AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

A Genuine Alternative Asset Class

Tony Foster

Marine Capital Ltd

Q1 2008

Whilst investors clearly accept the argument in favour of “alternatives” within their portfolios, the space has been dominated by hedge funds to the exclusion of others. It is small wonder that the term “hedge funds” covers such a wide range of sectors and strategies, if the mere nomenclature is a door-opener to the investor market. Ships, operating in a trillion dollar market (for “generic”/commoditised types only) which is both deep, liquid, transparent and uncorrelated, provide in every sense a genuine alternative, particularly when one considers that returns from investment in ships have outperformed those in hedge funds over the relevant time series.

By econometric analysis of return data for the main categories of the most common ship types, listed shares and different hedge fund categories, it can be shown that ship investment, over the ten year period of comparable data analysed, provides a higher return than investment in listed shares or hedge funds. The calculated Sharpe and Sortino ratios for the time series used (being as long as we can realistically go back in the case of hedge fund information) show better Sharpe and Sortino ratios for ships than the available hedge fund categories and listed share indices for the same period. The return data are calculated on the basis of a constant investment strategy of buying a standard ship in the market, fixing it on charter for a period of twelve months and then selling the ship at the then prevailing price. This is, therefore, comparing a random-walk investment strategy with executed investment strategies. The ship investment professional would expect to enhance his return with trading skills (market knowledge, timing and execution). The comparison is also of ungeared ship investments with geared investments elsewhere. Lower or minimal correlation with returns from listed equities is a further tick in the box for ships and speaks in favour of inclusion of ships within a managed portfolio.

Table 1: Quarterly correlation of returns - 40 Quarters to August 2008

Marine1
Source: MCL research based on data from Clarksons, Drewry and MSCI

The better risk/reward for ship investment can be explained in part by the barriers to entry, which have allowed ship-owners to command higher returns and the highly effective proxy which ship investment provides for growth in major emerging markets (industrialisation and urbanisation).

Access to this market may improve, if dedicated ship fund managers with the appropriate financial, as well as shipping skills, can open it to a wider group. The growth of the freight derivative market has already attracted investment banks and some hedge funds to participate, although mostly as “screen traders” and without necessarily having knowledge of the underlying physical market and/or obvious access to the physical market. As they enjoy the taste, the desire (even need) to grapple with real ships and cargoes will be obvious. It is also clear that the shipping market thrives, with a multiplier effect, in an environment of above trend trade growth. China’s development in particular, over the last few years, offers the prime example of this.

Hedge funds offer a wide range of strategies designed to provide alpha returns. The investment returns on ships described in Table 2 are still, on the other hand, generated by a random – walk investment strategy. For the purpose of this paper we define a hedge fund as an investment vehicle, which pursues an absolute return.

Comparison of Hedge Fund Returns and Ship Investment Returns

Table 2 shows the annual returns, standard deviations, Sharpe ratio and Sortino ratio calculated by MCL for a selection of hedge funds based on monthly data provided by Credit Suisse/Tremont Hedge Fund Index.

The type of hedge funds that have been selected on the basis that their investment strategies and market exposure to the world economy, arguably have some similarities with ship investment.

Table 2: HEDGE FUND RETURN DATA – (10 years from July 1998 to July 2008)

Marine2

Source: Credit Suisse/Tremont Hedge Fund Index

The following table shows the comparable annualised returns, minimum, maximum and SD for different types of ships based on a “long” strategy. (This means, buying a ship, fixing it on a twelve month charter and selling the ship at the end of the twelve month charter). It is important to understand that the ship types used for this comparison are the “generic” ship types, those where there are many ships of the same type, transactions are frequent both for purchase/sale and charter and trading activity is relatively commoditised. The Total Investment Return listed in Table 3 consists of the asset price return (created by changes in the ship price) plus the return created by Earnings from charter income less Operating expenses and age depreciation.

Table 3: SHIP INVESTMENT RETURNS – (10 years from July 1998 to July 2008) (UNGEARED)

Marine3


Source: MCL Research based on data from Clarksons, Drewry and MSCI

The data shows that ship investment has achieved higher returns than these hedge fund investments, over the same time series. Also, that the ship investments show better risk/reward as measured by both Sharpe Ratio and Sortino Ratio.
It is better to buy a ship supplying primary commodities to China than to buy a factory in China or to invest in a private equity venture pursuing such Chinese corporate opportunities or bet on Chinese equities; you can have the same or better upside without parallel risk. Typically ship investments would be funded, particularly in today’s credit environment, by 50-60 percent debt, paying rapidly down (depending on the ship type and charter cover) over the first few years of the deal. Actual (geared) returns for shipping investments are of course higher but we show ungeared figures in order to present return data that are consistently comparable. There is no comparable information in respect of hedge fund gearing but it is obvious that the performance gap is wider when there is gearing on both sides.
Direct investment in ships should not be confused with trading in freight derivatives. A freight derivatives market only exists for dry bulk and tankers (with the dry cargo derivative trading much more extensive). The participation of non-industry players in derivatives, driving the growth of the derivative market per se, will create arbitrage opportunities for owners of the underlying assets. Looking at it another way, those entering the market through the derivative space are likely to want genuine physical exposure sooner rather than later, if they intend to be major players.
No man is an island and the shipping market is not immune to global meltdown. At the time of writing (first week of October), the freight markets for container ships have responded quickly to the downturn. The dry cargo market has collapsed as Chinese import growth slows down (although a bounce in the dry cargo market is expected) and ship values are rapidly adjusting. The tight (if not impossible) market for debt, coupled with weaker freight rates, obviously removes a significant percentage of buyers from the market and exposes all concerned to increasing default risks, although we have seen no significant default so far. Such default could come at the shipyard (resulting in failure to build ships), by the purchaser from the shipyard or the charterer of the ship. Estimates vary, but there is perhaps $300+ billion worth of unfunded new ships, i.e., where buyers have paid their initial down payments (typically 20 percent) and do not yet have debt finance to assist with the balance of purchase money. Of course, some of the ships may have employment already arranged or be part of fleet replacement plans of the biggest companies. It may be messy for a while, unless dry cargo demand picks up quickly in 2009 and justifies the absorption of all the contracted new ships at “old”, i.e., high prices. This seems unlikely. Interestingly, the tanker market, including freight for carriage of clean petroleum products, has been firm and values have been sustained.
What is sure, however, is that the shipping market, as a lead market/indicator, will pick up quicker than many others. If you stand by the maxim that EM industrialisation/urbanisation/trade growth will continue to exceed Western growth for years to come, then the returns from ships should continue to outperform in the medium term. The year 2009 will undoubtedly provide excellent buying opportunities for ships, for those with cash.
 

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