The Blow-up of The Ospraie Fund

I'm sure some of you caught the story a few days about the collapse of The Ospraie Fund, which happens to be one of the largest commodity funds around. It's a good example of how good short-term performance hides risk:

A year ago, Dwight Anderson was being hailed as the "king of commodities," a precocious 40-year-old hedge fund manager who made a prescient - and highly profitable - bet that global food prices would spike in unprecedented fashion.

Now he is merely another in a long line of hard-luck speculators, his crown handed to him by a fickle commodities market that has proven itself capable of ruining fortunes as quickly as it created them.

In a letter to investors yesterday, Mr. Anderson announced he was shutting down the largest fund of Ospraie Management LLC, the firm he built into one of the largest commodities-themed hedge funds in the world. The Ospraie Fund, which focuses on natural gas, oil, metals and other resources, boasted assets of almost $4-billion (U.S.) at its peak last year, but so far in 2008 it is down 39 per cent - including a gut-wrenching 27-per-cent slide in August.

Here is an example of someone producing exceptional short-term returns, only to see everything fall apart in the end. Anyone that invested in this fund early probably made good money; but for those coming late to the party, well, the outcome is obvious in hindsight.

Jim Rogers likes to say that commodities are safer than stocks but I would argue that their extremely volatility makes them risky for the average investor. A 20% drop in a short period for the broad stock market would be considered a crash but not so for commodities. Gold and oil, among others, can drop 20% within a few weeks and it wouldn't be considered a crash. Fundmental investors don't care about these price swings but they may come under forced liquidation or face margin calls.

Commodity bulls have been mauled by the bear recently but the good news for them is that commodities are still the best peforming sector for the year, and you would still be sitting on big gains if you invested an year (or more) earlier. The downside is that a lot of commodity valuations are driven by momentum rather than the fundamentals, so if the momentum crowd gets out, prices can drop significantly.

The interesting thing about Ospraie is that they seemed to have turned bearish on commodities in 2006 with disastrous results:

In early 2006, convinced the exuberance surrounding commodities had gotten out of hand, Ospraie turned bearish and began shorting energy and mining stocks. The result? Mr. Anderson was forced to shutter one fund and absorb a loss of almost 20 per cent in his flagship, according to reports.

So here we have someone who turned bearish on commodities in 2006 only to lose his shirt (or maybe just his coat,) then turned superbullish on commodities and ended up losing his shirt finally. (for what it's worth, I turned bearish in 2007 and know what he must have felt in 2006.)

Some (unrelated to Ospraie) are still sticking with their bullish stance:

While many investors run for the exits, the true believers, like Mr. Sprott [of Sprott Asset Management] and Mr. Bell [of Salida Capital], insist they will stick it out, no matter how white-knuckled the ride. They argue that the fundamentals have not changed, and that the underlying drivers of demand, like China, will ultimately prevail over short-term price swings.

"Nobody has shown me an aerial video of peasants streaming out of the Chinese cities back to the rice paddies with their hoes over their shoulders," said Mr. Bell of Salida. "I don't think that's happening, but the market action would tell you that that's what some people are thinking. I don't buy it."

I don't buy this reasoning. What matters is not the present but the projected future growth rate. Commodity stocks are trading as if the demand growth from Asia (and other places) will continue indefinitely. A small change in growth will cause everything to come crashing down. You don't need the urban Chinese to go back to the farms for commodities to correct. Nope. All you need is for the commodity demand growth to be lowered and big corrections will occur. One of the reasons commodities are being sold off is because emerging market growth is decelerating. China's growth is decelerating rapidly; India is on the verge of a stagflationary bust; Vietnam and others are having big inflation problems; and so on.