FUNDVIEW-Merricks Capital: commodity profits without the stress

* Market distortions offer trading opportunities

* Credit squeeze creates cash-and-carry deals

* Owning the grain handler offers exposure to volume

By Bruce Hextall

SYDNEY, Sept 29 (Reuters) - Trading commodities can be a wild ride but Australia's Merricks Capital believes it can make money using old-fashioned arbitrage and some unconventional strategies based on volumes not prices.

The Melbourne-based fund manager, which targets a 15-20 percent annual return for investors, makes a lot of its profits from inefficiencies in the grains market, where it says prices on rival exchanges can move out of kilter for no fundamental reason.

"As a relative value commodity fund, we buy wheat where we think it is under-priced in one region and sell it where it is higher priced in another," Chief Investment Officer Adrian Redlich told Reuters in an interview.

Merricks runs several funds, including a soft commodities fund and a property fund that invests in farmland. The firm, set up in 2007, has around $135 million under management.

Redlich said index funds, passive investors hoping to mirror the performance of specific markets, create distortions by wagering billions of dollars in Chicago Board of Trade futures.

For example, Chicago wheat futures are based on lower-quality grain than the wheat underpinning Australian and Kansas futures contracts, yet the Chicago price can trade a premium to the other contracts for extended periods, simply because index funds prefer to invest through the highly liquid Chicago market.

The price differences create arbitrage opportunities.

"The dynamics of all this index money mean the relative values are so much better as there's all this silly money going into certain exchanges but not others," said Redlich.

To exploit the Chicago premium, arbitragers can sell long-dated Chicago futures and buy and hold physical Australian wheat. They then deliver the grain at contract expiry and buy back Chicago contracts to close out positions.

CASH AND CARRY

The fund manager also undertakes so-called cash-and-carry trades, which have become popular with mid-tier Asian food processors as they struggling to obtain credit.

The lack of credit means food processors cannot fund large inventories and are more eager to hedge through forward purchases instead. Rather than buy through a futures market, many instead buy through tailored, over-the-counter deals with funds like Merricks Capital, which stores grain and can sell it forward.

Merricks simply buys the grain and then agrees to sell it to a food processor at a fixed price at a future date, again ensuring that the deal more than covers the costs of storing it. "As part of their risk and capital management strategy they would much rather hold less but are willing to pay more to hedge out for six months or 12 months time," said Redlich.

Redlich's futures-market experience comes from his time at Chicago hedge fund manager Citadel Investment Group and, before that, at Merrill Lynch as a senior investment strategist.

Apart from arbitrage plays and cash-and-carry trades, Merricks also makes direct investments in agricultural firms that are exposed to commodity volumes rather than price.

It looks for companies that are more sensitive to changes in production than prices. Typically, these firms provide services to a commodities industry rather than produce the commodities themselves.

Redlich likes companies such as Australia's GrainCorp (GNC.AX), Australia's largest listed grain handler. As long as GrainCorp's trading volumes grow, it still stands to increase its profits despite any ups and downs in grain prices.

"You need to position yourself for reliant and consistent volume growth so that's why it makes sense to own a grain corporation," he said. (Editing by Mark Bendeich and Manash Goswami)