- In the age of Open AI, investing depends more than ever on automation and algorithms.
- With sophisticated quantitative models at its core, quantitative investment strategies (QIS), sometimes called factor investing, use machine learning to analyze factors such as value, momentum, volatility and liquidity and systematically incorporate them into a predetermined investment process.
- London-based Macquarie Group Managing Directors Maia Mathieson and Faheem Osman talk about the growth of QIS operations at their organization and why it’s a particularly attractive investment methodology in the commodities space.
The great fictional detective Sherlock Holmes once said: “It is a capital mistake to theorize before one has data.”
With apologies to Sir Arthur Conan Doyle, Maia Mathieson and Faheem Osman, both Managing Directors at Macquarie Group in London, have never made uninformed investment decisions. But now, as they lead quantitative investment strategies (QIS) operations at Macquarie, they can micromanage risk in more sophisticated ways than ever.
QIS relies on data-driven methodology, utilizing systematic analysis of historical and real-time data to identify patterns and trends. With statistical models and algorithms, QIS aim to quantify and mitigate risks associated with various market conditions, asset classes and economic factors. Investors can execute trades based on predefined rules and criteria, minimizing emotional biases and human intervention.
Though the QIS team at Macquarie is one unit, it includes specialists in a number of different asset classes, says Maia. But the team values “cross-pollination of ideas” because “something that works in commodities might be an interesting idea to explore in equities and vice versa, so it’s a great place to be in terms of covering all of the asset classes,” she adds.
However, commodities are “a lucrative avenue for extracting risk premia,” so they’re a significant portion of QIS activities.
“We’ve observed a growing preference among investors to incorporate commodities into their risk premia portfolios due to their unique properties,” Maia says.
We’re always up for a deep dive into commodities trading at Top Traders Unplugged, so we were pleased to welcome Maia and Farheem, who joined host Moritz Seibert for an installment of our new Open Interest series to talk about Macquarie Bank’s growing QIS business and how rules-based indices can help investors employ various risk premium strategies across asset classes.
Read on for highlights from their discussion of how commodity-focused strategies like curve carry and congestion work — and why.
The “it” factor (it is $)
Faheem says factor investing has a longstanding history, but more recently, there’s been a notable uptick in investors turning to QIS for its benefits, specifically its ability to facilitate diversification.
Macquarie has seen between 10% to 15% in the past 12 to 18 months (the exact numbers are challenging to ascertain due to the embedded leverage in QIS strategies). But he estimates the total assets under management (AUM) across Macquarie’s QIS operations to be at least $1 trillion, encompassing both long-only and long-short strategies. Commodities alone account for about $60 to $70 billion.
“We find that really people like to include commodities where they can in a risk premia portfolio,” Maia says.
What are the most popular risk premia (or return drivers) at the firm?
Before she talks about that, Maia explains that in commodities at Macquarie, “carry” means either curve carry — taking positions on various points along the curve and extracting value by the relative real yield — or vol carry, systematically selling volatility and capturing the difference between implied and realized.
Maia tells us that strategies take several forms as well: “relative value” strategies driven by value between commodities; curve-shaped backwardation-driven strategies; trend following (a perennial favorite among commodities investors); off-benchmark commodities, which are increasingly popular due to recent strong returns; and congestion strategies (“driven more by index flow and investor flow,” she notes).
Commodities, carry and congestion
No matter which one is in play, commodity strategies are typically driven by fundamental physical features of the commodity markets. That’s what makes them “quite robust and quite high capacity, even compared to other bigger asset classes like equities and FX,” says Maia.
The exceptions to those structural strategies are market congestion strategies, which focus on one-sided flow during certain days or periods during a given month or months — large commodity indices, for instance. By providing liquidity to these flows, investors can earn a liquidity (or congestion) premium.
Carry is driven by fundamental factors in the commodity markets that don’t depend on flows, such as the cost of storing commodities.
“What we mean by that is when you look at a commodities futures curve — not recently, but typically over the long term — those futures curve trade in contango,” Maia explains. “So, the front month contracts are cheaper than the further dated contracts. And the difference in price, between each month, tends to be biggest at the front of the curve.”
That’s because commodities are physical items that must be stored, insured and financed. If a commodity will be delivered in six months’ time, investors must factor in the cost of all three. Some commodities have high storage costs, due to their inherent nature (like natural gas, which is highly flammable). Another factor in this calculus is that the longer one stores a commodity, the lower the cost. For example, storing something for one month is typically more expensive than storing it for six months or a year.
Lean hogs are another great example of carry in the commodities space. They’re live animals that need specialized care and take up quite a lot of space relative to their value, so “we see steep contangos at the front of those curves that then even out,” Maia says.
Macquarie’s carry strategies usually are short on the front part of the curve (capturing that negative carry) and then long on the further dated portion of the curve with smaller carry.
“You’re paying a smaller cost of carry than you’re receiving, and that differential is the carry return,” Maia explains.
Short spread strategy and the seasons
Moritz wonders what’s usually on the other side of these trades — like, is there a way to hedge those hogs?
“If you’re short at the front and long at the back, would you say there is a market participant out there that is very motivated and willing to take the other side of that trade and essentially be long on the spread as opposed to short?” he asks.
Faheem tells us that producers and consumers who hedge production and consumption provide a lot of liquidity in commodity markets. Producers might sell forward a different part of the curve to lock in a potential gain, for example. But different commodities feature different flows along their curves, and those producers and consumers buy or sell accordingly.
However, investing (and life itself) is rarely perfect. Moritz asks the experts to talk about any scenarios in which the strategies they’ve discussed stop working or produce losses.
The standard implementation of curve carry is to short a calendar spread (short the front and long the back). Faheem says drawdowns can happen when a substantial spike hits the front end of the curve — for instance, “imagine being short a specific contract, and due to a supply or demand imbalance, the front end experiences a significant rally,” he explains.
A good example is the polar vortex of November 2018, when prolonged record-low temperatures in the U.S. pushed demand for natural gas through the roof.
“That is typically when a short spread strategy may undergo some drawdown,” Faheem says.
That’s why he recommends thinking about managing or controlling risk when establishing calendar spreads. Even without extreme weather events, summer and winter contracts behave differently, so investors should adjust their spreads to avoid crossing the two seasons.
‘Non-standard’ opportunities are good for the planet
Earlier in their conversation, Maia mentioned an increased interest from clients in “non-standard commodity markets.” Before their talk wraps up, Moritz asks her to elaborate.
“The main area in terms of risk premia where we see people incorporating [non-standard] commodities is the trend space,” she replies.
When following trend strategies, the larger the number of assets you bet on, the better your return profile can look, Maia explains.
“We see a huge demand from clients running trend strategies or buying our own trend strategies to incorporate … commodities like [Dutch TTF Natural Gas Futures] and UK gas.”
Macquarie has seen “extremely strong trends over the past year” in those areas, she adds.
Other clients find non-standard commodities useful when looking to hedge inflation.
“Taking exposure to the commodities driving that specific inflation in [a given] region can be very helpful,” Maia says, adding that from an environmental, social and governance (ESG) perspective, carbon mitigation and other sustainability-focused investments are gaining traction. Increasingly, she sees clients looking at UK emissions contracts, EU emissions contracts and even some New Zealand contracts as part of ESG-linked portfolios. She has also observed an uptick in commodities that will be “used more and more in the energy transition” like lithium, cobalt and other battery-related commodities.
“It’s quite broad and I would say it’s definitely an area that we’re quite excited about growing,” she says of the non-standard space. “Some of the commodities still … [have] liquidity [that] is relatively low, but the pace of change and the growth in liquidity is quite high. The opportunities in the coming two to three years are very interesting.” As always, we at Top Traders will be watching that with keen eyes. So, reader: Watch this space.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.