The Hindu Business Line : The importance of vigilant hedge fund investors

Amaranth Advisors LLC was one of the largest American hedge funds operating in the commodities space, managing more than $9 billion. When gas prices surged last year after Hurricane Katrina, Amaranth raked in more than $1 billion in profits. This also translated into a very large bonus for the head of its energy trading desk, 32-year-old Brian Hunter, who was ranked the 29th highest-earning member of his profession by Trader Monthly magazine, which estimated his annual income at $75-100 million in 2005.

Then suddenly, on September 17, 2006, Mr Nicholas Maounis, the founder and CEO of the hedge fund, wrote a letter to its investors informing them that the Amaranth multi-strategy funds had experienced significant losses in their energy-related investments following a dramatic move in natural gas prices. The New York Times reported on September 18 that Amaranth was facing an estimated loss of $3 billion.

As Amaranth's losses piled up, it got margin calls from its bankers and counter-parties. To meet these obligations, it desperately tried to unwind its positions, often at a discount. At the end of September, the hedge fund wrote to its investors informing them that the fund had lost more than $6 billion, about 65 per cent of its assets. Finally, J. P. Morgan Chase and Citadel Investments, another hedge fund, bought the complete book of energy trades from Amaranth for an undisclosed price.

Investors in Amaranth included fund-of-funds managed by top-notch Wall Street investment banks such as Goldman Sachs and Morgan Stanley and pension funds of 3M and the San Diego County Employees Retirement Association. All these investors will lose some money.

Immediate cause

The immediate cause of Amaranth's spectacular losses was an unprecedented narrowing in spreads between the March and April 2007 gas futures. The spread between the two futures contracts fell from $2.50 at the end of July to around 75 cents at the end of September. Usually, there is a large gap between the March and April prices, because gas prices fall in April relative to March, with the onset of summer. This is the case every year, so most analysts said that this narrowing of spreads between the two months was much rarer than a `sigma six' event (an event that has approximately less than 0.1 per cent probability of happening). One analyst put it as the unfortunate event where you are attacked by a mad axe-man while suffering a heart attack and being struck by lighting at the same time.

All this dramatic discussion about the rarity of what happened diverts attention from the real causes that led to Amaranth's downfall, and how it could have been avoided. Amaranth's Risk Management team was obviously napping or naive. They were running a `diversified' fund which had, at the end of August, about $3 billion (30 per cent of the fund) invested in natural gas futures, a highly volatile commodity (it experiences price changes of up to 66 per cent in six months). Absolute position limits on Mr Hunter's positions should have kicked in long ago. The Risk Management unit of the hedge fund should have also tracked and spotted the tightening spreads between the March and April 2007 contracts a lot earlier. This would have helped to reverse positions and stop losses before it became a crisis.

A VaR (Value-at-Risk) analysis would have given an indication of the size of possible losses, given the high volatility of the underlying commodity (natural gas). Under no circumstance should this VaR cross more than 5-10 per cent of the corpus of the fund. Here, it would have crossed 35-40 per cent of the fund. Technology can be harnessed to process the large amounts of historical data that need to be analysed to track trends and arrive at accurate VaR figures.

What hurt Amaranth

Amaranth is not willing to disclose its positions or its trading strategy just yet, so it is unclear exactly what hurt Amaranth so badly, but it is obvious that it had taken on very risky positions or it had a poor hedging strategy.

One theory is that Amaranth was selling April 2007 contracts and buying March 2007 contracts. As per Econbrowser, which tracks financial data, there was a $3.50 (per million BTU) decline in the latter during September. Even if Amaranth held every single one of the 90,000 March 2007 outstanding contracts, it would lose $3.1 billion. Short-selling the April contract would have provided at least some hedge, reducing losses, in spite of the limited fall in April prices ( $1.20) relative to March prices.

So if Amaranth had followed a strategy of "taking controlled and measured risks", as Mr Maounis had told investors in August, then it should have been able to avoid at least a part of these spectacular losses. They were obviously not hedging effectively, or taking riskier positions (such as selling uncovered options at unfavourable or `out-of-money' prices).

The numbers also suggest that Amaranth held a significant portion of the gas futures market, which has less liquidity compared to the oil futures market. Unwinding large positions in an illiquid market compounds the problem. When Amaranth got margin calls caused by losing positions, they had to sell their open positions in the market. Very soon, the market got wind of what was happening and took advantage of Amaranth's desperate situation by offering poor prices. The high amount of debt that Amaranth carried relative to owned funds (gearing) further exacerbated the problem.

As a result, Amaranth incurred further losses of about $3 billion simply trying to unwind its positions. So risk managers need to track positions not only with relation to the total funds deployed, but also with relation to the size of the market.

Lastly, investors in hedge funds need to be aware of the risks that they are getting into. They need to track the exposure of the fund to various sectors. At the end of the day, it is their money on the line. In the case of Amaranth, its investors, many of them sophisticated in terms of market knowledge, did not do this.

(The author is a Senior Consultant with the Domain Competency Group of Infosys Technologies Ltd. The views are personal.)

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