Bloodied but unbowed, hedge fund Merchant Commodity trudges on

Fri Jul 13, 2012 2:51am IST

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* Fund fights to stay in game after fresh losses in May and June

* Only "hindsight" will tell if plan to defend capital will work

By Barani Krishnan

July 12 (Reuters) - Unlike some of his peers, Michael Coleman is not throwing in the towel after a bruising 18 months during which his Merchant Commodity Fund lost two-thirds of its capital.

But after recently hitting another bad patch of volatile oil, grain and soft commodity prices, the veteran trader and co-founder of Merchant doesn't know how long investors will keep him in the ring.

"We're not thinking about closing shop," said Coleman, who gave up his trading role to focus full-time on managing risk at the start of the year. The challenge now: Halting the investor exodus that partly shrunk the Singapore-based fund from $1.5 billion at the start of 2011 to less than $500 million now.

The former Cargill trader is frank about whether it will work: "We'll only know with hindsight," he said in a telephone interview from the Singapore office of Aisling Analytics, the holding company for Merchant, which he founded eight years ago with ex-Cargill colleague Doug King.

Simply staying in the game is in some way an accomplishment. Two big commodity funds in London, BlueGold and Fortress, closed earlier this year after impatient investors pulled out. Natural gas trading legend John Arnold, in Houston, called it quits after struggling to break even.

The year got off to a promising start for Merchant.

After a 4 percent loss in January, the trading team led by London-based King produced three straight gains in range-bound markets, taking returns to a positive 11 percent through April.

Then came May's brutal sell-off across markets, which pulled the Thomson Reuters-Jefferies CRB index for commodities down 11 percent that month alone. June was also tricky, with prices mostly sliding before a violent snap back in the final trading session pushed the CRB up 4 percent for the month.

"June was not so much a game of two halves, but rather 85 minutes versus 5 minutes," Coleman told investors in a letter, using a soccer analogy.

Merchant, which trades in energy, agricultural and soft commodities, slipped back into the red after losing 15 percent for May and June combined. It is down 5 percent for the year now, the letter to investors shows.

According to Chicago-based Hedge Fund Research, commodity hedge funds, on average, were down nearly 1 percent through May. HFR data for June is not available yet.

ENDEMIC CHALLENGE

Coleman, the son of an English plumber who joined Cargill right out of Oxford University in 1982, and King, a fellow Briton who used to trade petroleum for Cargill, had built their reputation as commodity managers over the years.

One of the sector's earlier commodity-specific hedge funds and one of the few based in Asia, Merchant ran up a strong record initially: Launched with just $10 million in June 2004, it posted a near 50 percent gain in 2006 and was managing upward of $2.5 billion by early 2008. It continued its impressive run through the financial crisis, returning 24 percent in 2008, 5 percent in 2009 and 28 percent in 2010.

Its winning streak ended last year. It began the year with about $1.5 billion but lost about a third of that after wrong bets on commodities such as sugar and vegetable oils.

Investor redemptions then took another half a billion dollars out of the fund.

"We've never tried to convince anyone not to take their money out," Coleman said.

"But we do ask people whether they are redeeming because of us or the world," he said. Lately, he said, the answer seems to be the latter.

Redemptions, which that have slowed to $50 million since January, are "not particularly a function of our performance but rather a function of investors themselves cutting back on risk, like European fund-of-funds that may be under pressure," he said.

Merchant's dismal showing, and Coleman's new role as risk manager, were first reported by Bloomberg in February.

Other funds hit by redemptions have bowed out.

BlueGold, run by former star oil trader Pierre Andurand of Vitol, lost 35 percent last year after posting an annual gain of 200 percent at one time. It liquidated with less than $1 billion in April, after managing $2 billion previously.

Fortress Commodities, part of U.S. based Fortress Investments Group, lost nearly 13 percent through April and closed with less than $500 million, compared with its $1 billion capital at the start of the year.

RISK CHALLENGE

For their turnaround strategy, King and Coleman, with the help of an external risk consultant, split up the different commodity sectors and assigned risk levels on a daily basis for the five-man trading team at Merchant. They also formed a contingency plan for outsized market moves.

Merchant's value-at-risk (VAR), an industry measure for the maximum assets a trader is willing to risk in a day, has fallen from a peak 3.9 percent in November 2010 to below 2 percent now.

Coleman said it was still early to conclude if the strategy was correct.

But he and King like the fact that volatility in the fund's weekly returns has dropped since they began defending capital more aggressively. Before May, win rates also improved to six out of every 10, versus just four at the end of last year.

Coleman said his own analysis of 2011 showed the fund was not quick enough to shed risk in the mid-May to mid-June period -- when the CRB fell between 3 percent and 6 percent -- and again in July to September -- when markets were basically moving sideways.

"With hindsight and reflecting on what happened, we should have worked a lot, lot harder to constrain the downside of the fund to no more than something in the 20-25 percent range."

"We're probably going to have a bit of the same issue over July to August this year: Should we be thinking very defensively or should we be focused on upside opportunity?"

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