How “explosive” energy prices are fuelling a quant hedge fund surge
The “explosive” upward price movements in energy markets are helping power performance among machine-based hedge funds this year, as CTAs and trend-following strategies successfully lock onto strong price signals.
The rally in energy prices have proven one of this year’s most reliable and enduring trends, according to David Gorton, founder and chief investment officer, DG Partners.
Gorton noted that the energy “complex” of oil and gas has rapidly closed the gap on other commodity sectors this year – having earlier lagged them in 2020 - as economic reopening and increasing social mobility has bolstered demand. At the same time, supply-side factors have also come to a head as the green energy transition has struggled to fill the gap left by sustained underinvestment in more traditional fossil fuels, Gorton told Hedgeweek.
The price of Brent crude oil rose above USD81 on Monday - its highest level in two years - with the West Texas Intermediate benchmark hitting USD77, while natural gas futures reached USD5.9, a seven-and-a-half year high.
Trend-following hedge funds – as measured by Société Générale’s SG Trend Index, which tracks the daily net returns of a pool of 10 of the biggest trend-following managers – have scored a 10.2 per cent gain year-to-date on the back of the upward moves. The main SG CTA Index – a broader industry benchmark offering a daily performance snapshot of 20 of the largest CTAs – is up more than 7 per cent in 2021.
“Whilst energy markets have suffered several notable corrections this year, prices have consequently quickly recovered to new highs. As such, our models have been persistently long throughout the year,” Gorton said.
Gorton’s strategy comprises several models with differing characteristics which aim to take advantage of different market regimes, coupled with a series of risk modulators that dynamically allocate risk across sectors, which have persistently added exposure to the sector this year.
As a result, DG Partners’ models – which have been persistently long the commodity throughout 2021 – were also well-positioned to capture September’s energy price spike.
“The price action in natural gas has perhaps been the most explosive,” Gorton observed. “When markets become more volatile, and the price action less stable, the position-sizing algorithms endogenous to our models are designed to automatically reduce positions accordingly. In the case of natural gas, the rally reached such extreme proportions recently that our models began exiting their long exposure, quite aggressively in some cases.
“Nevertheless, with the longer-term trend still in-tact, we retain a core net long exposure heading into Q4. This perhaps illustrates the benefits of running several models with differing characteristics and reaction speeds.”
Meanwhile, Nicolas Gaussel, founding partner and CEO of Paris-based Metori Capital Management, said natural gas has been the best performing position in his strategy, both over the past month and year-to-date. Gaussel said recent energy upward moves had a positive impact on the fund, with the model considering the natural gas bet to be “the best risk adjusted/expected returns call” in the portfolio.
“The model is quite stable and remains long but not overexposed on energies, considering the high correlation across energy trends,” he said of Metori’s current positioning. “Since the end of July, our positioning has remained quite stable. The model has inner moderation principles which prevent it from over exposing to a trend and, hence, to a reversal.”
Jonathan Singh, discretionary manager at Fulcrum Asset Management in London, said further price moves can be expected up ahead, noting there is still “room for change” on both the supply and demand side.
“OPEC+ remain disciplined but may become less so as inventory continues to draw - we are now back to pre-pandemic levels for the first time - and if price levels remain high,” Singh told Hedgeweek.
“On the demand side, of course Covid mutations are a risk, but the recent rise in natural gas prices has brought into play questions around oil substitution for electricity generation this winter. Implied 1 million volatility in Brent is now back down to pre-pandemic levels, however, suggesting the market doesn’t see large volatility on the immediate horizon.”
He said CTAs’ positioning in crude is at post-pandemic highs, given the strong medium-term signal and low realised volatility. “Currently, with our momentum signal being at its maximum level since Q1, stronger upwards momentum in price will not in itself increase positioning. Instead, realised volatility will be the driver,” he said of the prospect of renewed volatility.
Pointing to the reactive nature of CTAs, Singh believes an increase in realised volatility will likely see long positions reduced, even if the momentum signal remains at the maximum level.
“But given signals in highly correlated markets are the pointing the same way, a broader energy sector significant price decline is a risk to current positioning.”
Looking ahead, Gorton said the interlinkages across commodity markets and the “often intense” energy required for their production may risk a further upward spiral across the broader commodity asset class.
Noting the impact of high energy prices in the UK on fertilizer production – and the attendant consequences for agriculture commodities and food supply – he said: “With governments unlikely to allow rising food prices to compromise their popularity with the electorate, in our view, and fiscal laxity having become more prevalent in the post-pandemic era, there is a risk that state intervention or subsidy prevents the necessary demand destruction to see prices normalise in the near term.”
He added: “As such, with supply bottlenecks likely to persist for some time, there may be further upside for commodity prices in the near-term, particularly as the post Delta-variant recovery continues and global economies run above potential.”