If youÆre a precious metals investor, then invariably, the profits you want to aim at are those that come from an appreciation in the price of the bullion itself. The beta story is what drives you, and that is precisely what gold bulls get so excited about. A better way to describe the emotional range of the invariably vocal gold bug might actually be æover-excitedÆ.

Trevor Steel, CIO and managing partner of Baker Steel Capital Managers, a London-based hedge fund spoke on Tuesday at the gold and precious metals investment world conference in Hong Kong. He raised a more analytic angle to that traditionally espoused, which is that of taking the theme of gold and adapting it to an alpha-generating strategy within a hedge fund.

Within $1.25 trillion of hedge fund managed assets, it is estimated that about 10% is circulating within the gold and commodities asset classes. After leverage, the level of hedge fund investment in this area could be double or treble that level. Typical hedge fund strategies lending themselves to gold investment include global macro, sector funds, equity long/short and CTAs, which might involve directional plays and black box style trading.

Baker Steel manages $600 million and offers two metals-oriented funds, Genus Natural Resources, a long/short equity fund launched in 2002 and Genus Dynamic Gold Fund, a long-only fund launched in 2003. If you want active management, alpha with no exposure to the gold price, then the former fits the bill, as opposed to the second, where you are exposed to a rising or falling gold price

ôLong only in commodities is a rollercoaster ride which many investors canÆt stomach,ö he observes, attesting to the tendency of commodity prices to swiftly revert to mean, ôWe strip out the effect of beta leaving the fund exposed to alpha from stock selection.ö

The Genus Natural Resources fund is therefore a market neutral (to the gold price), long/ short equity fund investing in gold mining companies.

It has 10% volatility, a sharpe ratio of 0.69 and a historic annualised return of 10.8%. Because of the long/short positions, this is therefore a pure alpha strategy. It operates with 10-15 long positions and 10 shorts on gold mining equities and a position on fundamental research. It takes a 6-18 month view based on over or under-valuations and the gross exposure of the fund is 150-200% with net exposure 10-15%.

Beyond valuation, the fund managers also look for catalysts, exogenous factors that alight upon the fund, being either good news or impending catastrophe. The fund doesnÆt short companies with a market capitalisation of less than $250 million, because of the risk of being caught in a short squeeze. At this size Steel says he hasnÆt encountered any problem with accessing stock borrowing in the names the funds want.

ôGold mining is not a buy and hold investment,ö says Steel. ôWe seek ideally a valuation anomaly together with a catalyst.ö

Examples of catalysts are accidents like the skip that fell a mile down a shaft at Western Areas gold mine. Fortunately, it didnÆt land on anybody, so nobody was hurt, but the stock price still fell 20%. In Mongolia, Ivanhoe Mines was hit in May 2006 by the announcement of a government imposed minerals tax, and its share price plunged. Steel had heard the rumours of such a move and put on a short position. Now he observes, this stock may be attractive on a risk adjusted basis.

Baker Steel splits 75% of the fund exposure to existing producers, 25% to developers. It allocates nil to exploration companies.