportunity of oil exposure, but what if prices fall? If oil is the worst performer over the investment term, it will be given a 0% weighting at maturity. For other fund managers, that would be a very large call and likely to be a huge move from their benchmark. Without the benefit of hindsight, this would be outside their comfort zone.
5 commodities
+
5 rainbow weights
Oil
30% - best performer
Aluminium
30% - 2nd performer
Copper
30% - 3rd performer
Nickel
10% - 4th performer
Soft commodities*
0% - worst performer
*Soft commodities are represented by the Goldman Sachs Agriculture Index
How did the name rainbow come about?
Believe it or not, it's actually a term coined by investment bankers who trade in structured products. The name started as "perfect hindsight" and was renamed "rainbow". It's not often that we'll choose to use industry jargon, but in this case we liked it. The objective is to make investors' returns larger - hence a bigger pot of gold at the end of the rainbow.
So how do we do it?
It's the most asked question - how do you do it? It seems to defy logic that we can wait until we've seen the performance of a basket of commodities and apply the weightings with the benefit of hindsight.
Simple story: When explaining it on a very simple level to investors, it's easiest to point out that we're experts at "re-engineering" risks and returns. It's possible because our funds have a fixed term and a fixed pool of investors. This means financial instruments can be used to alter both the risks and returns.
Technical story: the mathematical models assess the cost of a rainbow by looking at how correlated prices have been in the past. A rainbow feature is cheaper to buy when commodity prices have been more correlated (in recent years, price trends have been similar). When we design new funds our view is forward looking. In fact, at banks such as Barclays, their own researchers believe commodity prices will 'de-couple' in the future. That's why we believe this is a smart strategy. We're buying a rainbow at a time when it's cheaper. But, if as expected, some sectors outperform others to a greater degree, the performance of the fund will be enhanced.
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