In an earlier post on this site, I highlighted Reserve Bank of Australia Governor Glen Steven's concerns about hedge fund failure and the adverse impact such failure may have on Australia's financial system. In the same week that Mr Stevens delivered his speech in Hong Hong, prominent US hedge fund manager Amaranth Advisors was facing a major setback in its US$9. 2billion fund, losing US$6 billion on a natural gas investment strategy.
Amaranth manage a multi-strategy fund that delivered strong returns over recent years. There website described their approach as following a "broad spectrum of alternative investment and trading strategies in a highly disciplined, risk-controlled manner." However, according to the New York Times on 23 Sep 2006, a significant part of recent returns had been driven by trading-related profits from energy and commodities; contributions of US$1.26 billion in 2005 and US$2.17 billion Jan to Aug 2006. There was clue to the risk adopted in the fund with a 10% decline in May offset by high returns in April and June.
Apparently, the Fund held a position that would benefit if the spread between the March and April 2007 natural gas contracts rose. In the event they declined, and presumably because the positions were leveraged, the fund then had to meet substantial margin calls and/or close the positions in loss. In the end, the energy book was closed on 20 Sep and the fund realised a US$6 billion loss and a decline of 65% for the month and 55% calendar year to date.
One of the factors contributing to this outcome was liquidity in this commodity market. This was one of the risks raised by Mr Stevens. He said that just when liquidity is needed most, at a point of crisis, it is not available. This might spell trouble for the hedge fund, but what concerned Mr Stevens was the risk of destabilising the financial sysytem as a whole, as was the case with the failure of Long-Term Capital Management in 1998. Surprinsgly, given the size of the losses recorded at Amaranth there has been little flow-on impact observed so far. Its early days in this apparent failure, but this is encouraging.
Are there any lessons for Australia? The surprise is that this occurred in a so-called multi-strategy fund where an investor might expect a diversified set of strategies to drive returns. The fund had disclosed that energy had contributed 78% of year to June results of 20%+, suggesting limited diversification. The size of these gains and the subsequent losses are presumably the result of leverage. If the natural gas strategy was within the mandate for the Fund, and rational investors were aware of this mandate, they could have acted to ensure their own portfolios were suitably diversified and could cope with failure in any one position.
A knee-jerk response would be say that investing in hedge funds is risky and should be limited or prohibited. A more considered response would be to ensure that investment strategies/mandates, including leverage, are clearly set out in ASIC-registered Product Disclosure Statements. Armed with this information indivual investors and their advisers would then be in a position to make appropriate portfolio structuring decisions, that will protect investors from invidual investment failure.
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LCA publications has published a very summary of the lessons learned from the Armanath failure. Here is the comment repeated below:
Six lessons to be drawn from the Amaranth debacle 09 Oct 2006
In a little over a week, Amaranth Advisors, a respected, diversified multi-strategy hedge fund, lost 65% of its USD 9.2 billion assets.
In a paper entitled 'EDHEC Comments on the Amaranth Case: Early Lessons from the Debacle', noted commodities expert Hilary Till, Research Associate with the EDHEC Risk and Asset Management Research Centre and Principal of Premia Capital Management, LLC, examines how Amaranth could have suffered such massive losses and draws lessons from this debacle for investors, funds of fund & energy fund risk managers, multi-strategy hedge fund managers, policy makers, and the alternative investment industry as a whole.
Ms Till finds that the fund employed a Natural Gas spread strategy that would have benefited under a number of different weather-shock scenarios. These were economically defensible, although the scale of their position-sizing relative to the capital base clearly was not. Using a returns-based analysis to infer the sizing of positions, it is found that the Amaranth's energy portfolio likely suffered an adverse 9-standard-deviation event on the Friday (September 15th) before the fund's distress became widely known. Ms Till draws six early lessons from the debacle:
1. Investors would not have needed position-level transparency to realize that Amaranth's energy trading was quite risky. A monthly sector-level analysis of their profits and losses (p/l) would have revealed that a -24% monthly loss would not have been unusual;
2. If investors did have position-level transparency, they would have likely noted that the fund's over-the-counter Natural Gas positions were massive compared to the prevailing open interest in the exchanged-traded futures market, which would have given an indication of how illiquid their energy strategies were;
3. Risk metrics using recent historical data would have vastly underestimated the magnitude of moves during an extreme liquidation-pressure event;
4. If the fund's risk managers had employed scenario analyses that evaluated the range of Natural Gas spread relationships that have occurred in the not-too-distant past, they would have caught how massively risky the fund's structural position-taking was in its magnitude;
5. It is essential for a commodity trader to understand how their positions fit into the wider scheme of behaviors in the physical commodity markets: before initiating any large-scale trades in the commodity markets, a trader needs to understand what flow or catalyst will allow a trader out of a position; and
6. Amaranth was indeed likely to have been providing an economic service for physical Natural Gas participants; this hedge fund provided liquidity for physical-market participants who could then lock in the value of forward production or the future value of storage. But even so, like Long Term Capital Management, the scale of Amaranth's spreading activities was much too large for its capital base."
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