Untitled Document
Untitled Document

A safer bet

Louis Caron, RiskAdvisory, a division of SAS, Calgary

Energy hedge funds have a very particular set of technology needs when it comes to trading and risk management. A larger risk appetite, and the potential for exponentially larger yield, is a key to attracting sophisticated investors for these aggressively managed investment vehicles. Because they take such an aggressive stance toward the market, hedge funds can reap major benefits from information technology that enables them to measure and monitor market movements and their own position accurately — and quickly. That's especially true in the fast-moving world of energy commodities.

Recall the energy commodities run-up of 2008. The activities of energy hedge funds stoked controversy on Capitol Hill about the role of so-called "speculators." Arguably, the popularity of energy futures as an investment does add a premium to their price beyond fundamentals. The argument in Congress, of course, is how big a premium.

We'd say hedge funds add stability and much-needed liquidity to futures markets. In truth they are more focused on playing the spread between energy commodities than acting solely as directional players. And the reality in the trenches in 2008 was that, in pursuit of those cross-commodity arbitrage opportunities in the energy complex, energy hedge fund managers and traders had to navigate an unprecedented level of volatility in their portfolios.

In the first half of that year, oil repeatedly hit record-breaking levels above $100 and then quickly retreated, before peaking at $147 in July and falling back below $60 by November. The rest of a hedge fund's portfolio was subject to similar spasms as commodities from gas to wheat underwent massive fluctuations. Don't forget that in 2008 the price of rice more than doubled in less than seven months.

Faced with such dramatic movement throughout the portfolio, hedge fund managers rightly looked to technology for an assist. Historical data is of limited value in such a price environment — oil has only hit these relative heights twice in a century, in the late 1970s and the early 1860s. What's needed is accurate deal capture, actionable risk analysis, and increasingly robust scenario modeling — all on the fly.

Enter energy trading and risk management (ETRM) solutions for hedge funds. The ability to manage many different products and commodities in a single system is vital to a hedge fund, where it's common to find arbitrage strategies between energy commodities as well as between those commodities and other markets such as currency. Hedge funds should seek systems with computational power to enable a risk manager to collect a vast array of disparate data into a centralized data store, empowering analyses that draw out both strengths and weaknesses across the portfolio.

Beyond arbitrage, one of the challenges for hedge funds is that they won't see the upside if they don't put some money on directional trades, which sometimes means intentionally foregoing their established risk metrics. Crossing over those lines in search of opportunity, hedge funds can substantially mitigate the inherent risk through technology-driven monitoring and analysis.

ETRM technologies should help mitigate that inherent risk through reliable position management, intraday portfolio valuation, customized curve generation, and real-time analytics that allow a hedge fund to, for instance, stress-test around value, credit- or margin-at-risk while the market is liquid and volatile mid-session. Critically, an ETRM system empowers risk managers to aggregate risks and offsets between multiple commodities and positions across the portfolio, teasing out relationships that are otherwise often overlooked.

But there's more to hedge fund ETRM use than what amounts to crisis management during periods of atypically volatile commodity market fluctuations. At its most fundamental element, an ETRM system acts as de facto risk officer, auditor, and regulator on a trading desk with a small staff, where duties often overlap and the risk manager is very likely also to be a trader.

The small size of a hedge fund trading team allows it to be relatively nimble, but it also may allow the lines of authority to become blurred. An ETRM system offers ballast when a few people wear many hats.

Unlike a utility or refinery, the ETRM system is an integral part of the initial investment in a hedge fund. High net-worth investors consider system selection a critical part of their due diligence when deciding to place their money with a hedge fund manager. The trading group has to show acumen and a good strategy, but it also has to demonstrate that it has solid risk management processes and a good risk management system.

As a result, the decision to invest in an ETRM system often accompanies the influx of investment capital into a new hedge fund. Fund managers should ensure that their vendor is capable of implementing a system quickly — eight days should be enough in our experience — so that capital starts producing right away. That'll put a smile on a hedge fund manager's face as surely as a killer arb.

About the Author

Louis Caron is the Global Lead for Energy Commodity Risk Management at RiskAdvisory. Originally a financial and physical commodities trader with TransCanada Energy Management and Western Gas Marketing, in 1995 he was a founder of RiskAdvisory, leading the formation and growth of the software group that develops and markets SAS BookRunner. Caron led the transition of business activities when RiskAdvisory was acquired by SAS in 2003. Currently he provides software consulting to RiskAdvisory clients around the world based on his extensive energy trading and risk management domain expertise.

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