Allocator Insights: Ernest Scalamandre, AC Investment Management
About Ernest Scalamandre
Ernest Scalamandre is the Founder and Managing Member of AC Investment Management.
He has over seventeen years of experience in the alternative investment industry and has managed discretionary commodity Fund of Hedge Funds investments since 1993. From July 1995 until December 2005 Mr. Scalamandre was the Founder and Managing Member of Pinnacle Associates, a Fund of Hedge Funds specializing in discretionary commodities trading. Ernest has also served as a partner in several NYSE AMEX specialist partnerships.
Q: AC Investment Management, LLC has been evaluating commodity managers for a number of years. How did you get into this area of investing?
A: The seeds were sown early on when I was a trader on the floor. Commodities were one of the things that I traded back in the 80’s. Commodity futures were significantly larger than financial assets back then. However, around the time of the bull market in 1982/83 we saw the market share for commodities start to get smaller in size and less important relative to financial futures. By the 90’s, commodities were kind of forgotten by investors to some extent; it wasn’t a great opportunity set at the time.
The hedge fund landscape as it related to commodities, at that juncture, was primarily focused on CTAs, which were largely trend following. As a commodity trader, I was always waiting for commodities to come back. With the end of the equity bull market in 2000, many of the commodity markets became dominated by the merchant energy and commodity trading companies; Enron is the first that comes to mind. But many of these company’s balance sheets contracted materially in the early 00’s and it reverberated throughout the industry. This caused a lack of liquidity throughout the commodity markets, so the idea came to me that maybe this was the time to get back into the world of commodities.
By that time, I had left the floor and set up a FoHF shop called Pinnacle Asset Management, which invested in equity long/short throughout the 90’s. We started investing in fundamental commodity traders in ’01 and ’02 where we had some good success, since the Enrons of the world were not there to compete.
At the time, there weren’t that many people using hedge fund structures to deploy fundamental commodity trading strategies, but that changed as traders left these large merchant energy companies. This is when we started a fund, Pinnacle Natural Resources, that would take advantage of this opportunity set, which we thought would be around for a number of years. The fund was extremely successful from a risk/return perspective, especially for the first few years.
However, I found myself taking a different direction than Pinnacle, the firm that I started, because I wanted to focus on smaller investments in the commodity space and it wasn’t right to force a vision on a firm that had evolved into something different. That is when we formed AC Investment in early ‘06.
A few things have happened in commodities over the past decade that I didn’t foresee. The whole China and India phenomenon was a big game changer. The second phenomenon was the push by consultants and the bulge bracket banks to come up with reasons why large institutions should invest in commodities via indexes, derivatives, structured products, ETFs, etc. This naturally drove prices up and created more inefficiencies, which provided for a lot of trading opportunities and still do today.
Q: Commodities never seemed to have respect as an asset class. Why do you think it has been so difficult to sell to investors?
A: A few things; securities were created to fund businesses that ultimately offer some kind of yield. Owning commodities however has a negative real return because of storage costs. It almost pays you to be short. Also, commodities are there to be consumed. From a long-term perspective, financial assets should grow or pay dividends.
Additionally, there is a perception among investors that commodity traders can have extreme levels of volatility. While this may at times be true, it is also why we think the multi-manager/trader model approach works well within this narrow slice of the financial markets. For example, Natural Gas, Cotton and Copper, which are all volatile, are not correlated. So, at the FoHF level, we can have an annualized volatility of 7%, even though the underlying return stream for each individual trader can be much, much more volatile. Often, we find that allocators of other FoHFs don’t take enough risk, or rather, they tend to chose managers who aren’t volatile enough. If the managers are talented and not correlated with each other, then the portfolio diversification benefits are substantial.
Q: Commodities, in general have been through both boom and bust in the last decade. What makes your area of focus different from the asset class and what challenges do you face?
A: For us, what is interesting about commodities is not whether they are in or out of fashion. The direction is irrelevant because we are not investing in a commodity ‘story.’ ACIM capitalizes on the specialist trading activities within this space. The challenges that we face are really to identify talent that specialize in these very niche areas. As a consequence, our returns stream has no correlation to neither commodities nor financial assets. This is a challenge when it comes to marketing because there isn’t really a bucket you can put us in.
Q: What are some of your key considerations when selecting fund managers?
A: The problem that we have is that a lot of the managers we allocate to do not have a refined sales pitch. Many of these managers are “one man-bands” where they may or may not have the discipline to manage money. Our role is to identify whether or not they have that discipline, and make sure they carry that discipline while they are managing our capital.
The main thing that we look for is pedigree. For one thing, there is practically no cross pollination of talent; a good Cocoa trader cannot really trade Corn, for example. We usually attract traders with a long career in a single discipline that want to replicate their success in a fund structure. As a consequence, these traders are fairly well-known in the segment they trade, and quite frankly, there is really no place to hide.
Q: How much does track record affect your opinion?
A: Well, pedigree will reflect their successes and failures and this will show through. Another criterion we look at is discipline; how good are they at controlling risk?
We also look closely at the manager’s market environment. A manager could be the best in his space, but we need to understand if his market is either inefficient or mispriced. Or, will that market be mispriced in the future and for how long. We tend not to be in areas where we feel that things are fairly priced and will remain so.
Q: How long does the typical Due Diligence take and how much is face-to-face?
A: It is extremely important when evaluating a fundamental manager. We spend a lot of time discussing their background, what kind of people they are, etc. We will also speak with their former employers, brokers, and other people in the market. We do a lot of on-site visits, as well.
In terms of writing a ticket, we tend to move a little more quickly than other FoHFs. All-in-all, the process can take 2-6 months. We typically invest via Managed Accounts, which gives us more comfort with service providers, for example.
As we alluded to earlier about discipline, we enforce certain parameters (drawdown limits, margin-to-equity, etc.) on a daily basis under the Investment Management Agreement in order to ensure that the controls are in place.
Q: How do you source managers? Do you actively research managers or do they find you?
A: Managers commonly come through the brokerage community, not necessarily the Cap Intro teams. We are not opposed to working with managers that don’t have any money and/or are start-ups. While we do allocate to larger managers, we have a preference for smaller managers and start ups since the markets they trade are typically fairly small.
Q: What are some of the best or worst practices you’ve seen in how fund managers market themselves?
A: As mentioned earlier, many traders that we speak with are either newly launching or in some cases haven’t yet officially launched their trading vehicles, and are often single-man shops or are comprised of very small teams. This frequently translates into less than polished marketing materials, which frankly we don’t necessarily see as a problem (we’re investing because the manager can make money, not because they have a slick marketing pitch). However we do occasionally see more substantial mistakes, such as partnering with sub-par service providers, for example. Another red flag from ACIM’s perspective would include an unwillingness to be flexible on such items as liquidity, fund structure, or fees.
Q: What are the values that drive your thinking and decisions in your business position and personal life?
A: I tend to be very conscious of culture and want to work with people that communicate well and that are very honest; it has become a priority for me personally. This is also the case when dealing with our managers. There have been occasions when we have left a relationship because the other party didn’t share those same values. I think this is why our partners (investors) have been with us for many years, even though we offer monthly liquidity. We are very careful that we don’t act in a way that would conflict with our investors or the people that we have money with.
We tend not to invest in 2/20 funds anymore; in low interest rate environments, it just doesn’t make sense. Similarly, we make a point that our management fees are not a big profit center (if one at all). We don’t lose money as a company, and our investors appreciate that. So, if our fund managers are charging high management fees and have a lot of assets, how is that good for me as an investor? We are trying to be consistent, from our service providers to our clients. Transparency must funnel through to our clients. We speak to them on the phone all the time, provide bespoke reporting, and answer questions about markets and funds, regardless of the size of the client.
Q: What is important to you on a personal level?
A: I think consistency is something that I embrace on both a personal and professional level. I am fortunate to work with a consistent team. If you look at our company, we really haven’t had a lot of turnover. The people who started the firm 10 years ago are all still largely here. In many ways they are like family and I hope they will stay for another 10 years. You usually don’t experience that sort of stability in the Hedge Fund space. If we can create an environment where our partners are consistent across the board and even in my personal life, then I am happy with that.
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