Energy And Environmental Hedge Funds E-Book

Peter C. Fusaro

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 401

Veröffentlichungsjahr: 2011

Beschreibung

Praise for Energy & Environmental Hedge Funds: The New Investment Paradigm "I highly recommend this book for those investors interested in energy and environmental hedge funds. It is a great handbook on these topics. The authors make a difficult subject easy for investors to understand. Energy and Environmental Hedge Funds are both the newest and next area for hedge fund investment and diversification." --Lisa Vioni, President, HedgeConnection.com "Peter Fusaro and Gary Vasey have done a great jo9b in compiling all of the background information that a newcomer to energy investing should have. This insightful book helps in determining how best to gain exposure to the rapidly changing energy trading sector." --Raj Mahajan, President & Co-Founder, SunGard Kiodex "The entry of opportunistic hedge funds into the energy sector is creating a sea of change for the industry. Fueled by pension funds and institutional investors, hedge funds are attracted to the petroleum industry because the current price volatility provides generous returns for their investors. However, these investments are not without risk. Gary Vasey and Peter Fusaro explain the ins and outs of it all in their insightful narrative." --Don Stowers, Editor, Oil & Gas Financial Journal "Peter Fusaro and Gary Vasey write about energy and environmental hedge fund markets with greater style, aplomb, and insight that any other observers of financial high streets worldwide.... Outlining some of the early and provocative details of an industry's youthful achievement and potential, it is likely that this exposition by two of the energy and financial world's most credible experts will become a seminal work." --Ethan L. Cohen, Director, Utility and Energy Technology, UtiliPoint International, Inc.

Leseprobe

Contents

Introduction

Acknowledgements

Abbreviated Terms used in this Book

Chapter 1: The New Investors in Energy

NEW ENERGY INVESTORS

WHY NOW?

WHAT IS A HEDGE FUND?

US HEDGE FUND REGULATION — A BRIEF UPDATE

WHO INVESTS IN HEDGE FUNDS?

THE BASICS OF HEDGE FUND INVESTING

TYPES OF FUNDS

AN INTRODUCTION TO ENERGY AND ENVIRONMENTAL HEDGE FUNDS

NOTES

Chapter 2: What are Energy and Environmental Hedge Funds?

WHY NOW?

DIVERSIFICATION OF RISK AND HEDGE FUND COMPOSITION

A QUICK GLOBAL ASSESSMENT OF ENERGY FUNDS

TECHNICAL ANALYSIS AND ITS ROLE IN ENERGY TRADING

NOTES

TYPES OF ENERGY AND ENVIRONMENTAL HEDGE FUNDS

ENERGY COMMODITY FUNDS

EQUITY FUNDS

DEBT, DISTRESSED ASSETS AND OTHER INFRASTRUCTURE STRATEGIES

ALTERNATIVE ENERGY OR GREEN HEDGE FUNDS

FUND OF HEDGE FUNDS

WHERE THIS IS ALL GOING

MANAGED FUTURES AND COMMODITY POOLS

Chapter 3: Why are Hedge Funds Attracted to Energy and the Environment?

FACTORS IMPACTING ON OIL AND NATURAL GAS PRICES

THE ATTRACTION OF POWER TRADING

MIDSTREAM ASSETS

ENERGY TRADING GROWING

NEW FUND PLAYS IN THE ENERGY PATCH

SUMMARY

NOTES

Chapter 4: The Energy Complex and Investment Opportunities

ENERGY INDUSTRY VALUE CHAINS

THE ENVIRONMENTAL OVERLAY

INTRA-ENERGY OPPORTUNITIES

A BRIEF INTRODUCTION TO INVESTMENT OPPORTUNITIES

SUMMARY

Chapter 5: Energy Hedge Funds

THE UNIVERSE OF ENERGY HEDGE FUNDS

EQUITY FUNDS

COMMODITY FUNDS

DEBT AND DISTRESSED ASSETS

ALTERNATIVE ENERGY FUNDS

ENERGY HEDGE FUND PERFORMANCE

HYBRID FUNDS

Chapter 6: Impacts and Evidence of Hedge Fund Activity in Energy

NYMEX'S CLEARPORT: POSITIONED FOR THE FUND BUSINESS

WHAT DOES THE EVIDENCE SHOW?

THE “COMMITMENTS OF TRADERS” REPORT

IMPACT OF HEDGE FUNDS ON ENERGY TRADING FUTURES EXCHANGES

NOTES

Chapter 7: Green Hedge Funds: Trading the Environment

WHY NOW?

ENVIRONMENT BECOMING A BOARD ISSUE

WHY GREEN TRADING MARKETS ARE RIPE FOR INVESTMENT NOW

HOW THESE MARKETS WORK

HEDGE FUND TRADING

WHY ARE THE HEDGE FUNDS HERE?

WHAT'S AHEAD?

Chapter 8: Weather Hedge Funds

WHY WEATHER DERIVATIVES NOW?

NOTE

WHAT IS WEATHER DERIVATIVES TRADING?

SPECIFICS OF WEATHER OPTIONS

COMPONENTS OF A SUCCESSFUL WEATHER MARKET

TYPES OF INDICES FOR WEATHER CONTRACTS

HDDs AND CDDs ARE THE MOST ACTIVELY TRADED PRODUCTS

WEATHER DERIVATIVE STRUCTURES

CUSTOMIZED DERIVATIVE STRUCTURES

THE HEDGE FUND OPPORTUNITY

Chapter 9: Energy and Natural Resources Fund of Hedge Funds

FUND OF HEDGE FUNDS

BENEFITS OF FUNDS OF HEDGE FUNDS

THE EMERGENCE OF NATURAL RESOURCE FUND OF HEDGE FUNDS

FUND OF HEDGE FUND PORTFOLIO CONSTRUCTION

ISSUES WITH ENERGY FUND OF FUNDS

WHAT'S UP NEXT?

NOTES

Chapter 10: Energy Indexes

COMMODITY TRADING INDEXES

WHAT'S COMING UP

DOW JONES - AIG COMMODITY INDEX (DJ-AIGCI®)

THE GARDNER MACROINDEX® (GEMI )

ROGERS INTERNATIONAL COMMODITY INDEX

INDICES' RELATIONSHIP TO HEDGE FUND TRADING

EXCHANGE TRADED FUNDS (ETFs)

GOLDMAN SACHS COMMODITY INDEX (GSCI®)

REUTERS-CRB® TOTAL RETURN INDEX

DEUTSCHE BANK LIQUID COMMODITY INDICES (DBLCI)

Chapter 11: A Five-year Bull Market in Energy?

THE FUTURE OF ENERGY SUPPLY AND DEMAND

WHAT DOES THIS ALL MEAN FOR INVESTORS?

THE FUTURE FOR ENERGY AND ENVIRONMENTAL HEDGE FUNDS

SUMMARY

NOTES

ENVIRONMENT - THE NEXT WRINKLE IN ENERGY MARKETS

Glossary

Index

Copyright © 2006 by John Wiley & Sons (Asia) Pte Ltd

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Introduction

The rising power of hedge funds has continued to reshape both Wall Street and the City of London during the past several years. While hedge fund returns generally disappointed investors in 2004 and 2005, their movement into the energy complex has not. It now seems likely that their advance into energy is primed to follow throughout the world as the globalization of financial markets accelerates. Rapid economic growth in China and India, coupled with rising energy demand, is leading a sustained thrust into the energy hedge fund universe. This financial model is now changing to include more equity investment, as well as commodity trading, and begins to blur the line with investment banking, venture capital, and hedge funds. The second thrust of this powerful financial change will be the emerging environmental financial markets as drivers of both change and investment opportunities. The environment now overlays the energy value chain, as the recent emergence of “green” hedge funds attest to this investment opportunity.

Hedge funds seek new areas of investment where returns may be stronger, and that opportunity is in the global energy business and emerging environmental financial markets. This book is envisioned as a road map to identify investment opportunities in these new and volatile markets. It is a primer for investors and other hedge fund managers to take a hard look at this complex sector, which is now rife with both investment opportunities and risk. The relative immaturity of both energy and environmental financial markets point to much opportunity in this sector than is currently realized, but it does not fit tidily into the macro models and more sophisticated trading of foreign exchange and corporate debt trading, which is the traditional realm of hedge funds.

Today, there are more than 8,700 hedge funds with over $1 trillion at work, which could be levered to at least $2 trillion. This is double the number of hedge funds that existed in 1999.1 The flat or sideways trading of global equity markets for the past several years since the dot com crash has not shown the rates of return that investors have become accustomed to. Meanwhile, the energy complex is volatile, capital intensive, and just plain interesting. You can't put down the newspaper or watch television today without every angle of the energy complex being under intense scrutiny and investor interest.

Our research has revealed that there are over 450 energy hedge funds and perhaps that number could be as high as 600, with many new funds emerging on a daily basis. These funds run the gamut of strategies from energy equities, commodities, distressed assets, debt, and alternative energy (environmental) such as renewable energy and emissions trading, and increasingly, funds of hedge funds. Investors are looking for better returns every year as they abandon one financial sector for another, and they have now turned to the energy patch for those financial rewards - but energy is a risky and physical business that cannot readily be compared with other investment opportunities.

In this book we make the case for energy and later the environment, as it relates to energy, as the place to invest. It is an area where hedge funds in particular offer investors exposure to a wide variety of innovative and profitable opportunities. Our thesis is that a lack of investment in the entire energy complex over the last 20 years since the price collapse in 1986 has now teed up a sustained period of supply-demand tightness in all energy commodities. We argue that there will be no mean reversion in energy prices, and offer the view that energy markets are behaving differently this time around. Something has fundamentally changed in energy.

For the last couple of decades, energy commodity prices moved sideways within a narrow range, but then suddenly began an inexorable rise about two years ago. We feel that many in the industry were lulled into a false sense of security around market fundamentals, while many skills simply left the industry altogether during the past two decades. Many in the industry today, including Wall Street and other analysts, have no experience of anything but low and relatively stable energy prices. Indeed, after the collapse of Enron in late 2001 and the energy merchants in 2002, many predicted the demise of energy commodity trading and markets altogether. But, it was this event that accentuated opportunities in energy and even provided many of the trading skills that allowed the new energy speculators to enter these complex and risky markets. And so we have seen the new triangle of trading emerge these past two years, which includes investment banks, hedge funds, and multinational oil companies. We have not seen the predicted globalization of electric utilities, but instead foreign utilities retreated from American power markets. We have also witnessed the Wall Street power companies rise as they bought distressed assets and began to trade those assets through various asset optimization strategies. We have seen the resurfacing of the financial institution/utility joint ventures such as Calpine and Bear Stearns, as well as Merrill Lynch's purchase of Entergy/Koch, and more recently we have seen the entrance of financial hedge funds focusing on the energy industry for a variety of reasons, including acquiring and trading distressed generation assets.

It has been the rise in energy commodity prices and volatilities, the lack of investment in infrastructure, and the credit and debt issues of the collapsed merchants that have uniquely combined to create today's opportunities. Somewhat simplistically, the lack of investment in infrastructure across the complex this last 20 years, combined with the surge in global demand for energy, has resulted in a rapid rise in energy commodity prices and volatilities. In turn, this has created a situation where energy companies across the complex have seen profits rise. This is now resulting in increased spending on long overdue projects and activities. Meanwhile, the abundance of relatively cheap assets for sale, and the need for various energy companies to restructure debt, has created a variety of other opportunities. Finally, higher energy prices and the tightness in supply-demand dynamics across all energy markets is driving increased interest in alternative forms of energy and energy efficiency investment.

Although a small number of hedge funds have specialized in energy equities for several years, and many more general equity funds had a component of energy in their portfolios, it was the entrance of hedge funds into energy commodity trading that really spurred the interest on the part of investors in hedge funds. These early energy commodity funds, staffed with expert energy traders from the old merchant segment, produced extraordinary returns in 2003 and 2004. As a result, investor interest increased and many ex-traders and investment bankers created new hedge funds across the space. Existing funds, especially larger macro funds, also exposed more of their assets under management to the energy complex. Of course,itwasn'tjusthedgefundsthatgotintoenergy-itwasallofthe investment banks as well.

While many hedge funds concentrate mostly on price risk, there are almost unlimited risks in the physically oriented energy business. There is operational risk, geopolitical risk, event risk, regulatory risk, weather risk, tax risk, and others that add multiple additional dimensions to the more linear and traditional thinking of hedge fund operations. These externalities are also about to be overwhelmed by ''environmental risk,'' which is the wave beyond the current energy hedge fund euphoria. Therefore, trying to put the traditional hedge fund financial overlay into the energy complex is really putting the proverbial square peg into the round hole. Why? Because energy is the world's largest business with over $4 trillion in annual trade, but it is also a very immature financial market.

The notional value of the financial energy market is $2.2 trillion according to our estimates. Since commodities traditionally trade six to 20 times the physical market, we still have a long way to grow toward market maturation. Moreover, the Enron and energy merchant debacle set back natural gas and power trading a good three years. Today, the natural gas market is over $400 billion - where it was when Enron went down in December 2001. Oil trading still predominates energy trading and is the most liquid financial business. It also predominates in the energy commodity hedge fund business as it is still the only global energy market today.

Energy is a business that hedge funds really have just entered in large numbers during the past two years. Of course, it can be argued that commodity pool operators (CPOs) and commodity trading advisors (CTAs) have been around for decades, but the movement into energy trading by hedge funds has really accelerated in the more recent time period. In our Energy Hedge Fund Center (www.energyhedgefunds.com), we have counted more than 120 energy commodity trading hedge funds with over $50 billion or more in assets under management in our universe of over 450 energy hedge funds. Just 18 months ago there were less than 20 commodity trading hedge funds.

Energy trading activities such as electric power trading look attractive and bold, but they are fraught with unexpected risks - especially for those used to more mature financial markets. And that's the problem with energy for people and organizations more used to such markets. It's a very complex physical market. Superficially, it seems straightforward enough, but the more you probe into the business transactions required to make the industry work, the more complex and risky it becomes. Even crude oil markets are not as simple as just supply and demand. One has to consider transportation issues, crude quality issues, storage levels, refining capabilities, weather risks, and so on.

Certainly, there is a rapidly developing investor appetite for energy, but energy doesn't neatly fit the hedge fund business model and we observe some issues around that fact, particularly with respect to funds in energy and the institutional investor. However, we see an ongoing bull market for energy for some time to come and the results speak for themselves. Where there is a will, there is a way.

WHAT'S ON THE HORIZON?

Today, the energy hedge fund arena is ramping up, due to the need for higher returns for hedge fund investors. Our book attempts to frame this financial opportunity for them, but energy hedge funds are still only about 5% of the hedge fund universe - and growing. New York and London continue to be the twin capitals of both energy trading and energy hedge funds. Houston, Calgary, Chicago, Singapore, and Switzerland play second fiddle. More hedge funds and fund of hedge funds are in formation as the energy bull market continues with rocky price spikes and collapses.

After this investment window begins to close, watch out for the surge of environmental hedge funds coming into play that is just now surfacing. While carbon trading is the current focus of attention, there are also markets for sulfur dioxide (SO2), which causes acid rain, nitrous oxides (NOx), which cause urban ozone, and renewable energy credit trading (as it is called in the United States). There are also opportunities in alternative energy market caps, ethanol trading, and alternative energy project equity plays. The emissions market formation is global as we recently learned of emissions credit trading for sulfur dioxide in China, which burns a lot of coal. Thus, the energy wave is superceded by a ''green wave'' of environmental hedge fund trading. Its genesis is still the United States, but now it is spreading globally. Watch this space expand, contract, and mature.

The energy hedge funds have the trading talent, better credit, and risk-taking acumen to really roil markets. They already have in day trading in both West Texas Intermediate (WTI) and Henry Hub Natural gas on the NYMEX, and Brent on the International Petroleum Exchange (IPE), making more traditional energy traders squeamish about all that intra-day price volatility. More is coming. The energy hedge funds are a double-edge sword for energy trading, since while they bring more liquidity to markets they also bring more price volatility. They also bring in more speed in day trading that traditional energy traders are not used to. Our belief is that more traditional players will have to live with the new market dynamics of what we dub the ''trading triangle'' of multinational oils, investment banks, and the funds. What is really occurring is a rising financialization process in the energy complex. This transition is not without risks and market changes are seldom greeted with open arms.

In this book, we will also disclose our thinking on what is driving energy markets and the attendant investment opportunities, picking apart myth from reality as we see it. The media and politicians try to simplify energy to a sound bite, but it is far more complex than that. There are a multitude of views as to where energy is headed from the apocalyptic theory of''peak oil'' to the idea that this is just another dot com bubble. To us, it is about the fundamentals. Fundamentals have driven energy commodity prices these last two years, and the evidence suggests nothing much has changed as we reached the end of 2005. We hope to demonstrate that in this book.

For many years, the floor traders on the NYMEX have complained about hedge funds entering energy markets. For the most part they were wrong. Today, the funds have really arrived. They are looking for greater returns on equity for their investors than the flat trading of stock market equities. The missing ingredient is the understanding of energy markets and its complexity. Funds like to ''move money in and move money out,'' as one experienced energy trader commented to us recently. However, what they are missing is that there are now fewer opportunities for that type of trading. Second, there are greater risks in the market because they have arrived to trade. A seasoned energy trader we know commented that ''there is a billion fund with three traders, the oldest is 29 years old.'' The funds often lack knowledge and experience in energy markets, but they are gaining it. Energy trading is the most volatile and complex of any commodity. Energy prices are driven by supply-demand fundamentals, technical trading, weather, events, geopolitical issues, and regulatory issues. Credit risk is still an important risk to manage in the energy industry, particularly since this industry has less creditworthiness. The funds have better credit but less knowledge. They also sometimes have a ''know-it-all'' attitude. These factors bode for more impending energy trading disasters, and some have already occurred during 2005. Expect more to come.

Energy and the environment provide both opportunity and risks for hedge funds, fund of hedge funds, and investors to show much better than average returns. This book is an attempt to decode this new market. This is the beginning of a ramping up of energy and environmental hedge funds. It is sustained due to market uncertainty, supply constraints, and just plain old risk factors. We think it's a good thing as hedge funds are starting to provide the risk capital for investment in new technology that the venture funds are used to. This book should provide some insights into how these markets operate, where the hedge funds are entering, and where this all might ultimately lead us.

Peter C. Fusaro and Dr. Gary M. Vasey

April 2006

NOTE

1 Vann Hedge Fund Advisors, LLC website.

Acknowledgements

It is said that behind every good man is an even better woman. In this instance that would be Carmen and Maureen-who constantly ask us to strive for greater things but complain at the hours we put in! Love and thanks for their tolerance and patience.

Peter C. Fusaro and Dr. Gary M. Vasey

Abbreviated Terms used in this Book

ANWRArctic national wildlife refugeCATCumulative average temperatureCBOTChicago Board ofTradeCCXChicago Climate ExchangeCDDsCooling degree daysCFTCUS Commodity Futures Trading CommissionCMEChicago Mercantile ExchangeCOTCommitment oftradersCPOCommodity pool operatorCTACommodity trading advisorE&PExploration and ProductionEHFCEnergy Hedge Fund Center (www.energyhedgefunds.com)EIAUS Energy Information AdministrationEPRIElectric Power Research InstituteETFExchange traded fundEU ETSEuropean Union Emissions Trading SchemeFERCFederal Energy Regulatory CommissionFoFFund of hedge fundsGDDsGrowing degree daysGHGGreenhouse gasHDDsHeating degree daysHNWHigh net worthIEAInternational Energy AgencyIGCCIntegrated gas combined cycleIPEInternational Petroleum ExchangeIPOInitial public offeringIPPIndependent power producerLCHLondon ClearinghouseLMELondon Metals ExchangeLNGLiquefied natural gasM&AMerger and acquisitionMLPMaster limited partnershipNAVNet asset valueNWSNational Weather ServiceNYMEXNew York Mercantile ExchangeOTCOver the counterPAIPalo Alto InvestorsRECRenewable energy creditROIReturn on investmentRPSRenewable portfolio standardSECSecurities and Exchange CommissionSUVSports utility vehicleWTIWest Texas intermediateWRMAWeather Risk Management Association

Chapter 1

The New Investors in Energy

For the average investor the energy industry has always offered oppor-tunities to profit through the publicly traded securities available on the world's stock markets. Indeed, many multinational oil companies have long been considered “blue chip” stocks with both reasonable dividend and appreciation characteristics. Mutual funds have also provided investors opportunities to indirectly invest in the energy equities, although until recently usually as part of a more diversified approach. More sophisticated investors have had other options, including the use of options on securities and access to commodity trading through CTAs, hedge funds, and other alternative investment vehicles.

However, over the last two years, the energy industry has literally been transformed into the “hot” investment sector. Today, with high and volatile energy commodity prices impacting everyone, energy is in the news headlines 24/7. On a daily basis, new investment opportunities in the energy industry are offered in the form of energy or natural resource-specific mutual funds, exchange traded funds (ETFs), income and royalty trusts, master limited partnerships (MLPs), and other vehicles. The average investor now has a broader set of opportunities to participate in the booming energy sector. Yet these new vehicles only scratch the surface of the opportunities provided through the alternative investment universe via energy and environmental hedge funds.

NEW ENERGY INVESTORS

The new investors in energy are what we refer to as “the triangle of trading.” These comprise investment banks, hedge funds, and multinational oil companies. Today, utilities are being increasingly marginalized in energy markets as they drop back into trading around their assets and pursue a strategy of optimizing those assets for shareholders if they trade at all. With the energy merchants long gone after the fall of Enron and the others, a vacuum was left that these new investors have stepped in to fill.

The investment banks have been in and out of energy over the years to varying degrees, but over the last 18 months, the banks have increased their interest in and exposure to energy across the board. Almost every sizable investment bank now has a position in energy, while only Goldman Sachs and Morgan Stanley have had some form of presence for over 20 years. Other banks, including UBS, Barclays Capital, Lehman Brothers, Citigroup, Deutsche Bank, and ABN AMRO, among others, have all increased the size of their energy trading desks; and others, such as Merrill Lynch and Bear Sterns, have created joint ventures with, or even acquired, existing energy trading firms.

Investment banks continue to play a role on the distressed asset side of the energy business, too, while some have actually acquired significant energy assets and now operate those assets. For example, Goldman Sachs added to its energy portfolio with the purchase of East Coast Power and the acquisition of Cogentrix Energy in the United States. Both Goldman Sachs and Morgan Stanley can handle physical trading and take actual physical delivery of product. Goldman also holds a large renewable energy generation portfolio, too. Some investment banks have even bought oil and gas reserves in the ground.

The multinational oils have also moved in to fill the space left by the energy merchants in recent years. British Petroleum (BP) is now the largest trader of natural gas in North America, and it and other multinational oil companies have reported huge profits from their energy trading activities over the last 12 months.

However, the key area of interest and the topic of this book is the evergrowing and “secretive” hedge fund community. Despite increased interest from regulators such as the US Securities and Exchange Commission (SEC) and others, hedge funds are being funded at a record pace. Once the exclusive domain of private wealthy individuals, institutional money is now flooding into hedge funds seeking promised better returns (Figures 1.1 and 1.2). The $38.2 billion that flowed into the funds in Q1 2004 was a record and that pace has continued as public and corporate pension funds now allocate an average of 5-7% of their assets for investment in hedge funds. Van Hedge Fund Advisors1 recently issued a report in which it expects assets under management at hedge funds to double to $2 billion by 2009.

Figure 1-1 Growth of global hedge funds

Note: Estimates for 2005-2008 are projections based on current data and may be revised in the future. © 2005 Van Hedge Fund Advisors International, LLC and or its affiliates, Nashville, TN.

Source: www.hedgefund.com

Figure 1-2 Growth of hedge fund assets under management

Note: Estimates for 2005-2008 are projections based on current data and may be revised in the future. © 2005 Van Hedge Fund Advisors International, LLC and or its affiliates, Nashville, TN.

Source: www.hedgefund.com

But as hedge funds gain access to increasing amounts of capital, so too has the average hedge fund return declined to something less than spectacular. Hedge funds returned less than 9.64% in 2004, compared to 15.44% in 2003, and under-performed more conventional asset classes according to the CSFB Tremont hedge fund index.2 Hedge fund managers attributed their lower performance in 2004 to low volatility and low interest rates. As a result, hedge funds have been looking for other asset classes to invest in. Seeking new opportunities where the sparkle can be put back on their reputation for producing a significant return on investment, they have identified the energy industry as having that potential. Early indications have only served to raise energy's profile since some of the better performing funds last year were focused on energy.

As a result, those ex-energy traders from the merchant era are now back in demand. Energy traders are being snapped up by hedge funds, multinational oil companies, and investment banks, and, in some instances, they have formed their own hedge funds based on their energy trading expertise. Indeed, the number of specialist energy commodity trading funds with between $1 million and $25 million in assets under management is growing rapidly. Not all the energy funds are so small. Several of the better known energy-focused funds are quite large, between $400 million and over $1 billion in assets under management. But we are also seeing a trend for much larger (greater than $1 billion under management) macro funds to switch more of their assets into energy, too. Today, our research has identified over 450 hedge funds that are active in the energy industry and that number continues to grow. Their assets under management range from $1 million to $2 billion.

WHY NOW?

Perhaps those of us in the energy industry have been too comfortable and too close to the business to notice the lack of sustained investment in our industry over the last 15 or so years. Whether it is oil and gas exploration, development of new reserves, or investment in the power industry, we are now seeing supply-demand tightness in all energy commodity markets and a historical under-valuation of energy companies and their assets. At the same time, demand has continued to grow robustly, and we are now at a stage where unforeseen events such as acts of terrorism, industrial disputes or accidents, weather-related events, and transmission constriction can be enough to create considerable concern about supply. This has resulted in increased price volatility, particularly in oil markets, and the funds love that price volatility.

There is now a growing awareness and even acceptance that in global oil markets supply tightness is such that OPEC no longer holds the swing vote on oil price formation. Today, oil prices are set by the trader's views on the NYMEX as much as anything else. News events such as those that occur in Iraq, Nigeria, Russia, and Venezuela over the potential for or actual supply disruptions, combined with reserve estimate reductions bymajor oil companies and the lack of transparency into the true nature of OPEC's own reserves, are now sufficient to cause $2+ daily swings in the oil price. Over the last two decades, oil companies have been more interested in buying back their stock to increase share price and please share holders than in investing in new exploration or production activities. Wall Street just hasn't rewarded explorers and risk-takers, and the majors have not significantly increased their exploration and production budgets partly because other commodity markets, like steel, have also risen accordingly, adding to the expense side.

For each energy commodity the picture is similar. While oil is a global market and impacted by global events, regional natural gas, coal, and electric power markets are now often subject to similar supply tightness. The rush to natural gas-fired generation has helped to increase the perception of supply tightness in gas markets and the 2003 black outs did likewise for electric power.

Hedge funds like volatility. They like to identify trends and bet on those trends. Today they see that the trend in commodity prices has been largely up, and as they place their bets they are accentuating those trends. They are also followers and will follow each other, chasing the money and the returns. Some of the energy commodity trading funds had returns of over 40% during the past year and that has not gone unnoticed.

Similarly, as oil companies made money on increased commodity prices, their equities looked undervalued. Energy stocks, including oilfield services, looked the same. Also, the collapse of the merchant sector in the industry has created a significant distressed asset and debt play for the funds. As ex-merchants seek to raise cash by selling perfectly good assets, so the hedge funds have seen their opportunity, and today hedge funds are among the leading holders of ex-merchant debt backed by valuable collateral. Even as the industry seeks answers to its own problems, the hedge funds see opportunities in renewables and green trading, for example.

WHAT IS A HEDGE FUND?

A hedge fund is a type of “alternative” investment. The term “hedge fund” is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that uses sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. While hedge funds have traditionally been limited to sophisticated, wealthy investors, over time, their activities have broadened into other financial instruments and activities. Today, the term “hedge fund” no longer really refers to their hedging techniques, which they may or may not use, but it simply refers to their status as private and unregistered investment pools. They are usually unregulated.

Hedge funds are somewhat similar to mutual funds in that they are both pooled investment vehicles that accept investors' money and generally invest it on a collective basis. However, hedge funds differ significantly from mutual funds because they are not required to register under all of the federal securities laws. They have this status because they generally accept only financially sophisticated investors and do not publicly offer their securities.

Hedge funds are also not subject to many of the numerous regulations that apply to mutual funds for the protection of investors, such as those requiring a certain degree of liquidity, that mutual fund shares be redeemable at any time, protecting against conflicts of interest, assuring fairness in the pricing of fund shares, disclosure regulations, limiting the use of leverage, and more. This freedom from regulation allows hedge funds to engage in leverage and other sophisticated investment techniques to a much greater extent than mutual funds. Hedge funds are subject to the antifraud provisions of the federal securities laws.

Part of the difficulty in defining what constitutes a hedge fund is that other investors engage in many of the same practices. For example, investment bank proprietary trading desks take positions, buy and sell derivatives, and alter their portfolios in the same manner as hedge funds. Individuals and institutions buy stocks on margin, and even commercial banks will use leverage. For these reasons the line between hedge funds and many other types of institutional investors is blurred.

However, there has been a change in the status of hedge funds recently.On December 2, 2004, the US SEC adopted Rule 203(b)(3)-2 and related amendments under the Investment Advisors Act of 1940. The new rules will require most hedge fund managers to register as investment advisors with the SEC. The effective date for many of the provisions of the new rule was February 10, 2005, and all hedge fund managers had to be in compliance by February 1, 2006.

The United States is not the only country looking more closely at a variety of hedge fund regulation issues. The French Regulator has also adopted new hedge fund regulations, providing for the creation of single manager funds and revising the rules regarding the criteria applicable to investment by French funds in hedge funds. Other nations are following suit or have already acted.

Hedge funds are often labeled in the press as secretive and by inference as sinister. They have been blamed by the media, politicians, and others as being behind the run-up in energy commodity prices, but, as we will show, this is grossly unfair on both counts. In the United States, hedge funds are not allowed to market themselves. They have to show that potential investors are properly qualified before they can send fund materials. This means that hedge fund websites are stark password-protected pages offering no explanation of what or who they are. It means that it is exceedingly difficult to obtain any information about the fund, its manager, and its strategy for making money. However, this is simply a legal requirement of being a hedge fund.

These funds have been justifiably criticized because of the lack of transparency in investment methods. For hedge fund investing to become more widespread, the issue of transparency has to be approached. A fine balance has to be achieved between risk exposure information for investors without position-level transparency, which may be detrimental to a fund's performance. A fund may also use proprietary strategies and trading tactics that are vital for the manager's success.

Outside of the United States, marketing and solicitation rules are different and more information can be readily obtained on funds in the United Kingdom, for example. In fact, several hedge funds, such as London-based RAB Capital, are actually publicly traded in the United Kingdom and therefore offer a significant level of transparency to potential investors and shareholders. The supposed secretive and therefore sinister nature of the funds is in fact something largely dictated to them under law and regulation. We suspect that they would like nothing better than to build their own brands, profiles, and investor base if they were permitted to, just like any other business.

Alternative investments, and hedge funds, in particular are now widely acknowledged as a source of enhanced return compared to traditional portfolios. A number of strategies are available to the hedge fund manager to take advantage of declining as well as rising markets. Alternative asset managers aim to generate high rates of return for a given level of risk, regardless of market trends. Contrary to the sometimes prevailing public opinion, intelligent and effective risk management is a core component of each hedge fund strategy.

Hedge funds offer investors a number of advantages over other types of investment including, for example:

instant portfolio diversificationproducts can be created and structured quickly to meet the demands of a clientthey have traditionally offered superior risk-adjusted returns over the long run, with better downside protection over other investmentsabsolute performance orientation, which can deliver positive return in all market conditionsthe potential for low correlation to traditional asset classes, particularly fixed income.

Another type of fund that has gained in popularity among certain types of investor is the fund of fund (FoF) or multi-manager fund. A fund of fund is a managed portfolio of other hedge funds designed to provide greater risk diversification among a set of strategies, and investors in funds of funds are willing to pay two sets of fees, one to the fund-of-funds manager and another (usually higher) to the managers of the underlying funds. The fund of fund may be actively managed, meaning that the actual investments in other funds can change through time. The fund of hedge funds will be dealt with in more detail in Chapter 9, but according to Vann Hedge Fund Advisors3 there are now over 3,000 fund of hedge funds compared to less than 50 in 1990, holding about 40% of the industry's assets. There are also investments known as fund of fund of funds, where investors of fund of funds invest in other fund of funds.

US HEDGE FUND REGULATION — A BRIEF UPDATE

As stated above, on December 2,2004, the US SEC adopted Rule 203(b)(3)-2 and related amendments under the Investment Advisors Act of 1940. The new rules will require most hedge fund managers to register as investment advisors with the SEC. The effective date for many of the provisions of the new rule is February 10, 2005, and all hedge fund managers must be in compliance by February 1, 2006.

The new rules essentially require that advisors of “private funds” with more than 14 clients (more than 14 investors on a look-through basis) during the previous 12 months are required to register as an investment advisor if they have at least $30 million in assets under management. Also, they would be permitted to register if they have at least $25 million in assets under management. The SEC defined a “private fund” as an entity that:

1.Would qualify as an investment company under the US Investment Company Act of 1940 as amended if not for the exemption in either section (c)(1) or 3(c)(7) of the Investment Company Act;

2. Permits investors to redeem their interests within 2-years of purchase(lock up period); and

3. Offers its interests based on the investment advisory skills, ability or expertise of the investment advisor.

The new rules also require offshore advisors to look through all funds that they manage, whether or not those funds are located offshore and count as clients any investors that are US residents. Any offshore fund that had more than 14 US resident investors over the past 12 months would generally have to register also. The US resident designation is made at the time of investment in the private fund. An exception to the definition of “private” fund is included for a company that has its principal office and place of business outside of the United States, is regulated as a public investment company under the laws of a country other than the United States, and makes a public offering of its securities outside the United States in the same jurisdiction in which it is regulated as a private investment company.

Additionally, a registered investment advisor is generally prohibited from charging a client fees based upon capital gain or appreciation (meaning performance fees), unless the client is a “qualified client” (meaning a person or entity that has at least $750,000 under management with the advisor, has a net worth of more than $1.5 million at the time of the investment, or is a “qualified purchaser” as defined in the Investment Company Act). There is a “grandfathering” provision to allow investment advisors to maintain current fee arrangements with existing clients.

The new rules include a number of other provisions, such as modified record-keeping requirements, custody rules, and that readers should review the complete SEC rules for themselves.

Registration with the SEC as an investment advisor includes full compliance with the Advisors Act such as:

1. the preparation and filing of form ADV

2. the prohibition against charging performance fees to new investors who do not qualify as “qualified clients”

3. the adoption of written compliance procedures and the appointment of a chief compliance officer

4. the adoption of a written code of ethics

5. certain disclosure requirements upon payment of a cash referral fee to third-party placements agents

6. enhanced record-keeping requirements

7.additional reporting and audit requirements if the advisor has custody of its clients' assets

8.periodic inspections by the SEC.

One potential impact of the SEC registration requirement is a move to lengthen lock-up periods. Historically, lock-up periods had been 12 months, but recently managers have begun offering reductions in per-formance fees for longer lock-up periods. By lengthening such periods beyond 24 months, funds might avoid being defined as a “private fund,” and hence work around the new rules. The two-year lock-up rule was apparently intended to distinguish between hedge funds and private equity funds, but may now be potentially used to avoid registration.

WHO INVESTS IN HEDGE FUNDS?

It is generally estimated that 80% of all hedge fund assets belong to high net-worth individuals. This group of investors was the first to massively allocate assets to hedge funds. Currently, US “accredited investors” (minimum $1 million net worth) are reported to have 8-10% of their portfolio allocated to hedge funds. But institutions have been increasing their allocations to hedge funds at a rapid pace, too.

According to Van Hedge Fund Advisors,4 about 60% ofUS foundations and endowments, and around 20% of pension funds, have invested in hedge funds. European financial organizations are also known to allocate on average 1.3% of their total assets under management to hedge funds, and researchers believe that this percentage will rise above 5% in the future.

Some institutions are going still further. Some actually buy an entire fund; for example, Unicredito's purchase of Momentum Asset Management and JP Morgan Chase's purchase of Highbridge. Yet others set up an in-house fund of hedge funds (for example, the traditional manager Jupiter) or chose to establish an independent alternative investment firm. Institutions investing in hedge funds encompass many different sectors: portfolio managers (including private banks), insurance companies, corporate treasuries, pension plans, college endowments, and foundations. In all cases, the growing acceptance of hedge funds as a vehicle for institutional investment means that the available capital will continue to grow significantly.

Another survey by Prince & Associates5 also shows that about 45% of family offices are invested in fund of hedge funds, and this is set to grow significantly. Family offices are the world's private investors who invest the monies of high net worth (HNW) individuals. Since the 1980s most hedge fund investing came from HNW individuals and private banks. This is also now changing with the bulk of the new exponential growth coming from insurance companies, pension funds, and endowments.

The 8,700 hedge funds with around $1,000 billion in assets under management is double the number of hedge funds in 1999. It demonstrates the rapid growth of the hedge fund as a popular investment vehicle among particular groups of wealthy investors. The asset management industry is changing rapidly. The poor performance of traditional and index tracking funds in past years and the success of many individual hedge funds with different strategies, have shown that alternative investments are a plausible means to invest. Alternative assetmanagement differs from traditional asset management in its dynamic investment strategies, and hedge funds form the most dynamic sector of asset management today.

Stimulated by strong interest from sophisticated investors, this sector continuously attracts highly creative talented managers and enjoys sustained growth. The low correlation of hedge funds to equity and bond markets has become an increasingly important consideration for investors.Additionally, the effects of globalization have reduced the investor’s ability to achieve meaningful diversification through geographical spreads across traditional markets.

Over the past decade, hedge fund assets expanded dramatically; from US$20 billion to almost $1 trillion today, and estimates are that they will reach over $2 trillion in five years.6 There may be another 7,000 funds by then. In this decade the number of hedge funds has increased from 200 to more than 8,000 equally divided between the United States and offshore funds. However, some experts argue that hedge funds are experiencing a phase of consolidation, after which only 1,000 funds with an average size of $200 million (instead of $50 million today) may remain. That is highly debatable.

Hedge funds can take both long and short positions, and use leverage through financial derivatives in concentrated investments in order to maximize their profits. Their fund managers typically have a portion of their wealth tied up in the fund so that their relationship is in alignment with their investors.

Hedge funds have become a standard allocation class for corporations such as GeneralMotors, educational institutions such asHarvard andDuke Universities, and state and local government pension funds. In Europe and Asia the boom is also underway. Germany has loosened its requirements so that there is no minimum investment requirement. In effect, they sell them to the retail market. But in reality there are only two hedge funds there at present. Singapore is allowing a tax holiday in order to attract hedge funds to establish there.

It should be pointed out that over 70% of hedge funds have less than $100 million to invest and are thus not necessarily good candidates for institutional investors, although that criterion may change for energy hedge fund investing. In the past, investors waited for funds to develop a 3- and 5-year track record, and could wait for funds to grow to acceptable size before investing. However, that is now changing and huge capital inflows coupled with the relatively few number of “institutional quality” funds will cause funds to grow very quickly. Therefore, investment decisions will need to be made quicker with less reliance on long-term track records. This is creating new investment criteria for the hedge fund industry.

According to Strategic Financial Solutions,7 of the 8,000 or so distinct hedge funds and funds of hedge funds in 2004, approximately 5,500 were single manager hedge funds and accounted for over $1.5 trillion under management. They also found that nearly 175 of these funds have already surpassed the $1 billion assets under management mark, but that the majority manages less than $25 million. About 2,600 funds of hedge funds exist and manage approximately $415 billion in assets, but the majority of funds of hedge funds manage less than $50 million. The survey also found an additional 650 commodity trading advisors managing approximately $81 billion, with over 40% managing less than $25 million.

Worldwide financial assets are estimated at $126 trillion and the funds are now estimated to engage 0.8% of that amount. It is still really quite small.

THE BASICS OF HEDGE FUND INVESTING

As potential investors in a hedge fund, individuals first have to meet certain standards as HNW individuals, including, for example, having a net worth of $1 million or at least $500,000 under management with the advisor. Under Section 205(a) and Rule 205-3 of the Investment Advisors Act, investment advisors are prohibited from receiving hedge fund-like compensation based on a share of the gains, unless certain conditions are met. One of those conditions is that the advisor's clients are “eligible investors.”