Adapted from Hedge Hunters: Hedge Fund Masters on the Rewards, the Risk, and the Reckoning. by Katherine Burton Copyright 2007 by Bloomberg LP. Published by arrangement with Bloomberg Press. All rights reserved. Available wherever books are sold.
Mastering a Changing Market
Bruce Ritter grew up on a two-thousand-acre farm in Bonanza, Oregon. His family raised cattle and grew wheat, barley, and alfalfa, and Ritter did his fair share of hard labor: branding cattle, planting crops, and driving combines. Today, Ritter runs $500 million Yannix Management, named for a small mountain in southern Oregon that one can see from the fields of his family’s farm, which his brother now runs. Yannix trades corn, wheat, soybeans, cattle, hogs, and other livestock.
Ritter, fifty-seven, is lanky with dark hair and a calm, professorial air. When he talks shop, he sounds a lot like an academic, tossing out phrases like price elasticity and tail events (his undergraduate degree from Oregon State is in economics). Yet he sees his edge as coming, in part, from those days on the farm, when he learned firsthand that the price of a commodity drives farmers’ behavior. He knows the price at which farmers will decide to plant one crop rather than another, or switch one kind of animal feed for another. It’s all about substitution.
Joining a network of funds—called Ospraie Wingspan—seeded by Dwight Anderson’s Ospraie Management, Ritter opened Yannix in July 2005. In exchange for undisclosed portions of the 2 percent management fee and the 23 percent of any profits Ritter charges his clients, Ospraie takes care of all the administrative and operational business of the fund once the trades have been placed. Ritter is free to spend 95 percent of his time on investing, which he does from a sparsely furnished office in Wilton, Connecticut, with a five-person investment staff that includes a meteorologist.
Ritter’s fascination with agricultural commodities remains undiminished after more than thirty years in the business. “Agriculture affects everything in the world,” says Ritter, “and everything in the world affects agriculture.” He has a point. If the housing market dries up, that could send beef consumption tumbling as families feel poorer and opt for chicken or pork over steak. Likewise, higher economic growth in China may mean an office worker in Beijing goes to KFC twice a week instead of once. “Under-standing where the economic stress points are and which way the political winds are blowing is extremely important. Our markets are a function of economic analysis, politics, and the weather,” he says.
Yannix made its debut at a particularly interesting time both for the commodities markets and for Ritter. Launching a hedge fund is considered a younger man’s game, with most managers making the move in their late twenties or thirties. Ritter was a few months shy of his fifty-fifth birthday when he decided to go out on his own. He had spent nearly thirty years in both management and risk-management positions with the commodities trader Louis Dreyfus, and for his last two and a half years, he managed an agricultural commodities fund using the firm’s own capital. “I was at a point in my career where I wanted a change,” says Ritter. “I wanted a new challenge and this was it.”
Ritter had known Dwight Anderson over the years, and he respected him. He also liked the business model at Wingspan, and he figured raising money would be relatively easy, given the huge bull market in commodities. A range of investors—from wealthy individuals to funds that invest in hedge funds—was clamoring to put cash into commodities, once the backwater of finance. Ritter was right about the pent-up demand, and by 2007 he had reached his self-imposed limit on the amount of capital he wanted to manage, given the relatively small size of his markets.
As Yannix started up, Ritter saw seismic shifts taking place in the commodities markets. “They’re dynamic markets, and if you look back ten years from now, you’re going to see some dramatic changes. We’re not all going to survive,” says Ritter. “To enter this field, either you have to be naïve or you’ve got to think your skills are well above average.”
The market changes Ritter foresaw are the result of two trends: in-creased interest in fuel made from corn and other agricultural commodities, and huge inflows into commodities funds from institutional investors. Both have changed the very nature of how commodities trade.
The push to use so-called biofuels like ethanol started in earnest with the passage of the Energy Policy Act of 2005, which requires that 7.5 bil-lion gallons—5 percent—of the nation’s annual gasoline consumption come from renewable fuels by 2012. In his State of the Union address in January 2007, President George W. Bush mandated that the United States cut gasoline consumption by 20 percent by 2017, replacing it with biofuels.
Ritter, for one, thinks this push for biofuels is bad public policy. The modest energy savings, he says, are far outweighed by the danger of cut-ting food supplies around the world, particularly in third world countries. Heavy government subsidies are encouraging the production of ethanol from sugar and corn and the production of biodiesel from soybeans. The trouble, as Ritter sees it, is that the first time there’s a major drought or other natural event that reduces supply, governments will be faced with a dreadful dilemma: Do we feed people or fuel cars?
Over time, Ritter says, politicians will understand these dangers, but he doesn’t see enlightenment coming overnight. “Politics is a popularity contest,” says Ritter. “And today the use of biofuels is popular. It sells well in Des Moines and it sells well in San Francisco. It’s not going to sell that well when there’s a shortage of meat. And it doesn’t sell well today in the developing world.” Warning signs are already appearing. The demand for corn by ethanol producers drove the price of the grain up 80 percent between the beginning of 2006 and mid-2007, and that’s already causing problems in Mexico, where half of the average citizen’s calories come from corn tortillas. The government intervened in early 2007 to ask retailers and food manufacturers to cap corn tortilla prices.
The other major catalyst in the commodities markets is the entrance of institutional investors, who started buying commodities in about 2002 through index funds and other so-called long-only products, which wager exclusively on the rising price of commodities. As prices have steadily risen, more pension funds and other large investors have jumped in, buying into funds run by Goldman Sachs and other large financial services firms. The investors betting on commodities these days are doing so for the long haul because they foresee huge demand coming from China and emerging markets. These huge inflows make the market much less predictable in the short term, although in the longer term, the forces of supply and demand still apply. For example, a forecast for better-than-expected weather in the Great Plains would normally mean greater supply and lower prices. Nowadays that drop in price might be less severe than expected—at least initially—because of the money pouring into commodities funds from the likes of Goldman Sachs buying futures for their index fund investors and pushing prices higher. “The endgame is clear; how you get there is not always clear,” says Ritter.
These investment flows in late 2006 threw Ritter a curveball that cost him about 9 percentage points of performance that year. Although his funds ended the year up 11 percent, that’s below his long-term target of about 15 percent a year, a return he aims to make without losing more than 5 percent in any given month.
September 2006 was not one of those months. The price of wheat by then had already risen about 30 percent since January because of droughts in the United States and Europe and dry weather in Australia, which led to the perception that the world was going to run out of the grain. Ritter wasn’t convinced. He calculated that given the rise in wheat prices, farmers were already feeding their livestock corn or other types of feed so the current supply of wheat would be adequate. The price rise had persuaded growers in Russia and other former Soviet Un-ion countries on the Black Sea to plant more wheat, and that wheat, he figured, would be exported, rather than used domestically.
So Ritter made a wager—what’s known in the commodities world as a calendar trade. He bet that the price difference, or spread, between the most active futures contract at the time (due to expire in December 2006) and futures for delivery in July 2007 (the first month of the follow-ing year’s crop) would increase. Normally, because of storage costs for agricultural commodities, the futures contracts closest to expiration are less expensive than those that expire later. On September 28, the December 2006 futures were trading at about $0.15 less than July 2007 futures.
Later that same day, Australia’s sole wheat exporter estimated that the drought would cut wheat production by half, more than anyone was expecting. The news sent December 2006 futures contract trading in Chicago to a nine-year high. The amount of cash from institutional investors that was pouring into commodities at the time created a shortage of futures and exaggerated the price jump, as did the fact that producers were selling a smaller amount of futures to hedge price moves. Over the next eight trading days, the spread between December 2006 futures and July 2007 futures jumped to over $1 as the price of the near-term futures rose above those expiring the following year. Ritter and other investors who had been betting the December futures would drop in price got creamed.
It was the most dramatic price move Ritter had seen in his thirty-plus-year career in that it was not caused by weather, political unrest, or other “normal” events. “I’ve seen larger absolute price movements, but they were explainable price movements,” says Ritter. With stops in place as insurance against such price swings, he eventually was forced to sell his position. Within thirty days, the markets were back to where they had been in late September. “It was a classic case of being right on the economic analysis, right on the long-term consequences of price, but underestimating the volatility of the path.” He credits the use of stops with saving him from losing a lot more money. “Anybody who doesn’t use stops is going to be out of business at some point. It’s not if; it’s when.”
The influence of long-term investors on commodities prices has prompted Ritter to change the kind of research he does. Before 2002, he spent most of his time looking at crop production and weather as a means of forecasting prices. That’s no longer enough. He must also try to divine how much cash is going into commodities index funds. Nowadays, he says, absent any unusual weather, these flows are the biggest determinant of price in any thirty-day period. Getting such data is difficult, though, because the big banks that run the commodities funds aren’t likely to tell the world what they’re doing. “If you’re Goldman, the last thing you’re going to do is tell me that I’ve got a billion dollars coming in or a billion dollars going out,” says Ritter.
As more traders have come into the market, Ritter spends more of his time second-guessing less experienced investors. “The markets have excess information,” says Ritter. “There’s so much noise that it’s very hard to know—but very important to know—which data are most important on any given day. And it also makes a difference, more so than it used to, to understand what other people think is important.” For example, an economic indicator may be coming out that Ritter has learned from his long experience is meaningless for commodities. Yet, if a group of investors think it’s important, it becomes important.
Ritter is also cognizant of his relatively puny size compared to that of other players in the market. “There are a lot of multibillion-dollar hedge funds that have the ability to move money into or out of agriculture very quickly,” says Ritter. When they are wagering against him, it’s best to get out of the way.
Also worrisome to Ritter is the fallout for his markets should there be a major crisis—if political support for ethanol suddenly dries up, for example, or if the economy unexpectedly slows. A rush of investors all trying to exit at the same time would wreak havoc on prices. This pros-pect has made Ritter more conservative in his investing, and as of July 2007, he was up about 2 percent for the year. “People that get in easily won’t always be able to get out easily,” he says.
Although Ritter keeps a vigilant finger on the pulse of investment flows into commodities, he continues to do the same kind of research he’s al-ways done, and good weather forecasting is a huge part of whether his investments are successful. Suppose, for example, that an acre of land produces 153 bushels under typical weather conditions. Even relatively small differences in weather can cause that production to vary between, say, 145 bushels and 165 bushels. Most investors don’t realize that such differences in yields have a significant effect on prices, Ritter says, and that’s why an accurate weather forecast is so important.
Complicating that task, however, is the abundance of meteorological data now available. “There’s a lot more information out there now, 90 percent of which is irrelevant. And the weather forecaster’s job, and my job, is to determine which 10 percent of the input is meaningful and which 90 percent is extraneous.”
The judgment needed to sort that data is not unlike what’s required in culling for profitable trades. The same attributes that make a good trader also make a good meteorologist, Ritter says. They both take a set of data, analyze it, and make a forecast. A very talented meteorologist is probably right 65 percent of the time, and if the weather map changes, the meteorologist has to change the forecast. “It demands the same objectivity and dispassionate analysis and ability to understand when the situation changes as does trading,” says Ritter. Indeed, at Louis Dreyfus, Ritter’s knack for uncovering essential information enabled him to take on the kind of calculated risk that Anderson said he was so good at as-sessing. The market in 2004 was expecting a shortage of soybeans, which caused the spread between the July futures contract and the following November futures contract to widen. “This is one of those classic arbitrage trades which either makes people a lot of money or, from time to time, takes people out of business,” says Ritter.
The perception of a soybean shortage in the near term was so great that the price of July futures rose higher than the price of November futures. As with the more recent wheat trade, Ritter thought the perception was all wrong. For starters, there was a surplus of soybeans in South America, notably Brazil and Argentina, and he knew that if the shortage in the United States was severe enough, South American soybeans would make their way north to meet the demand. What’s more, Ritter had a good handle on the amount of investment flows coming into the market. He also had forecast that the weather in July was improving—so more soybeans would be produced—and he reckoned that farmers had already cut their demand for soybean meal by substituting corn to feed their livestock.
Confident, Ritter made a bet, increased with borrowed money, that soybean prices would tumble. He made the wager by buying put options whose exercise price was far below where soybeans were currently trading. He figured the plunge would come soon, once the other market participants understood just how much substitution of animal feed had already taken place, and when it did, the price swing would be dramatic. “Markets in their final phase are very vertical,” he says. The profits from Ritter’s wager were substantial. “That’s a case where the experience of understanding historical price relationships and price elasticity served me well. That’s our job, to understand that we’re at a flex point in the markets.”
Doing a money manager’s job well, in Ritter’s view, takes someone who’s creative enough to understand dynamic changes in the market, has the conviction to execute those trades, and has the discipline to under-stand that when a mistake’s been made, it’s time to look for the next trade. “You have to know when to hold ’em and know when to fold ’em,” says Ritter. “You have to recognize that the amount of capital held by someone across the table from you is very, very large. That means you have to get out of positions quickly—even if you’re right. That takes discipline and conviction.”
Ritter’s conviction that he has the necessary discipline to conserve his investors’ capital is strong. But after twenty-one months at the helm of his own firm, he has some concerns. “I have not achieved the returns I would have liked to achieve over time and part of that is the need to ad-just to a different market makeup,” says Ritter. He does not expect the current market dynamics to last forever, though. He’s convinced that something is going to go wrong in the next five to ten years—whether it’s an unexpected slowdown in the Chinese economy, a change of heart from the government about the practicality of biofuels, or poor returns from index funds that eventually drive institutional investors away—which will make for a very difficult market situation. Most investors in these markets don’t realize the magnitude of this risk, says Ritter. “I want to make sure that I am not caught in it.”
Essential as his experience and expertise may be, Ritter knows they can be a handicap if they blind him to new forces in the market. “I think they’re a very definite plus over time, but in the short term, they can easily lead you to be right too early,” says Ritter. “Being too far ahead of the herd can be as painful as being behind it.”
Adapted from Hedge Hunters: Hedge Fund Masters on the Rewards, the Risk, and the Reckoning, by Katherine Burton, Copyright 2007 by Bloomberg LP. Published by arrangement with Bloomberg Press. All rights reserved. See also: Must-Read Investing Books.