The Implications of Amaranth - into the Echo Chamber

I'm thinking the same thing - what can I possibly add to all that's been written about Amaranth? There have been many excellent pieces across the investment blogosphere, ranging from Trader Mike to The Stalwart, from Barry Ritholtz at The Big Picture to Bill Rempel at Bill aka NO DooDahs! (in fact, I "borrowed" the echo chamber idea from Bill), as well as stories in the top MSM outlets (WSJ, NYT and FT). But I'd like to take this opportunity to step back, take a deep breath, and give you my sense of what went down and the potential implications for both Amaranth and the hedge fund industry (and its investor denizens) going forward. But before that, does anyone find it ironic that LTCM happened in the wake of a crisis in Asia and that today we have Thailand falling under martial law? Strange...

How Could This Happen?

I think a list might be in order here:

Greed. Happens at Wall Street firms all the time where proprietary traders have massively skewed utility functions - I roll the dice big and lose, I may be disgraced and lose my job. I'll just get another one, because anyone who has traded big enough to get ousted must be good enough to work on the Street, right? Alternatively, I roll the dice big and win, I take home $25 million bucks. Sounds like a pretty good and heavily skewed return distribution to me. Even increasingly sophisticated risk management systems and processes are insufficient to stop this behavior from happening from time to time. We just don't expect to see this at a massively successful and massive hedge fund that bills itself as being multi-strategy where the partners have a lot of their own capital in the game. There is much closer alignment of motives between between the principal owner of a hedge fund and his traders than the head of a Wall Street trading department and his traders. It's not house money - its his money (or at least some of his money). One would think it would be taken care of much better than it has been at Amaranth. Why not? The only reason I can think of is pure greed.

Poor risk management. Duh. Most of the what can be said has been said. But let's be clear - this was not the issue of a rogue trader a la Howard Rubin in the Merrill Lynch MBS trade tickets-in-the-drawer scandal in the 1980s or Nick Leeson and the Barings debacle in the 1990s. This was an action taken by an individual where his bosses and risk managers knew EXACTLY what he was doing and didn't curtail his risk-taking, make him size his bets appropriately and wind down positions as they moved sharply against him. "No, we're doubling down, boys. We dropped a billion before and made it right back - we'll surely do it again here." Right? Wrong.

Poor culture. Yes, poor culture. Brian's bosses KNEW he was swinging for the fences, saw the inherent volatility (natural gas, right?) and DID NOTHING ABOUT IT. Any place that lets something like this happen has a real problem, and it goes beyond risk management, it's culture. All hedge funds have some degree of a greed culture, and this is one of the reasons whey they're successful. However, one is truly "successful greedy" if one can continue to play the game day after day, which is not the case when lousy risk management and a culture that supports weak practices forces you to be at the mercy of your creditors, counterparties and the market.

Losing touch with the mission. Amaranth was purportedly a diversified, multi-strategy hedge fund. It's roots were that of a convertible arbitrage/merger arbitrage fund, which themselves are not terribly volatile strategies. It represented itself as being multi-strategy, and took in investor dollars on that basis. Now, their offering document might give them trememdous latitude to basically do anything they want, but that's not the point. Representing yourself as a multi-strategy hedge fund and taking positions akin to the riskiest of CTAs (please, CTAs, don't take that characterization as an insult. I know many of you and your trade sizing/stops/risk management practices are infinitely better than those on display here) is just wrong. Regardless of whether or not Amaranth survives isn't the point. How can the principals look investors in the face ever again?

Desperation. Once you're down and it's really bad we all know what happens. Empirical research tells us what happens. People lose all sense of perspective and logic and begin to gamble irrationally. "How can I face my investors? How can I face my friends? How can I live this down? How? How? How?" It is a rapidly accelerating downward spiral out of which there is little hope for salvation. I was quoted in Reuters as saying that "Fifty percent is a yardstick that some people use to say that once you have dropped that much, the game is over...The next week will be telling because if there are other positions that are directionally similar that continue to move against them, then they are going to be in deep trouble." Well, based upon the recent announcement in Bloomberg that JPMorgan and Citadel are taking over Amaranth's energy trades, I'd say that maximum ugliness has started to set in.

Bad due diligence practices (which was very well discussed by Barry Ritholtz in his post). Due diligence for large funds tends to be pretty pro forma. Well, as with fat tails, black swans and other "chance" occurrences, the Amaranths of the world do, in fact, happen, and certainly not only once in a blue moon. Investors have to bear some of the brunt of criticism here, as they're the ones that let Amaranth have a document that could let something like this happen, as well as supporting a culture that could engage a Brian Hunter and let him trade the way he did. Let's face it, folks, hedge funds are not for kids. If you don't like the results, either accept your fate that stuff like this WILL happen, do something about it or get out. It's that simple.

This certainly isn't exhaustive but gets to the root of the important stuff I'm thinking about. Now what about the implications of this little debacle?

Fund-of-hedge-funds (FOHFs) - maybe two layers of fees are worth it. So, the argument went that as institutional investors became more sophisticated and as large multi-strategy funds became more "institutional," these multi-strats would eventually supplant FOHFs as the primary vehicle for institutions' entry into the hedge fund asset class. You could cut out a layer of unnecessary fees, get the opportunistic asset allocation expertise of a top investment team and start generating alpha. Right? Well... Amaranth really shines a bright light on the definition of "multi-strategy." Should a multi-strategy fund be placing 50%+ of its capital in a single asset class, which also happens to be one of the more volatile asset classes on the planet? No. But how, as an institutional investor, can I protect against such a thing happening to me? The easiest, safest and most defensible way to accomplish this is to engage a FOHF to spread my bets. I really didn't think that the industry would go this way but with this blow-up at Amaranth, I do think that the big winner here (aside from those on the other side of the Amaranth trades) are FOHFs. I guess Christmas has come a little early this year.

New hedge fund offering documents will become increasingly restrictive. I think the market will see a change in the language of documents, particularly those who are targeting institutional investors. I can't imagine that due diligence and document review procedures won't tighten up, and that fund managers won't have sector/concentration/risk parameters of some type embedded in these documents. How else can an institutional investor be comfortable that they're not an unwitting participant in Amaranth, The Sequel? When I ran a large trading business, the documents I had with the traders laid out some very basic and fair risk management thresholds (sector, concentration, position size, etc.) to ensure that things couldn't possibly get way off the rails. It would seem logical that new hedge fund documents would include some of these principles. As for the large, very successful and sought-after multi-strategy funds, they won't have to change anything. Supply and demand is still way out of whack, with much more capital seeking access to top managers than the capacity (or desire) of these managers to take in more funds.

Some large institutional investors agitate for a change in multi-strategy fund documents. Admittedly a low probability, but if we see a few more blow-ups of the Amaranth sort anything is possible. Threaten redemption? Nah, the top funds won't be forced into doing anything. But I thought I'd put this possible tail event on the table, anyway.

The hedge fund asset class loses favor. I can certainly see that those about to enter the hedge fund asset class for the first time might think twice before taking the plunge. Nobody wants headline risk, and I am sure the folks in San Diego (who have more than enough problems already) are rueing the day they put $175 million into Amaranth. However, this is counterbalanced by the pent up demand for exposure to the asset class. This might actually drive those who might have considered going directly into multi-strategy funds into FOHFs in order to get their exposure. It can't hurt to have a fiduciary stand in the middle, right? Can't look stupid hiring one of those, right? We'll see.

I don't know if this has been helpful to you but it has been to me. I truly enjoyed writing this. It has been a constructive way to get a bunch of stuff off my head that has been rattling around for the past 36 hours. Thanks for your support and your eyeballs!

Comments

[Ernie Chan]

I recently did a historical analysis (see epchan.blogspot.com) of the spread position that brings down Amaranth and finds that this position loses money 3 out of 6 previous years. The only big win was last year, when Amaranth reportedly made $1 billion on this trade. If I were the risk manager of Amaranth, I would have been very nervous with this much capital in this position given its shaky track record.

[Kelley Ritchey]

Very good post.

You are right that a multi-strategy fund doesn't mean much if it just means they'll put 50% or so in one- on the surface and in reality- risk strategy.

I wonder on my blog where the risk managers were- I think there was a mention of a staff of 12?

Clearly, it wasn't a desperation or rogue trader situation either-they had 50% in energy in June!

[Greg Battle]

http://news.moneycentral.msn.com/provider/providerarticle.asp?feed=FT&Date=20060926&ID=6055658

Well, it looks like investor pressure has blown that gating provision away. Let the run for the exits begin. Haha. I tell you, as time goes on, these supposedly iron clad fund docs by the SRZ's of the world are going to become loosly adhered to suggestions. You don't need regulation or oversight when investors team together to force HFs to be accountable and get their act right. Amaranth Advisors is a cautionary tale. HFs may want to reconsider biting the hand that feeds them.

This almost makes me feel glad they dinged me when I interviewed there a couple years ago (sour grapes notwithstanding).

[Greg Battle]

One more comment regarding fund documentation. It just came out that Amaranth's quarterly gating provision was and insanely low 7.5%! For those who don't know what a gating provision is, it's the maximum AUM available for redemption on a quarterly basis (if investors request more than 7.5%, redemptions are on a pro-rata basis). This is sold as a provision to "protect" the remaining investors, but really, it's simply giving the fund a chance to recover and retain LPs investment. In the case of Amaranth, it will take investors 4 years to retrieve all their remaining money back. So, let's just get this straight - 2&20 structure, 1 year lock out, 7.5% gating provision.

I gotta say it again folks...CAVEAT INVESTOR! I don't feel bad for those LPs - not one iota. They got what they deserve - an illiquid investment with a gun-slinger. My question is, what kind of liquidity constaints do Nick & Co. have on their invested monies?

PREDICTION: As megafunds grow and investors wisen up, HFs will begin to tranche the returns, much like a CDO, and sell share classes reflecting an investors risk appetite. The lowest equity tranche will be primarily owned by the fund's management company, PMs, traders and analysts. Hence, LPs have first loss protection due to the waterfall effect of payouts. It's a capital structure around HF returns - low risk investors who want t-bill plus returns buy the "debt" pieces, high risk ones buy the "equity" pieces. Another way to look at it is options on the return profile of the fund - my conviction level in the investment team isn't determined by deployed assets alone. The effect being a vehicle that can attract MUCH more assets as it can compete with multiple asset classes on top of realigning the incentive structure. If a PM wants to gun-sling, he assumes the first losses. In my world, Nick & Co. would be PENNILESS today.

[Greg Battle]

A few random thoughts in light of the Amaranth implosion.

The "multi-strategy" moniker has been a boon to hedge fund business for four reasons.

1) Disintermediation of fund of fund "fees on fees" structure.

2) The implied (but undefined) promise of diversification.

3) A flexible investment mandate allowing portfolio mangers to engage in what would otherwise be categorized as style drift.

4) The ability to market an A-level operation composed of a collection of B-level talent.

As I am often wont to do, I'm going to a make a gross generalization. The investment management business model (mutual funds, hedge funds, fund of funds, etc.) is a basic one - separate investors from their capital by means of fees.

[Jack Doueck, Stillwater Asset Backed Strategies]

As investors hurt by Amaranth this month sort through the damage, here are some principles they may want to have in mind:

It goes without saying that a good hedge fund investor has to pick good funds to invest in. The key, though, to success in this business, is not to choose the best performing managers, but actually to evade the frauds and blowups.

Frauds in this business can take on the form of a misappropriation of funds, as in the case of Cambridge, run by John Natale out of Red Bank NJ, or a misreporting of returns as in the case of Lipper, or Beacon Hill, or the Manhattan Fund, or a host of others.

Blowups usually occur when a single person at the hedge fund has the power to become desperate and "bet the ranch" with leverage. The classic example of this week of Amaranth. Amaranth’s investors will be seeking answers to questions including: to what extent did leverage and concentration play a role in recent out-sized losses.

With both frauds and blowups, contrary to public opinion (and myth), size does NOT matter: Beacon Hill was $2 Billion, Lipper was $5 Billon, Amaranth was $9 Billion).

How do we avoid these two pitfalls of investing in hedge funds?

The answer is long and complex. It takes years to walk on the high wire and not fall off. If you're a long term hedge fund investor and you haven't been burned by one or both of these, you've been either incredibly skilled or incredibly lucky. I should know, for I have been burned by both of these. We have invested billions of dollars in hedge funds over the last ten years in this business. We have done well despite our battle scars and thankfully we have been blessed with a lot of good luck from above.

Suffice it to say that this should be the main question investors should be focused on as they interview and select hedge funds to entrust their dollars to.

Jack Doueck
Stillwater Asset Backed Strategies
Stillwater Capital

[Yaser Anwar]

MP,

Any asset class can be exploited and can result in catastrophic losses, why? Leverage.

LTCM did it in bonds & complex derivatives, AA did it in natural gas & over the years there have been blow ups in equities too, although not as famous as LTCM & AA or their extent.

Just look at Victor Neiderhoff. He uses tremendous leverage to trade stocks & when market does well he's double triple the market return but when the market blows up he gets killed. Just this May or June, he was down 50%, so its all about leverage

[Market Participant]

As long as people want big easy money things like this will happen.

The key question how "commodities" came to be thought of as a strategy. It's a zero sum game with no anomalies to surf. (Unlike options, value investing, XYZ-arbitrage).

[Robert Passarella]

Great post. You just made me think of the movie "The Deer Hunter". Its Russian Roulette when you trade like this, you can play with 3 bullets in the gun for only so long and then BANG!

[howard Lindzon]

Good post -

Funny how desperation and gambling pay off for some.

Cramer admits to doing just that in 1998 in his first and best book.

problem is - all he did was gamble and add risk at the wrong time. Now he is the poster boy for CNBC and financial intelligence.

[Roger]

Yaser, I agree with your analysis. And yes, Wall Street firms have done a much better job over the past 15 years controlling both single trader and portfolio exposures due to better analytical tools and better management oversight. While breakdowns sometimes do occur, they are generally not of the "break the bank" variety. Most of the time the losses are within expected loss parameters, even if large, and the firms deal with them as part of running a large prop book. This clearly was not the case at Amaranth.

[Yaser Anwar]

ADV in natural gas is approximately 11K contracts, with close to $50K per contract = $550 Million of daily turnover. OI is roughly 79K contracts with total value of just $4 Billion. What do you get? Extreme volatility.

For AA to loose 50% of its assets in a week goes to show that even after debacles such as LTCM & Barings, there was no precedence given to risk management. This catastrophe goes to show how hungry hedge funds have become with regards to generating alpha. Instead of monitoring the VAR closely, AA let "cowboy tactics" of one single trader, Brian Hunter, generate alpha for them. Who's at fault here? Management, Brian Hunter & Investors.

Management- Because investors trusted them with their assets, to exercise the necessary due diligence & keep a tight leash on their traders. As history has taught us, failing to do so, will only result in calamities no matter how good your "models" or "skills" are. Example: When Geniuses Failed at LTCM & Brash Gambling at Barings. Management should have paid more attention to Brian's antics at DB, which should have been a red flag. But of course not, Hedge Funds are too busy trying to generate Alpha. Can you blame them? With so many HFs popping up & as we discussed in Mr. Ehrenberg’s “Say It Ain’t So, Stevie?” post; the fragmentation of markets & disappearing opportunities, HF managements believe they are forced to swing for the fences. So when you swing for the fences once too often, you’re going to STRIKE OUT.

Brian Hunter- After being tagged as one of the best natural gas trader, Brian thought he was the market. Just like the LTCM group did. He forgot that the market has the ability to humble the best of them [flashback: LTCM]. Brian Hunter was also offered 10 million up front for jumping to SAC & up to 20%+ in profits from his trades. I can only imagine what that did to his ego.

Lastly, Investors- Why investors? I'll quote Barry Ritholtz who said it best, "Their investors demanded huge returns, and they turned a blind eye to the inordinate amount of risk required." we all know that Huge Returns HIGHLY CORRELATES with Huge Risk. They got what was coming to them, a disaster.

I doubt a coup like this would have been possible at the big brokers such as GS, JPM or BAC. Having read Goldman Sachs Culture of Success, I know they strongly discourage & straight up don't like any cowboy tactics, as were on display at AA, LTCM & Barings. Right Mr. Ehrenberg?

If you play with natural gas (fire), you are going to get burned, especially if you have leveraged yourself to a point of no return.