Family offices, prop shops, electricity markets…and portfolio diversification

To reduce their investment risk, family offices are diversifying portfolios away from equities and fixed income by using asset classes whose return does not correlate with either.

Some are content to measure correlation, or a lack of it, by using performance numbers. We prefer to analyse the underlying quality of uncorrelated opportunities before going on to decide whether this is backed up by data.

The best way for outside investors to get involved is by agreeing to back prop traders when they set up on their own

We ask ourselves: “What fundamental variables are driving the returns?” And: “Are they different variables to what is driving the current portfolio?” 

The electricity market offers some of the best opportunities to diversify from equities and fixed income we have come across. 

Imagine a situation where returns depend on how cold Chicago is – or the fact New York is hot and humid while New Jersey down to North Carolina is relatively mild – or because it is a windier day in Detroit than expected – or because a thunderstorm came through California. 

These are the primary drivers of the supply and demand side of the US wholesale electricity futures market. Fundamentally, it doesn’t care if equities are dropping, what GDP or unemployment statistics are, what the fed funds rate is or whether the “Fed put” is a feasible long-term trading strategy. 

Nor are power futures included in any of the large commodity ETFs that investors currently access. It is not included in any indices. One product can be traded on the ICE marketplace, but the full range of opportunities can only be accessed through Independent System Operators (ISO), which manage the electricity needs for different US states. 

Just like electricity diversifies family offices’ portfolios, there is natural diversification within the different ISOs themselves – the weather in California, for example, has nothing to do with the weather in New York. In addition to the futures product, you can trade other power-related instruments which, for example, offer exposure to products designed to manage potential congestion in the electricity grid. 

The size of each opportunity is constrained, but trading opportunities arise continually as utilities seek to hedge retail contracts on a short-term basis in a wholesale market. Utilities seek profits from the spread between the cost to them in the wholesale market and how much they charge their end-users in the retail market, leaving investors the opportunity to take advantage of mispricing in the wholesale market. 

The largest player (utility companies) aren’t involved in the market to speculate or capture mispricing but rather to hedge their customer contract demand risk.  

They often invest alongside prop shops, where a few experienced traders have broken away from proprietary trading operations to build a business through equity participation, rather than their trader commission profit share. Their company also provides the collateral they require to trade for the prop shop traders. 

Short-term trading products are capital efficient but capacity constrained. Prop shops are able to put between $1 million to $15 million to work and expect a realistic gross return of between 50% and 100% each year. 

The best way for outside investors to get involved is by agreeing to back prop traders when they set up on their own. Because product capacity is constrained, we have generally found the opportunity is better suited to family offices than institutions.

Prop shops are exposed to risk for hour-long periods up to 36 hours in advance. If a pandemic occurs, and demand gets significantly affected, traders can easily adjust because they only submit trades one day in advance. 

Hedge funds using power futures tend to trade longer-term products, comprising monthly, quarterly and annual contracts. Hedge fund structures are in a better position to raise third-party investment and tend to manage between $100 million and $150 million, where a realistic expected return can fall between 20% – 30% annualised.

Why can we expect persistent positive returns from the Power market? 

We source and analyse strategies and markets that take advantage of structural inefficiencies. What are the structural inefficiencies within the power market that traders can take advantage of to pull in profits? I highlight five main inefficiencies with my clients:

• The largest players in the market are utility companies whose role within the market is to hedge their retail customer contracts. They make their profits via the spread between the retail market and the wholesale market. Their role is not to speculate within the wholesale market and are therefore not price sensitive
• There is a unique commodity characteristic for electricity in that it cannot be stored. If demand suddenly drops, we can’t flip a switch to get electricity that was needed to disappear. It must continue to be in the grid which can disrupt the required equilibrium of supply and demand and cause significant short-term price corrections
• Old, expensive infrastructure; generation plants and transmission lines are both expensive to retire and build and require significant time to implement 
• The weatherman; the biggest driver for demand is weather and the unpredictable nature of weather forecasts, even just 36 hours out, leads to problems within that supply and demand balance
• The move to renewables; although fantastic for the environment, it is not efficient for electricity supply as the level of supply and timing of that supply is down to nature where, for example, naturally falling wind levels can occur at the same time as naturally increasing demand which results in a compounding negative impact to the grid.

Karl Rogers, ACE Capital Investments