January 2021The London Metal Exchange’s (LME) roots lie in the physical metals market. Its core customers, for most of its history, have been producers (those who make metal) and consumers (those who make things out of metal) as well as intermediary merchants. Nevertheless, even from its earliest days, the market has attracted and benefitted from participants who neither produce nor consume metal – that is to say financial participants who provide liquidity through market making or investing in metal. This article attempts to shed some light on how this investment community (also known as the “buy-side”) has evolved, the way it interacts with the market and its impact on liquidity and price discovery.
In our previous LME Insight piece, “Proprietary Trading Firms on the London Metal Exchange”, we explored “prop traders”, one type of financial investor active in the LME community. In this instance, we take a look at a number of other financial investors participating in the market.
Financial investors include a broad range of funds including sovereign wealth, macro, pension, managed futures/commodity trading advisors (CTAs), systematic and quantitative, and fundamental specialists. Their reasons for trading on the LME are diverse and the way in which they gain exposure to the LME differs.
The participation of financial investors (who typically take on risk) is as necessary to a healthy market as that of physical participants (who typically want to transfer, or “hedge” their price risk). Both bring much needed liquidity and regular activity to an exchange.
COMMODITIES AND OTHER ASSET CLASSES
Commodities were the first assets to feature on futures markets and thus the first to attract speculators as well as hedging interest. Financial futures markets are a relatively recent development, having been established in the 1970s and 1980s. However, trading volumes and the notional value of contracts traded in financial futures markets (largely, equity indices and fixed income) now substantially exceed commodity markets.
The buy-side universe is now dominated by investments in equities, fixed income, FX as well as private equity and real estate. Indeed, the number of investors with exposure to industrial metals as part of their portfolio (and the value of those funds invested) is very low when compared to investments in other asset classes.
Broad-based commodities indices and funds have had a few lean years in terms of returns after a bull run which persisted through much of the 2000s. This has led to the closure of many commodity-focused hedge funds with specialist funds particularly hard-hit. Many large institutional investors, such as pension and sovereign wealth funds, still continue to allocate a percentage of their funds under management to the commodity space – often as a diversification strategy or as an inflation hedge. Typically, they will either track an index themselves or, more commonly, allocate to an outside manager with instructions to replicate the return of a particular basket. The asset management sector also allocates to many systematic hedge funds.
There are a number of well-known commodity indices, including the S&P GSCI, Bloomberg Commodity Index (BCOM) and Rogers Commodity Index.
S&P GCSI is more heavily weighted towards energy, with 61.71% exposure in this sector; grains and softs comes next at 15.88% followed by livestock at 7.25%. Industrial metals make up 10.65% and precious metals 4.5%.
BCOM has less of a bias towards energy at 29.97% of the portfolio, grains investments follow closely at 22.65%, with industrial metals accounting for 15.56%, precious metals 19.00%, softs commodities 7.23% and livestock 5.57%.
Rogers has the broadest number of commodities in their basket, with 38 individual commodities versus 24 for S&P GSCI and 23 for BCOM. Its industrial metals component accounts for around 14% of the portfolio.
Usually weightings are reviewed and adjusted annually by the index provider.
So as part of the broader investment universe, commodities in general and metals specifically play a small role, relatively speaking.
Passively tracking indices is of course not the only way funds gain exposure to commodities. Below we explore investors by type and look at the strategies they typically employ.
SOVEREIGN WEALTH FUNDS
Sovereign wealth funds tend to allocate less than 1% of their overall assets directly into commodities exposure but, given the size of some of these funds, this can translate into significant volumes on the LME. They are often also indirectly exposed to LME metals via investments in outside hedge funds. Typically, they are passive investors, tracking established indices, but some also operate in-house quantitative trading teams, adopting their own models and trading in a more dynamic way.
Many pension funds will have a small exposure to commodity markets which, in almost all cases, will be an indirect investment via established commodity hedge funds or by the creation of specific funds to achieve a return based off the performance of a basket of commodities. Generally, the latter will have an outside manager.
GLOBAL MACRO FUNDS
These funds base their investment decisions on overall economic and political factors and typically their portfolios cover the entire suite of asset classes, including FX, equities, fixed income, credit and commodities. Their investments are often undertaken to achieve a proxy exposure to a given macro factor. A typical example would be investing in copper futures as a proxy for the global economy – the fabled “Dr Copper”. Copper is recognised as an asset which acts as a barometer of global economic activity. Others may take a position in a commodity as a proxy for a particular country’s economy or a correlated currency play such as silver vs Mexican peso.
COMMODITY TRADING ADVISOR (CTA)
Essentially, CTAs are hedge funds running managed futures strategies. CTA is a term which features in US securities regulation. In order to offer managed futures funds to US investors, CTA operators must be registered with the US CFTC and NFA. Perhaps surprisingly, however, while “commodity” is in the name, these funds do not necessarily trade any commodities. CTAs mostly run systematic trend-following strategies, though a few are discretionary (ie decision driven). Of the US$283 billion currently cited as the amount under management, US$263 billion follow systematic models versus US$11 billion which follows discretionary position management. The majority are US domiciled with around 30% in Europe and 11% in the Caribbean. Their advantage over some other hedge funds is that they tend to invest in only the most liquid futures markets, thus making redemptions easier.
SPECIALIST COMMODITY FUNDS
These funds tend to trade on a discretionary basis, with enhanced fundamental analysis of supply and demand dynamics and a closer relationship with the underlying physical market. In the LME’s case, this manifests as entities trading across the date structure of the market (spread or carry trading), and arbitraging between the LME and other exchanges, such as CME and SHFE.
These entities sit at the convergence point of prop traders and hedge funds. They have very similar employees, rigorous data driven analysis and mathematic and statistical modelling. They often undertake relative value strategies, such as mean reversion/statistical arbitrage or trading the historical relationship between two assets. Some engage in high frequency intraday trading, and some use trend following/momentum trading strategies. A lot of these strategies are automated and driven by algorithms. These algorithms and strategies are close-guarded secrets, leading to the term “black box” trading.
Trend-following/momentum trading and statistical arbitrage strategies have previously been covered in the LME Insight piece on props published in September 2020. However, the way hedge funds tend to trade these strategies differs, especially with regard to time horizons and trade-holding periods. Props tend to be more focused on very short-term intraday signals, while hedge funds often consider longer time horizons, perhaps over weeks or even months.
So how does this diverse group of market participants access the LME? Most large macro funds, sovereign wealth and pension funds trade across multiple asset classes and so are typically serviced by the prime brokerage departments of the big investment banks, most of whom are also LME members.
CTAs also use the services of the big prime brokers but may also have relationships with independent brokers, while specialist firms may need the services of a number of traditional LME independent firms and other commodity oriented banks. This is especially true if they are involved in physical markets and need to take physical delivery from time to time.
Many systematic and quant funds have a strong preference to trade electronically. For most, their preference is to enter their position on the most liquid points, which in the LME’s case is the 3-month (3M) prompt for physically-settled non-ferrous metals. They then adjust the positions to the next 3rd Wednesday contract (or a month of their choosing). As they approach maturity, they will tend to roll or “carry” to the next selected month’s 3rd Wednesday date. Managing the timing of these rolls is an important part of a trader’s responsibilities. Some of these entities will trade directly into a 3rd Wednesday contract, as an outright trade, providing the bid-offer spread is competitive when compared to the cost of carrying from 3M date.
However some funds and CTAs, running on a model-based system, are not latency sensitive and will send a list of orders to their brokers to execute each day. These tend to be in the form of stop orders, “market if touched” (MIT) and “market on open” or “market on close orders” (MOO or MOC) which require manual intervention and care to execute.
Specialist funds tend to use a mixture of electronic trading and trading over the phone, as they often trade further down the price curve, where electronic liquidity is not as prevalent. This type of strategy attempts to capture positive returns on carry/spread trades. If these entities are also involved in physical trading, they are more likely to be trading odd-dated carries (ie trade dates which are not on the 3rd Wednesdays), and these are mostly traded over the telephone.
A major concern of investors is the cost of rolling positions to the next selected date down (or up the curve). Portfolio managers spend a lot of time analysing their slippage costs and look for the optimal time to both enter a market and also to roll existing positions. They search for the optimal time when liquidity is deepest and spreads are tightest.
Slippage costs also include broker commissions and exchange fees and so the portfolio manager’s analysis also needs to include the minimal number of steps in order to minimise “churn”. The LME, with its more complex date structure, when compared to a monthly dated futures market, can seem expensive, given the higher number of carries or rolls needed. As a result, portfolio managers often look to roll their position further down the curve to avoid month to month rolls, as well as using 3rd Wednesday as their entry point rather than 3M.
Many index trackers will look to trade at settlement (TAS). In many futures markets this process has now been automated, with the ability to leave TAS orders in an electronic order book. On the LME however, the settlements are still derived from the Ring (COVID excepted), so these closing orders are left with brokers to execute.
The LME has three execution venues, albeit the Ring is currently suspended due to COVID-19. Financial investors’ method of execution will depend on their preference and where the necessary liquidity can be accessed.
The professional investor community is an important and growing part of the LME market. The liquidity this sector provides, via the various strategies employed, augment the LME’s mature and robust market, improving both volumes and open interest. For this community, the asset class traded will be driven by the balance between opportunity and the need to diversify. As a result, commodities as an asset class will wax and wane, however, generally all of the investor types mentioned will require some element of exposure to this sector leading to ever evolving strategies to find the best returns possible.