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Who's to Blame for Amaranth's Losses?

Answer: their investors.

Before you roll your eyes, hear me out on this. I have some very specific experience with this, as I have spent the past 18 months or so traveling around the United States, speaking with  my limited partners (i.e., investors) and with potential investors for our hedge fund.

My experience with this is why I have been watching the unfolding debacle at Amaranth Advisors’ with some bemused detachment.

Now, without revealing any specifics, I will tell you we have had conversations with some very intelligent people who were a pleasure to meet with; Brilliant, fascinating, successful folk with interesting lives and of great accomplishment. However, once we sat down with their financial advisors - lawyers - accountants, things became, well, repetitious. In every meeting, there were some variations on the same conversations; Its like there is some hedge fund due diligence form that makes everybody ask nearly identical questions:

What's your track record?  (Good)
How much skin do you have in the game? (alot)
How is Alpha generated (our models keep us on the right side of the major trend, and avoid big counter-trend moves)
What do you think will happen to the economy and the market?
(I don't know, but here's an underappreciated possibility . . .)
What is your Gamma ? Sharpe Ratio?  (I neither know nor care; This isn't a B-school exam)

Then comes the exact same question, which I  (foolishly) answer honestly:

"What sort of performance are you looking for?"

I usually start with: "It depends upon what the market offers us; If we remain range-bound, it will be difficult to put up great numbers without a lot of leverage or a lot of risk (or both), and we don't do that. We do particularly well, however, in major dislocations or strong rallies."

My initial answer is rarely accepted, and I am forced to go to a 2nd and 3rd option:

"Give us more details on what you want to do. What performance would you be happy with?"

Answer two:  "What we want is irrelevant; Its what we can reasonably do while still managing risk, and not overleveraging. Our goal is to outperform the S&P500 with less risk, and in the event the SPX is negative, still have positive expectancy (i.e., be up when the indices are down)."   

"So you are a relative (rather than absolute) performance fund?"

Answer 2b: "Well, most funds actually are, despite their claims of absolute performance regardless of market conditions. Consider the mediocre performance numbers from most funds recently when the market's been range-bound. Its been pretty weak, and that's no coincidence. There are only a handful of true absolute performance funds with great long term track records (and if you are talking to me, its because you cannot get into them)."

Now comes THE QUESTION. This is the one that gets people into trouble:

"We are looking for a number. What should we expect from you in the first 2 years?"

What they want to hear is "I am going to do 30-40% annually, fully hedged."

I don't say that, because it isn't true. (God bless Jim Simons, who actually can honestly say that). That's what too many investors are looking for; its nothing more than the greed factor at work.  They don't say it explicitly, but its true: We want you to outperform the long term S&P500 benchmark by 300-400% annually (and we don't care about mean reversion). We really don't care how you do it. We want outsized profits. WE WANT THE LATE 1990S AGAIN.

Money raisers and some GPs have long ago figured this out. You have a few choices: you can answer the investors' questions honestly -- or to quote Ray Davies, you can give the people what they want (or think they want):

"We expect gains of 35-45%, with minimal risk or leverage. Our black box algorithms  have been backtested, and generate better numbers than that, but we would rather under-promise and outperform."

Of course, that statement will be nonsense for 99.8% of the people who utter it. The vast majority of funds will not out-perform the indices dramatically year after year. We were fortunate -- we ended up with investors who understood this; Then again, we are a small fund, and not a $9B giant.

There are some funds that aim to fill this niche. They use lots and lots of leverage, play the highest beta moves, load up on derivatives, put up good numbers for a stretch. Eventually, they do one of two things: They take on some risk management -- lower their volatility plays, reduce leverage, aim for more sustainable gains.

Or they blow up.

Not all of them, but enough. Something like 25% of all hedge funds every couple of years dissolve, go away, reform, pop up elsewhere. That's not a coincidence, either.

~~~

So Amaranth put up great numbers for a while. And now we know how they did it: They took extraordinary risks, using lots  of leverage on the highest beta trades. And when one went against them, it blew up, and they lost a few billion dollars in a week.

Don't blame them. Their investors demanded huge returns, and they turned a blind eye to the inordinate amount of risk required.

Who is to blame?

I think you have a suspicion as to who I think is the cause of Amaranth's losses . . .

Wednesday, September 20, 2006 | 06:48 AM | Permalink | Comments (67) | TrackBack (6)
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Comments

Thank heavens! Breath of fresh air. We are in the same business and it is exactly like this (if not worse). It may seem hard to say the right things up front, but we have found that if you do, you tend to get the types of investors you want to keep.

Posted by: Steve Colglazier | Sep 20, 2006 7:51:46 AM

Exactly -- if someone says to me "We want to see a 5 year track record", or "we dont do emerging managers," or "we already have Macro exposure," I am perfectly cool with that.

But when they say -- no, you are too realistic, we don't want that, we want 30% year over year regardless, well, what can you say to that?

The obvious performance sluts end up getting exactly what they want -- and we saw that with Amaranth ...

Posted by: Barry Ritholtz | Sep 20, 2006 7:53:46 AM

Hey, that's like blaming the girl who spilled her hot coffee for not exercising personal responsibility to keep it from spilling. Holy cow.

Or smokers for getting cancer.

Or over-eaters for getting diabetes because they're fat.

They want risk? Give 'em risk.

Posted by: Uncle Jack | Sep 20, 2006 7:55:48 AM

Somewhere in Greenwich, Nassim Nicholas Taleb is laughing hysterically as yet another set of traders were "Fooled by Randomness". The story of Brian Hunter is the story of John Merriweather and the story of Victor Niederhoffer and every other trader who made lots of money for periods of time only to find out that any string of numbers multiplied by 0 is still 0.

Posted by: joe | Sep 20, 2006 8:11:06 AM

If some greedy people loose money, so what. The possible bigger effects get me worried. When will the next LTCM happen?
Anyway, Amaranth is a good case to show that it is better to respect the risk in a trade and avoid too much of it.

Posted by: Gunther | Sep 20, 2006 8:15:23 AM

will more hedge funds be blowing up ... look at the decline in OIL.

Posted by: christopherrobin | Sep 20, 2006 8:16:38 AM

If a fund lies and tells people that they will earn 30-40% fully hedged then they are at fault.

Hedge funds trying to accumulate money are not the first people to run into the problem of unrealistic expectations. If honesty was always profitable, then nobody in business would ever lie. The fact that there are foolish people with lots of money does not condone lying.

In the case of Amaranth, they may have been incompetent rather then lying.

Russell

Posted by: Russell | Sep 20, 2006 8:17:22 AM

hello from germany,

fantastic barry.

what really scares me is that the main players in this minefiled like goldman sachs were up on the news.

a huge portion of their business depends on the hedgefunds and their own trading / own funds.

you would assume that at leat the big blow up would take the stock down a bit.

maybe the blow up was not big enough. the next one is coming for sure...

http://immobilienblasen.blogspot.com/

Posted by: jmf | Sep 20, 2006 8:18:53 AM

This story is no different than Gleeson bringing down Barings; a guy got caught on the wrong side and instead of owning up, he martingaled his way to the poor house.

It's one thing to hold on too long to a loser (a common mistake), but quite another to keep doubling down on that loser.

Posted by: Uncle Jack | Sep 20, 2006 8:30:33 AM

Barry, well said. I have been a broker/money manager for 25 years. Your experience with client expectations has been my experience as well.

I too refuse to compromise my presentation to get money in motion my way.

On a personal level: at the end of the day in this business my goal is to keep clean my reputation and name.

Posted by: Bill | Sep 20, 2006 8:46:38 AM

The quest for outsize performance should be a personal choice and should entail higher risk. That is a cardinal rule in a legitimate system.

In this cycle, commodities are one of the primary arenas of massive speculation by funds of all stripes and varieties who have been "at work" seeking outsize gains. And most have gotten them as "risk (speculative)" premiums have driven up the prices of oil, base and precious metals, natural gas, etc.

The more obvious losses from a hedge fund masks the diffuse losses that mom and pop have suffered over the past several years in higher prices, distorted economic allocations, higher interest rates, untenable mortgage schemes, etc.

Any time the Federal Reserve provides excessive monetary stimulation and market regulation is insufficient to limit leveraged control by speculators, it is everyone who suffers the losses. The transfer of risk from the financial community to the population at large, with official support, lands on the general population far more than some silly ass hedge fund.

The stage is set for a slow down and probable recession to re-balance the risk/return equation. Everyone pays. Just ask Japan. Thanks for the blog.

Posted by: blam | Sep 20, 2006 8:59:28 AM

Anyone want to guess when that house of cards FNM blows up?

Posted by: Michael | Sep 20, 2006 9:44:08 AM

I think in 2-3 yrs hedge funds will be sweet memories..finance-driven markets meet only one fate: Death. These are leaches who suck blood from good, hard working people....

Posted by: andiron | Sep 20, 2006 9:44:15 AM

Amaranth's biggest mistake was messing in a field it knew little about -- namely natural gas futures. The company's roots are in convertible bond trading, which is a whole other ballgame.

Posted by: Larry Nusbaum | Sep 20, 2006 9:45:18 AM

A friend who is a long time manager tells me: YOU GET THE CLIENTS YOU DESERVE.

There's some truth to that.

Posted by: Barry Ritholtz | Sep 20, 2006 10:10:31 AM

But there are victims. There are the poor schmoes who got suckered into these "funds of funds" over the last couple years--the opportunity to invest in the most mediocre funds and with not just one, but two levels of outrageous fees! But then, maybe they aren't victims either.

Of course, there are the people whose pensions are in these things. I read the San Diego County pension fund was in Amaranth and I believe there was already a scandal about them being under-funded.

Posted by: Bob_in_ma | Sep 20, 2006 10:30:24 AM

"Don't blame them. Their investors demanded huge returns, and they turned a blind eye to the inordinate amount of risk required."

Yes, but whether investors can be fully aware of the specifics of the risks involved is another issue altogether. These involved not only the type of bets Amaranth was making in this case, but the controls it had in place for mitigating losses if these bets went bad. Amaranth appears not to have fully understood its own risks, and its investors were being provided optimistic risk control assessments. Whether there should have been greater appreciation for this additional form of risk, that is, that your fund may be overly optimistic with regard to its own risk assessment, is a matter of debate.

We may see this debate take place in the days and weeks ahead in the case of Amaranth.

Posted by: James C. | Sep 20, 2006 10:38:43 AM

How can responsible, conservative investors get a reasonable return on their investments - with predictable risk - when some drunken bozo is crashing through the party breaking all the furniture? I believe LTCM, Refco, and now Amaranth have effects beyond their own clients.

Posted by: Fred | Sep 20, 2006 10:44:25 AM

but u see the WSJ article this morning: both Morgan Stanley and Goldman Sachs funds (presumably the smartest guys in the room) had 5% of their money in Amaranth!! stunning to me that there isnt more fall-out in the market. if they can lose it here, they can lose it anywhere. if i were an investor i'd be banging on the door trying to get my money out. but apparently no-one really loses money any more, they have off-setting derivatives in place to protect. no losers, only winners

Posted by: scorpio | Sep 20, 2006 11:13:35 AM

Even Simons has effects. Entirely eschewing folks with backgrounds in the field may help him put up great quant trading models, but I have seen his SEC filings pop up as long in some really abysmal names. That said, by all accounts his funds continue to crush the market year after year, so I can't criticize. Sometimes you make a ton of money long really abysmal names; I just can't bring myself to do it.

Hunter made his nut ($100m last year, I believe) and will probably get hired again on top of that, so I can't fault him, though there is no way I would have been pressing the aggressive long in March/April NG spreads he apparently had. Like Leeson, apparently Hunter had become an in-joke among NG traders, but why should he care? His children will die rich.

Amaranth themselves bear some culpability. They appear to have bought Hunter's line that he was managing his risk. A good risk desk never, ever trusts a trader. Which, of course, brings me to Barry's point.

The investors absolutely bear ultimate responsibility. They shouldn't have been asking so much about returns, and should have been asking about the management and the risk desk.

Posted by: wcw | Sep 20, 2006 11:13:50 AM

Barry,

FANTASTIC POST. As a PM with a long-term track record, I can tell you that we've left a lot of potential money on the table over the years by being stringent in who we took on as LPs. That's been a conscious decision, and a sometimes difficult one to make, but we have always maintained that we have to be absolutely honest in our approach and if HONESTY isn't good enough to interest the LP, they're not an LP we have interest in.

My first reaction when Amaranth blew up was, how could the diligence efforts of any LP that was TRULY focused on risk have accepted Amaranth's trading policies? I can't envision a risk/payout curve whereby there was an implied payout that justified the coincident risk there.

Jason

Posted by: Wood | Sep 20, 2006 11:17:19 AM

>>>Of course, there are the people whose pensions are in these things. I read the San Diego County pension fund was in Amaranth and I believe there was already a scandal about them being under-funded.<<<

I found this on the web regarding the San Diego County Employees Retirement Association. Of the $6.5B, "it allocated $175 million each to D.E. Shaw & Co. and Amaranth Advisors in addition to giving $125 million to Silver Point Capital. In so doing, the fund demonstrated that it has deepened its level of understanding vis-à-vis individual hedge fund strategies, choosing Amaranth for its arbitrage approach..."

Posted by: Michael C. | Sep 20, 2006 11:22:19 AM

I blame the hedge funds and the government for allowing these funds to exist without strict regulation. Hell hath no fury...............

This whole hedge fund debacle will blow up because there is no regulation. The ironic thing is the best way to legitimize the industry is to regulate it. Yet, the industry refuses to support. Ultimately, those reasons are highly suspect as it pertains to the potential investor.

I'm not throwing everyone in the same boat but since there is no regulation, do I really have any other choice?

Posted by: BDG123 | Sep 20, 2006 11:30:31 AM

"The investors absolutely bear ultimate responsibility. They shouldn't have been asking so much about returns, and should have been asking about the management and the risk desk."

And perhaps some or even many were, and perhaps faulty and/or misleading information was being provided in response. We don't know at this stage, which is why so much of the discussion for now is speculation.

Let's see how this plays out going forward (including the response of investors, who may feel they have legal recourse).

Posted by: James C. | Sep 20, 2006 11:30:34 AM

An interesting point you make about 25% of hedge funds blowing up every 24 months. I wonder whether that statistic (if statistic it is) should not affect the hurdle rate at which successful managers start to make their 20% peformance fee?
Of course the very culture of performance fees is likely to encourage make-or-break concentration. Now that Corporations are expected to expense the cost of options granted to management, is there not a case for the hedge fund industry expensing the cost of the implied option involved in a performance fee?

Posted by: bold'un | Sep 20, 2006 11:31:31 AM

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