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THE VOICE OF tHE ALtERNAtIVE INVEStMENt INDUStRY

Plain sailing as the GMI ship fund makes some pieces of (very non-correlated) eight
Date: September 2007
1991. He traded extensively on freight futures and in 1994 co-founded EMC Ltd, a freight trading firm.

Foot in both camps

M2M has made quite a splash in its first year with its Global Maritime Investments shipping hedge fund, making 31% and raising $111m in barely 10 months. GMIs Stephen Rodley and Stuart Rae told David Walker how they managed both
If youre looking for non-correlated pieces of eight, to the tune of 31% on volatility of about 4%, then M2Ms freight hedge fund, Global Maritime Investments (GMI), may have just the tonic. GMI launched on 5 October 2006, well beat its target returns of 20% by 31 August, breached the $100m assets under management mark in less than 10 months and has a variety of existing and committed future investors. Standing at $111m in mid-September, a large commitment from a large institutional investor sees its expected AuM at around $200m, close to its $250m capping target. Stuart Rae, joint managing director of M2M, says he would expect GMI to be closed to new investors by years end. Stephen Rodley, joint managing director of M2M, explains the fund is involved in both freight derivatives (notably forward freight agreements or FFAs) on the worlds dry bulk freight, and is also in the physical market, hiring ships to ply the seas and deliver dry freight such as grains, iron, ore, metals, coal, silica and the less-wellknown spodumene.

Physical edge

Understanding the ins and outs of specific freights in physical shipping provides a distinct edge to managing such a fund, Rodley says: for example, in deciding whether to ship silica which may need expensive and time-consuming scouring of holds to remove traces of previous loads or take the simpler option of coal. The portfolio managers knowledge of the worlds dry freight carriers is so extensive Rodley notes: if you showed Stuart or me the broad parameters of a ship, we would probably know which yard it was built in and when. GMI is active in dry freight, rather than the wet so does not get involved in crude oil on the physical delivery side, known as wet freight. So, why, oh why, just dry, why not get wet, if China among other factors sees oil demand running as high as that for dry commodities? keeping nice and dry Stuart and I have been active in the dry market for 35 years, so when people come to do their due diligence we can stand up to the interrogation, Rodley says. He brings with him direct experience from the commodity industry side, having managed BHP Billitons Panamax freight operations. Ship classes Panamax is a class of freighter that can traverse the Panama Canal, carries a load of 74,000 to 76,000 tonnes, mainly in grains, coal and iron ore. Panamaxes stand in contradistinction to classes such as the Cape, which can round the Capes Horn and Good Hope with a load of around 160,000 to 170,000 tonnes, lugging coal and iron ore on routes predominantly including Brazil, Australia, South Africa and Columbia. Being involved in the physical market will afford Rodley and M2Ms team a more elegant view of when a decision will be made to split one Capes load into two loads for Panamaxes, for example, or provide them foresight as to when a congested port may prefer Capes, so they would only have to pay penalties to one ship if they could not unload or load it quickly enough. And finally, there is the Handymax, whose handier smaller size affords them entry to smaller ports, carries all the cargo Cape and Panamax can carry and also loads such as steel products and cement. Beside Rodley, at GMIs helm sits Stuart Rae, who began his shipbroking career in 1986 in London, establishing shipbrokers and consultants GMT Shipping Ltd in

It is believed GMI is the only hedge fund to straddle both sides of the physical and financial markets around freight. We remain today, the only shipping hedge fund trading the physical, although there are three or four other companies around trading equities or freight futures. We think it is critical to be on both sides because we make most of the margin on the arbitrage between the physical and the derivatives markets. Rodley estimates more than 80% of GMIs trades straddle the two markets. While the physical shipping market obviously involves hiring ships to deliver goods as GMI will do, for example, next year for steel producers to move Brazilian iron ore to Europe a forward freight agreement in the derivatives markets encompasses all the costs of hiring a ship and its crew. While banks and other speculators have added to what Rodley dubs exponential growth in the FFA marketplace, they are not simultaneously crowding into the physical market. knowledge is power The information flow you get from being on the physical side is critically important, Rodley adds. We get to know exactly what ships and cargoes are around and what the demand is. Also, if you are hiring ships at a fixed price for a year, if the market goes down and youre losing money you can sell a derivative hedge against that long position you have in the physical. Rodley explains further, that being involved in physical delivery satisfies the need for information flow in a very real way that helps managers avoid losing trades, trades that movements in the derivatives markets alone could well have recommended. After Hurricane Katrina hit New Orleans in 2005, for example, Handymaxs were used to bring in cement and steel for reconstruction, Rodley explains and the resulting demand moved the indices for the various ship categories. On charts, it would look as though you should be selling the smaller ships (as their asking price had gone up) and buying the bigger ones (whose price had stayed lower relative to the Handymaxs) but against all historical curves there were fundamental reasons why they (Handymaxs) were higher and would keep going up, M2Ms Rodley says. Rodley adds that, from an investment perspective, there is also more opportunity on the dry side than in wet, as the dry market is more disjointed. While the wet side of the physical market is dominated by a few majors Exxon Mobil and BP, for example, all shipping their own petroleum, jet fuel and Crude the dry market is more fragmented, with firms such as mining companies, power utilities and grain producers using third parties to transport coal, grains and metals, for example. Rodley notes, M2Ms managers experience in the physical market affords them a more precise view of which vessels are sailing which routes GMI leases ships to conduct physical transport which also aids the elegance of the funds derivatives trading program, which both hedges against loss and aims to generate profit on its own account. The fund runs with a market-neutral positioning. We have typically been having a net ship day position not often much more than 100 days either side, Rodley adds. On the physical side, the portfolio began by use of Panamax vessels (ships carrying about 70,000 tonnes of cargo), for set periods or defined journeys or sub-letting, to deliver freight globally. It has since expanded into Handymax, as well.

Shipping liquidity

On the derivatives side, GMI seeks out arbitrage opportunities in the FFA market. Figures from the Baltic Exchange in London show how much depth this marketplace has added in the past few years. In March 2007, figures compiled from the FFA Brokers Association showed a market for freight derivatives with around $56bn in 2006. Even recently, in the second quarter of 2007, volumes of FFAs leaped, up 32% on the first quarter, according to figures compiled by the Baltic Exchange. In total 432,809 lots were traded in the dry freight derivative market in the second quarter, against 326,650 in the first quarter. A key driver of freight rates Rodley identifies presently, is congestion at ports in Brazil, China and especially Australia. Indeed, Rodley explains enthusiastically, if

W W W. H E D G E F U N D S R E V I E W. CO M

MANAGING MONEY

one visits the quays at Newcastle, one sees up to 70 ships sitting offshore, waiting to dock. It was (the case) around 12% of the dry freight (capacity) was around offshore in Australia, Rodley says. One of the main factors in the trades is (miners) can dig commodities out of the ground, but getting the goods across rail tracks and infrastructure has not improved much over time, he adds. Everything is running pretty much at full tilt, theres not a rail car in the world not moving commodities, not a crane doing its maximum rotations, and there is an awful lot of port expansion and rail expansion planned globally, but with more new ships being built there will be more ability for shipping and to a degree it will be absorbed, Rodley says. But the minute the supply chain breaks or stalls, the queues build up immediately. Another spanner in the works of unstressed global commodities movement is that of extra tonne miles. If you say there will be x million tonnes more of iron ore in 2008 shipped to China, you have to ask where is it coming from? If it is predominantly coming from Australia, thats a 30-day voyage, if its from Brazil it will be 70 to 80 days, thats more shipping days for the same number of tonnes, he adds.

As can be seen by the index on the previous page from Diapason Commodities Management, prices for dry commodities have also reached high levels, making conversion to dry bulk carrying an economically attractive proposition. While some ships, called oil bulk ore (OBO) carriers, can carry wet and dry freight, Rodley explains, they are in the minority and typically do not switch freight types on return journeys, but rather load one type of freight for many years, then switch for a number of years to the other, before switching back. About 24 vessels, representing around 5m tonnes of dead weight capacity, have been earmarked for conversion to dry carriers. Stuart Rae says the rates ships can command for wet freight falls markedly after a ship celebrates its 15th birthday, so come a vessels 12th or 13th party the owner may break to it the news it is to be converted to dry freight.

Rsk management

White waters

Index volatility is the friend of the non-directional, arbitrage-seeking GMI fund and measured on a one-year moving average. The Baltic Panamax Index shows it rising from around 20% in late 2003. It has remained high, despite the underlying dollar-timecharter shifting up and down, for example, the rate falling by up to nearly 75% at the end of 2004. The derivatives market has been a backwardated curve for years, in terms of prices looking forward, explains Rodley. As reported last month in Hedge Funds Review, the Baltic Dry Index (BDI) hit all-time highs, reaching 6230 points on 27 April, with Baltic Exchange chief executive Jeremy Penn having concurred with Rodleys assessment by attributing high rates to congestion at Australian ports, as well as coal and iron ore demand from China and a weak dollar. Between 1985 and 2003, by comparison, the BDI traded in between 500 and 2500 points, according to figures sourced from the Baltic Exchange. Views in the traders market are bifurcated between those seeing only downhill and those who foresee even sunnier days ahead, with the fourth quarter historically the busiest for global dry freight rates, as ship supply is squeezed by northern grain harvests, winter heating oil and salt, all needing moving ahead of colder weather. The BDIs north easterly direction stands in stark, non-correlated contrast to stock markets, which dropped around 12% by mid-June. The shipping rates indices can head whichever way the wind blows, as far as Global Maritime Investments is concerned, however, Rodley says, as he and Rae can trade the arbitrages on both the upswings and downswings of the market. We are looking for disparities and arbitrage opportunities, we are not a directional fund, so uncertainty and volatility is good for us. For us, the market can trade at $70,000 or it can trade at $10,000, as long as it moves around, says Rodley. Large price disparities exist for GMI along the Baltic Panamax Index curve, for example the fourth quarter Panamax is trading at around the mid-$60s, (namely, the mid-$60,000 mark to hire a Panamax for one day) whereas the 2009 delivery was trading at between $35,000 and $36,000, Rodley said on 14 September. There are some people who will say the strength of the fourth quarter will roll through into 2008 and there will be lots of demand for the first and second quarters (of 2008), he adds. With the average earnings over the last 20 years being at around $20,000 per day, a sizeable gap read opportunity for hedge funds may exist where such a long-term average gapes away from a shorter-term rate rise. On the FFA side, Rodley explains, GMI does not typically trade out as far as two years because we get more bang for our buck by doing nearer trades. The 2009 and 2010 contracts on futures are not as liquid, whereas the fourth quarter of 2007 and 2008 is massively active and you can get out of trades without too much slippage just as important as being able to get into them. One of the trends the shipping market has witnessed of late has been the conversion of wet freight tankers into dry bulk carriers, an irreversible process that allows the ships operators to take advantage of tight supply in the dry freight market (as represented by the Baltic Dry Index of shipping rates sitting at all-time highs).
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To manage the risk its portfolio takes on from both markets, GMI employs value at risk-based limits and stress testing, it limits fund exposures by time (we do not typically enter into trades more than three years forward, notes M2Ms Stephen Rodley). The aforementioned net exposure limits are also applied. Some of GMIs operational risk has also been reduced by the centralised clearing of freight futures, Rodley notes, a move from the bulk of the market having been over the counter and involving greater counterparty risk. Now 15%20% of the FFA dry bulk is being cleared the London Clearing House and by NOS Imarex and the Singapore Stock Exchange, and 60% of the FFA part of our portfolio is cleared by NOS Imarex or the LCH. Why take on the credit risk if you do not need to?, GMIs Rodley adds.

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