Nestled inside the world’s largest bond fund manager, a team of commodities specialists has quietly built the sector’s most enigmatic hedge fund.

Since opening to investors in 2013, the PIMCO Commodity Alpha Fund has made returns of more than 10% each calendar year. It’s a rare feat for any hedge fund, even more in the the volatile world of commodities derivatives.

Commodity Alpha has managed those returns while growing to manage more than $2 billion, making it the largest hedge fund of its kind. The strategy totals almost
$5 billion when including a low-volatility version that PIMCO combines with commodity index swaps, what is known as an “overlay strategy.”

Now, PIMCO has plans to take in another $1 billion for a computer-driven fund capitalizing on predictable market patterns, people familiar with the plans say. The so-called risk premia fund promises access to a slice of Commodity Alpha at a lower cost – less than 1.5% of assets under management, or a 1% management fee and 10% performance fee.

The strategy has long made up part of Commodity Alpha’s mix of trades. Whereas a generation of traders made their names from outsize bets on the direction of energy markets, PIMCO aims to profit from small price differences in as many as 40 different commodities markets. The fund, led by Mihir Worah, tests fundamental conclusions against years of commodities market data.

“We don’t try to make money by believing we are smarter than everyone else or that we have better information than anyone else about fundamentals,” says Nicholas Johnson, a portfolio manager for Commodity Alpha. “I think there’s a certain amount of humility that we have.”

Relative value

The approach has proven resilient during a volatile period for the sector. The commodities supercycle has come and gone, leaving in its wake a group of floundering markets only recently unsettled by rising oil and gas prices.

Billion-dollar hedge funds, including Jamison Capital Partners and Andy Hall’s Astenbeck Capital Management, shut down recently following periods of underperformance. Adding to the run of closures, veteran oil and gas trader David Murphy’s Saugatuck Energy closed its main strategy earlier this year.

“Whereas it once seemed positions could be held with an eye to a longer-term secular appreciation, that is no longer the case,” Hall wrote in a letter last year.

Commodity Alpha has managed some of the industry’s most consistent returns against this backdrop. In more than five years of trading, the fund has achieved a Sharpe ratio of 2.23, according to Absolute Return data, bettering most of its peers on a risk-adjusted basis.

The fund has continued its positive streak this year, gaining 6.77% through September. The 15 largest commodities hedge funds made returns of almost 4% on an asset-weighted basis during the same period, according to the Bridge Alternatives Commodity Hedge Fund Index. (The index counts Commodity Alpha as its largest constituent.)

Hedge funds focusing on a single corner of the commodities markets, such as energy, agriculture or metals, have had a particularly difficult time making money. Markets that once exhibited clear trends now stutter between tightly-defined ranges, frustrating long-time traders.

“The specialists can’t create those opportunities,” says Ryan Duncan, co-founder of Bridge Alternatives. “They’re reliant on markets they trade to provide opportunities, and when those opportunities don’t present themselves, there’s not a lot for them to do.”

Instead, PIMCO has looked to exploit the structure of commodities markets. Those opportunities can also be fleeting, as exemplified by one trade Johnson explained to a room of investors earlier this year.

For years, PIMCO consistently made money on the spread, or price difference, between wheat futures traded in Chicago and Kansas City. High storage costs in Chicago caused a steep case of contango, where futures prices consistently outstripped their corresponding spot prices.

PIMCO would buy Kansas City and sell Chicago, profiting from this small discrepancy. The fund exited the trade this year after Chicago and Kansas City adopted the same storage model, eliminating the structural difference.

Recently, the flood of private equity into the energy industry has also created profitable structural features. The move has caused energy companies to increasingly hedge their oil production with futures contracts, creating stickier prices in long-term derivatives markets.

Johnson says the trend has helped contribute to a positive roll yield in energy futures, meaning their prices converge upward to corresponding spot prices. It has also cleaved differences between domestic and foreign futures markets, creating pockets of opportunity.

“If we have some fundamental view on valuations and it’s consistent with this flow-based structural interpretation of the market, that’s a good trade in our view,” Johnson says.

Growing pains

Commodity Alpha’s rise stands out against some of its competitors, which accuse PIMCO of generating consistent returns by betting against volatility. PIMCO has said a portion of the fund trades the volatility of single commodities and broader indexes, though it constitutes a small part of the portfolio.

Commodity Alpha does not disclose the sensitivity of its derivative holdings to changes in parameters such as price and volatility. The measures, carrying Greek names such as “gamma,” could give a hint to the fund’s exposure to volatility in various commodities.

“We occasionally hear rumors that’s mainly what we do,” Johnson says about short volatility trades. “If that was mainly what we did, we would have had a horrible five-year return period.”

Commodity Alpha also relies on large amounts of borrowed money to amplify the small returns generated by its trades. The fund borrows more than six dollars for every one dollar of investor money, a ratio that places it in line with similar relative-value strategies.

The leverage heightens PIMCO’s already-large stature in commodities futures markets, where the fund executes more than a third of its trades. Since the 2008 financial crisis, funds like PIMCO have played an increasingly active role setting prices and providing market liquidity, filling the space left by the retreat of bank trading desks.

Such a large footprint means PIMCO must consider the effects of its trades on broader markets. Earlier this year, Millburn Ridgefield Corporation closed a more than $200 million fund to new investments for similar reasons, saying the fund had bumped against the market capacity for its spread trades. “There are trades we like where we would do more of them if the market were bigger or deeper,” Johnson says.

Commodity Alpha trades a greater range of markets than many of its competitors, investors say, giving the fund room to expand. But over time the strategy has concentrated most of its money in the energy sector, similar to several other large commodities hedge funds.

At the beginning of the year, Commodity Alpha had about 60% of its money in petroleum and natural gas trades. That ratio has since crept up to about two-thirds, bumping against the fund’s own guidelines.

Commodity Alpha’s exposures can change materially each quarter, Johnson says. At the same time,the fund has recently avoided trades in metals markets, which present fewer opportunities for relative value trades.

“There have been times recently where we have had almost zero risk in natural gas, and there are times otherwise where we have had the majority of our risk in natural gas,” Johnson says. “…In a perfect world we would like to take on average equal risk across all the markets.”

Risk premia

Institutional investors have slowed investments to commodities hedge funds, pushed away by faltering performance and a spate of closures. Last year, in a sign of flagging investor interest, Blackstone Alternative Asset Management disbanded a fund that had seeded several prominent commodities managers.

“You haven’t seen a lot of new entrants to the space,” Duncan says. “They’re waiting to see performance pick up within the whole commodities hedge fund space before they start doing real work.”

At the same time, commodity risk premia funds such as PIMCO’s have gained popularity as investors seek exposure to real assets without the volatility of traditional hedge funds. Banks have also rushed to develop their own risk premia derivatives, providing clients such as pension funds easy access to the trades.

Commodity Alpha has been closed to new investors since the end of 2016. Its clients include pension plans for Pennsylvania teachers, Illinois university employees and public employees in Kern County, California.

For investors who missed the cutoff for Commodity Alpha, the commodity risk premia strategy promises access to some of the same trades. “This strategy is no different, it’s just a more systematic version and a subset of what we have done for years,” Johnson says.

With the offering, PIMCO also joins a growing list of computer-driven strategies that have come to dominate commodities futures trading. Several hedge funds have blamed trend followers and other systematic funds for distorting markets, skewing trades that were once cash cows.

Johnson, however, doesn’t buy that explanation. “I think that’s the most ridiculous thing I’ve ever heard,” he says, instead offering a silver lining: “If there’s a trend-following strategy that’s pushing prices to…non-fundamentally justified levels, that should be a great blessing for all of these commodity hedge funds.”

Inside the commodity sector’s largest hedge fund on Absolute Return.