Lessons from Amaranth

Lessons from Amaranth implosion William Hutchings
28 Dec 2006
The financial system coped with a record loss... this time

This year saw the largest loss of hedge fund assets by a single firm when $6.5bn (€5bn) was wiped off the value of funds managed by Amaranth Advisors during two weeks in September.

Investors belatedly recalled an alternative name for the flower after which the firm was named: pigweed. Amaranth certainly made a pig’s ear of its investments in natural gas futures and many funds of hedge funds were left nursing big losses. But, despite the scale of losses, the financial system registered hardly a blip. Was it proof of the system’s resilience, or a warning of worse to come? Here are 10 lessons from Amaranth’s collapse.

1) Trading from separate locations is controversial

Brian Hunter, the trader responsible for Amaranth’s natural gas position, worked in Calgary, Alberta. The chief risk manager was in Greenwich, Connecticut, more than 2,000 miles away. Isaac Souede, chief executive of fund of hedge funds manager Permal, said this was one of the reasons his firm did not invest with Amaranth: “You have to question the wisdom of having a guy trading in Canada and the risk manager in the US.”

2) Beware concentrated positions

Amaranth said in February that 39% of its fund’s capital was allocated to energy and commodities.

A prime broker, responsible for financing hedge funds’ trades, said: “You have to ask why it thought it was OK to have that much exposure to one product.”

Amaranth told investors last month: “Although the size of our natural gas exposures was large, we believed, based on input from our trading desk and the stress-testing performed by our energy risk team, the amount of risk capital ascribed to the natural gas portfolio was sufficient.”

3) Managers are under too much pressure

Amaranth was relying heavily on returns from its energy trading desk. Investment returns from the hedge fund industry have dwindled to single digits over the past five years and investors have expressed their unhappiness. A fund of hedge funds manager said: “Maybe we have been putting too much pressure on managers to take risks in an attempt to perform.” Managers agree the pressure has made them more likely to invest in less-liquid positions.

4) Managers must disclose their positions

No one outside the firm knew the full nature or extent of Amaranth’s 15,000 positions. It also used as many as nine prime brokers, and one said: “Each was seeing only a small part of the overall position. It is unlikely that any one broker would have seen anything that looked too risky.” Jacob Schmidt, an independent investment consultant, said: “Nicely presented risk management data may not be helpful – a 95% confidence interval is useless if the 5% kills you.”

5) A hedge fund can be too big

Amaranth was one of the 30 largest hedge fund management firms. Consultants worry that large firms may be taking excessive risks to make money. A fund of hedge funds manager said: “Amaranth was too large. Some systematic hedge funds are sustainable at a larger size but for a talent-driven manager there has to be a limit.”

6) The financial system is at risk

Prime brokers congratulated themselves that their controls had worked, while the European Central Bank and the UK’s Financial Services Authority said they took comfort from the way Amaranth’s collapse had been contained.

But the Bundesbank, in its financial stability review this month, said it was not impressed: “Despite the fact that the big losses sustained by Amaranth Advisors have been absorbed by the financial system quite well, this is not sufficient evidence that hedge funds’ potential for systemic risk is lower than it was at the time of the Long-Term Capital Management incident.”

7) No one aggregates positions across the industry

No one has an aggregated picture of hedge fund positions. Hedge funds might concentrate unwittingly in the same position and find no counterparties when they want to sell. Germany has put hedge fund transparency on the agenda of the G8 group of eight wealthy countries meeting next year.

But the FSA cannot envisage a workable mechanism to report hedge fund concentrations. Callum McCarthy, chairman of the FSA, said this month: “I do not see what any regulator would do with such information; and I see very considerable moral hazard in regulators seeking and holding information that is not used, but is known to be collected.”

8) Multi-strategy hedge funds might not be diversified

Amaranth said it was a multi-strategy hedge fund manager, which diversified its approach to investment. Moore Capital has since picked up a team of equity and bond derivatives traders and Goldman Sachs a team of credit specialists, implying there was more to Amaranth than just energy. But Schmidt said: “The phrase multi-strategy is a misnomer – in reality it is a licence to do anything.”

9) Funds of hedge funds could be taking uncomfortable risks

Funds of hedge funds comprised 60% of Amaranth’s investors.

Dan Waters, the FSA’s director for asset management, said in October: “There may be interesting questions for fund of hedge fund managers to ask themselves about whether the collapse could have been foreseen.”

However, investment consultants said they believed the fund of hedge funds managers had conducted thorough due diligence, understood the risks of Amaranth and decided to accept the risk. Investors expected falls of 10% or so in any given month. What they did not anticipate was a loss of 70%.

10) Investors are at the bottom of the heap

Amaranth said its prime brokers had told it they “would not be comfortable continuing to extend credit” if it had not sold off its natural gas exposures by the following day.

Its investors, on the other hand, had agreed to lock themselves into Amaranth’s funds for two years and give the firm the right to limit redemptions in any quarter to 7.5% of the size of the fund.

They will get their money sooner, however, because Amaranth has been slowly liquidating its positions to pay back investors.



http://www.financialnews-us.com/?page=ushome&contentid=1046859202

 

In these days of easy money, nothing can take the market down simply based on liquidity concerns alone.

Amaranth lost 6 billion in a week and the market didn't even notice.

Pfizer lost 20 BILLION IN ONE DAY on 12/4 and the Dow Jones rallied to All Time Highs.

 

exactly right!!!


these 2 stories went unnoticed

 

All secondary reasons.

Brian Hunter was an intellectual that was an expert on natural gas supplies. He did a lot of studying, analysis, projections, etc. on real supplies of natural gas. Great work in that regard.

Of course, not having a trading background, nor the cynical view that most traders have, he had absolutely no idea that futures of any market are the "fake" market, not the real. The whole concept of speculation, which is inherent even to the most conservative investor, completely eluded him.

Hence, he placed position on the futures market based on the real market. He let his analysis and opinion be known. And he got taken.

Check who was on the other side of his trades. They saw the sucker and took advantage of him.

 

How would the other side know exactly what he was trying to do and they took him for a ride?

 

He wasn't exactly secretive about what he was doing. His colleagues and the street knew about his very big position. And they catered to it. Let him push up the price as he was accumulating it and then....who knows. Maybe they started shorting and working it down or just sit back and advise clients and their own operations to remove bids and wait for a strong pullback. Profit taking by the smaller players took place and you all know the rest.

The liquidity issue was another big factor, that was mentioned in your article. Pretty dumb of him to be such a huge chunk of the daily volume and the open interest, all while so heavily leveraged.

 

i'm convinced trading natural gas is something near a black magic.. i happened to do very well that month, but following months failed miserably with outright positions.

i think you need to be on the inside of this market to trade it with any advantage - knowing there is someone in a big position, etc. a little guy trading a few qg's will have a tough time. (personal experience)

but all of this talk is a distraction from the main point: he was fundamentally overleveraged long when at the same time record storage was occuring and hurricane risk dissipated. there was nothing grounded or studied in that position.

previous poster alludes to Hunter doing his research to back his position. I just can't imagine that. I think this was a wild impulsive speculation gone awry.

in retrospect all these things make good sense, but here and today is another story.