Jonathan Davis

Amaranth: how to lose $6 billion in a fortnight

Jonathan Davis continues our debate about hedge fund risks and rewards with an analysis of a spectacular crash

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Hedge funds, you read here in June, are often riskier than they are made out to be. Putting your money into ‘a fund that blows up, closes down or disappears with all your money’, I suggested, is a real risk for the unwary investor. The danger, I could have written, is that you will find your money being looked after by Brian Hunter, a 32-year-old energy trader from Calgary who last month single-handedly accounted for the largest hedge-fund meltdown since records began.

In the space of two short weeks, Mr Hunter worked his way through some $6.5 billion when his complex strategy of forward bets on the price of natural gas went badly wrong, wiping out 70 per cent of the capital deployed by his hedge fund employers, Amaranth Advisors. In one day alone, Mr Hunter and his colleagues on the energy trading team lost $560 million as the price of natural gas futures plunged and they were unable to liquidate their positions fast enough to meet their margin calls and preserve their lines of credit.

The fund is now attempting to close down what remains of its operations in an orderly fashion. The energy trading positions have been sold to other market participants and what is left of its $9 billion of capital (not much) will be returned to investors. This being North America, a carrion-seeking flight of lawyers is hovering over the scene, looking to institute a legal action of some sort for the unhappy victims.

Aside from wealthy individuals, those feeling the heat from the meltdown include the San Diego county pension scheme, which has lost some $100 million, and two fund-of-hedge-funds run by Morgan Stanley and Goldman Sachs, whose allegedly sophisticated monitoring systems proved unable to spot the trouble ahead. Man Group, the quoted UK hedge fund group, also had a small exposure to Mr Hunter’s trading activities.

The losses at Amaranth dwarf even those of Long Term Capital Management, the now infamous hedge fund that boasted two Nobel Prize-winning economists among its founders yet still went down in flames in 1998. It lost $4 billion in a few weeks when an even more complex series of bets on a range of financial derivative contracts proved to be less fireproof than its ultra-sophisticated risk modelling had suggested. LTCM was eventually bailed out by a consortium of leading Wall Street banks at the instigation of the Federal Reserve.

The failure of Amaranth has fortunately had few such repercussions. While there is no question that hedge funds are here to stay, the Amaranth case is an unwelcome setback for the industry at a time when its advocates are pitching hard to persuade pension funds that hedge funds are a valuable new investment class, and regulators that private investors should be allowed much broader access to these new and poorly understood investment vehicles.

Amaranth was not some fly-by-night bucket shop, but an A-list fund operating from Greenwich, Connecticut, the hedge fund capital of the world, a place cutely described at a recent industry dinner as ‘New York on steroids’. Morgan Stanley and Goldman Sachs were both happy to put clients’ money with Amaranth — and if they can’t spot a blow-up coming, we may well ask, what hope has anyone else?

All hedge funds trumpet the fact that they have sophisticated risk systems that allow them to pursue absolute returns — that is, make money in both up and down markets — in a controlled manner. The best, to be fair, do just that, but the lure of big bucks is now attracting a much more diverse crowd of wannabes, to the point where even veteran hedgies such as Steven Cohen, founder of SAC Capital Advisors, says that it is getting harder to make outsize returns. ‘We’re entering a new environment. The days of big returns are gone,’ he told the Wall Street Journal this summer.

At Amaranth Mr Hunter routinely held hundreds of positions in an array of derivative contracts linked to future prices in the natural gas market. These bets were ‘geared up’ by using borrowed money and margin calls to magnify the gains and losses. As so often happens, it appeared for a while that he had the Midas touch. In 2005 Amaranth made $1.3 billion from his trading activities, and $2 billion more in the first four months of this year.

But there were warning signs too. In May he lost nearly $1 billion. At his previous employers, after a similar period of success, he departed abruptly having lost two thirds of his gains in the last month of the year, something he apparently attributed to faults in the bank’s trading systems. Some seasoned hedge fund investors, it now appears, declined to invest in the Amaranth fund because of its flawed risk controls.

In September, triggered by a sharp fall in energy prices and a disappointing (for some) absence of hurricanes, the whole operation blew up in Mr Hunter’s face. According to his boss, the dramatic losses were the result of a highly improbable combination of events, a sharp decline in the future price of natural gas coupled with the rare inability of the fund to unwind its positions in the market. The reality, everyone else in the business suspects, is rather different.

Hubris and overconfidence surely played a part, as evidenced by the ever bigger bets that Mr Hunter appeared to be taking. Whatever risk systems the hedge fund had in place, losing two thirds of the firm’s capital in two weeks suggests a certain (shall we say) inadequacy on that score. Judging by the way that natural gas prices have bounced back up since the Amaranth meltdown, other traders were happy to put the squeeze on when it became clear that the firm’s trades were not working out. Mr Hunter’s fall from grace is further proof of the adage that in investment, as in the Battle of Britain, ‘there are old pilots and there are bold pilots, but there are no old, bold pilots’.

There is a more fundamental issue too, one that increasingly exercises regulators who worry about the damage that so much highly leveraged trading could do to the financial system the next time something goes wrong — as it surely will. Taking huge leveraged bets on such volatile phenomena as future natural gas prices, where the weather is a major factor, is in truth more akin to gambling than investing, as properly understood.

The lopsided reward structure of hedge funds — heads the fund manager wins, tails the investor loses — actively encourages aggressive managers to take big bets with other people’s money, a factor that industry apologists typically neglect to mention. There is nothing wrong with the hedge fund concept, nor with taking calculated risks, but investors who have the gambling instinct, as Keynes perceptively wrote some 70 years ago, ‘must pay to this propensity the appropriate toll’.

Jonathan Davis edits Independent Investor.