Energy Transition and Commodities: Alternative approaches to capturing alpha
Two alternative approaches to capturing alpha
As we shift into a new era of heightened macro uncertainty and market volatility, long-short strategies that target uncorrelated returns provide an increasingly important and differentiated risk-return profile in investor portfolios. We look at two funds from award-winning UCITS platform Lumyna that seek to deliver alpha by focusing on opportunities in the energy transition and commodities markets.
I. ENERGY TRANSITION
A long/short approach to investing in a new technology revolution
The Lumyna – Proxy P Energy Transition UCITS Fund reached its one-year anniversary in April. In this article we explain why a long-short approach to investing in renewables may be particularly favourable in the face of higher market volatility
"We believe that the energy transition is a technology revolution, and we believe that we are at the beginning of a disruptive change"
by Dan Lindström
Co-Founder and CIO at Proxy P.
A disruptive change
We believe that the energy transition is a technology revolution, and that we are at the beginning of a disruptive change. Our thematic investment approach focuses on supporting companies around the world that are trying to move our economy away from traditional fossil fuels into renewable energies. This is a megatrend where the share of renewable electricity generation has to rise from 26% currently to 57% by 2030 and 86% by 20501.
At Proxy P., we look for both winners and laggards in the energy transition and play this with a long-short approach that aims to benefit from the tailwinds and withstand some of the volatility associated with this change. We believe the current market outlook for higher volatility, wider stock dispersion, increased macro uncertainty and higher interest rates should create a favourable environment for alternatives.
The investment team at Proxy P. has worked together since 2009 and we have backgrounds ranging from hedge funds to physical commodity trading to equity derivative expertise – all with a focus on energy. Over the first year of the fund we manage, performance has proved to be quite lowly correlated to general markets and we’re pleased to say the portfolio was able to deliver strong convexity despite the good performance from the energy sector as a whole over 2022. Although the sector then falling around 50% since February 2023, the fund has still delivered positive returns over time2 , with a long bias.
Capturing and mitigating energy volatility
Our investment process combines classic bottom-up analysis with top-down drivers. As an Article 9 fund under SFDR classification, ESG is fully integrated into the risk management, investment process and firm culture at Proxy P3. On the long side, we look for cash flow positive companies that have an identifiable edge in a space that is currently cash flow positive and to back those companies as they grow. Meanwhile, on the short-side, we look for laggard companies that may be in the right space but are not really exploiting the opportunity as well as they could; or we look for companies that may lose out in the move to sustainable energy.
The energy transition is a directional opportunity with strong tailwinds from regulatory and consumer support, but it’s also worth remembering it involves technological disruption, with hard-to-price information. So we are on a volatile ride with an upward trajectory. As an investors, we aim to manage that volatility, either with individual shorts or with hedges to manage general sector risk. In a volatile year like 2022, the short book was a strong contributor of returns given the wide levels of dispersion in the energy sector, and year to date around half of the fund’s returns are from the shorts.
Positive renewables momentum but hedging recession risk
Looking ahead, we remain optimistic about the greater affordability of renewables technology, and ever-increasing disruption and momentum. Given the current uncertain market outlook where the threat of recession looms large, we are holding a high degree of protection in the portfolio. We use a variety of tools to hedge the growth book, including broader market put options which are tailored to hedge large tail risk events and a high beta sector basket which is designed to protect the growth book from a direct linear perspective4.
Download the factsheet for more information on the strategy
II. COMMODITY ALPHA
Aiming to capture a persistent structural alpha
Theis a market neutral, total return commodities strategy. In this article we explain why the fund may present an attractive option for investors looking for a risk-return profile that is truly uncorrelated to wider markets.
"…performance is largely driven by physical, not financial, market sources
by Paul Holmes
Head of Distribution at Lumyna
Structural alpha comes from storage arbitrage and market flows
Pandemic supply chain chaos, war in Ukraine – there is no doubt that the last few years have seen wild swings in commodity markets. Despite the volatility, the physical, essential nature of commodities make them an investment mainstay.
However, as an investment that is typically accessed via traded futures contracts, the associated costs can make it incredibly easy to see performance eroded. The main driver of these “costs” is associated with storage; a feature that is unique to commodity markets, and is generally highest in the front end of the curve (e.g. comparatively, renting gas storage next month is more expensive than in 3 months’ time). Cost of storage and consequently the shape of the forward futures curve correlate closely over time to the availability of storage capacity. On average, the harder it is to store a commodity, the larger its carry cost tend to be – for example, natural gas being one of the most expensive to store, and base metals being the least.
Furthermore, consumers and producers have a different planning horizons and therefore engage in trades on different parts of the forward curve:
Producers generally sell the back end of the curve (planning long term over the lifetime of a drilling well, metal mine, etc.)
Consumers concentrate buying in the first few contracts (mostly planning for the next one to two fiscal years)
Investor flows into commodity indices have historically provided systematic pressure on front-end carry buying the second and selling the first contract as benchmarks and index based ETFs typically roll same contracts on the same days.
A non-directional opportunity, uncorrelated to wider markets
This structural market inefficiency is at the core of the Lumyna – BOFA MLCX Commodity Alpha UCITS Fund, which has a unique approach to exploiting the inefficiencies inherent to commodity markets in a completely non-directional fashion.
The fund does this by taking advantage of the efficiency gains offered by commodity markets by entering a relative value trade on commodity indices, whose compositions and weightings are similar but whose rolling methodologies are different. Market neutrality and premia capture is achieved by buying the “more efficient” proprietary index and selling the “less efficient” BCOM index.
Simply put, the more efficient index rolls further out, reducing the cost of carry. The efficient index – created by the Commodity Solutions team at Bank of America Merrill Lynch in 2007 – rolls systematically every month from the third into the fourth contract, significantly lowering carry costs on a historical basis when compared to the benchmark Index.
The strategy’s track record dates back to 2007 and the UCITS fund has been live since September 2010. Since inception, the fund has delivered an attractive level of return with no discernible correlation to broad hedge funds, equities and bonds, and has been negatively correlated to commodities. Drawdown periods have been relatively short, and approximately two-thirds of monthly returns have been positive.
The core reason we believe this strategy has been able to deliver consistent returns over a long period of time is because its performance is largely driven by physical, not financial, market sources5. The significant gap in notional investment between physical and financial market players (with physical being far larger) has decreased the opportunity for financial investors to arbitrage inefficiencies in the markets and allowed the risk premium to exist. In a new investment era characterised by high levels of uncertainty and volatility, we believe the fund may offer a valuable alternative source of alpha generation.
Download the factsheet for more information on the strategy
The Lumyna – Proxy P Energy Transition UCITS Fund is managed by Proxy P, a Stockholm-based global equity long-short manager.
The Lumyna – BOFA MLCX Commodity Alpha UCITS Fund is managed by Lumyna and accesses a strategy developed by and run by the Commodity Solutions team at Bank of America Merrill Lynch Securities.
Both funds are available through the Lumyna platform, one of the largest alternative UCITS providers in Europe and part of the Generali Investments ecosystem of asset management firms. Lumyna select best-of-breed hedge fund managers to bring investment opportunities to the European market via regulated, liquid and transparent UCITS vehicles.
1 Source: IRENA https://www.irena.org/-/media/Files/IRENA/Agency/Publication/2020/Apr/IRENA_GRO_Summary_2020. pdf?a=en&hash=1F18E445B56228AF8C4893CAEF147ED0163A0E47
2 Past performance does not predict future returns.
3 The Fund has sustainable investment as its objective as per Article 9 of Regulation (EU) 2019/2088 on sustainability related disclosures in the financial services sector (“SFDR”).
4 There is no guarantee that an investment objective will be achieved or that a return on capital will be obtained. The Fund does not benefit from any guarantee to protect the capital. Past performance does not predict future returns. 5 This Fund is not a guaranteed product. Investments bear risks. You may not recover all of your initial investment. Investment may lead to a financial loss as no guarantee on the capital is in place
This marketing communication is related to Lumyna Funds, an open-ended investment company with variable capital (SICAV) under Luxembourg law of 17 December 2010, qualifying as an undertaking for collective investment in transferable securities (UCITS) and its Sub-Funds “Proxy P Energy Transition UCITS Fund” and “BOFA MLCX Commodity Alpha UCITS Fund” altogether referred to as “the Fund”.
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