Hedge, I Win... Fails, You Lose

Bill Bonner & Lila Rajiva
The Daily Reckoning
Sep 25, 2006

The Daily Reckoning PRESENTS: It recently came to the attention of the public that the hedge fund Amaranth Advisors managed to lose $6 billion in just a few days, due to a miscalculation of the price of natural gas futures. We aren't all that surprised. Hedge funds are notorious for sucking up investors' money - and turning it into nothing. Read on..

Amaranth:

1. Also called pigweed.
2. An imaginary flower that never fades.

Last week investors found to their chagrin that the Greenwich, Connecticut genus of the pigweed, is not only far from imaginary, it can fade out at lightning speed. Hedge fund Amaranth Advisors managed to lose $4.6 billion - about half its entire value - in a matter of just a few days through a sensational miscalculation of the price of natural gas futures in the spring of 2007. Today's news tells us the figure has now grown to $6 billion.

Star trader Brian Hunter bet the farm on the idea that the gap between the March 2007 natural gas price and the April 2007 would increase. Instead, it fell from about $2.60 per 1,000 cubic feet to about 80 cents, wiping out Amaranths' 20 plus percent yearly returns, in one fell swoop, to a 35% loss.

Hunter, a Canadian, had made millions for the firm after natural gas prices exploded in the wake of Hurricane Katrina. He was thought to be so savvy about gas futures that his bosses at Amaranth let him work out of his home in Calgary, where he drove a Ferrari in the summer and a Bentley in the winter. The jazzy wheels matched the snazzy wheeling...and the honeyed dealing at the American energy fund, where 1.4% of net assets went for "bonus compensation to designated traders" and another 2.3% was doled out for "operating expenses." When an account made a net profit, the manager took care to cut himself up to 1.5% of the account balance per year in addition to a 20% cut of its net profits - less the traders' bonuses and operating expenses. But when the account lost money, the managers suffered no penalty, though the investors still remained on the hook for the operating expenses and possibly for trader bonuses as well.

What kind of a gig is that? Where investors have to pay to play and then pay to lose, as well? What can investors be thinking when they see their accounts shrivel like anorexics on a fat farm while their managers grow sleek and prosperous in their Greenwich pads?

The hedge fund world is famously populated by math whizzes, each one claiming to have solved Poincare's Conjecture. But the important math of hedge funds is very simple: it's heads I win, tails you lose.

The typical fund charges 2% of capital, plus 20% of the gains above a benchmark, often the risk-free rate of return - say around 5% today. So, a fund with a 10% return charges its clients 2% of capital...plus, another 2% (20% of 10%) for the performance. Even a fund that is able to do twice as well as the benchmark - a difficult feat - only leaves the investor with a 6% return, net.

A common pattern is that for four years in a row, the fund gets twice the return as the risk-free rate and every fifth year it suffers a 10% loss. When this happens, the fund managers do not send out a letter offering to share 20% of the loss. No, they are happy to take a percentage of the profits, but not the losses. So, in the four fat years, the fund builds up...with the managers taking their cut. But in the fifth year, investors take all of the loss, effectively magnifying it, making a dollar of loss equal to $1.25 of gain.

The essential math is not only easy...it is perverse. As demonstrated by Amaranth, fund managers have every incentive to take wild gambles. If the gamble pays off, they become rich and famous. If it does not, they are still the same math prodigies they were before. It is like playing strip poker with a beautiful woman. When you lose a hand, you take off your shirt. But when she loses, she puts on a leather coat.

Why do investors think they can get anywhere in such a game? The quick answer is that investors are not thinking.

In the late stages of empire, thinking becomes a vestigial function - about as useful as an appendix...and as liable to be cut out in a crisis.

Instead, investors rationalize...and theorize...to justify the excesses and extravagances of the imperial economy. Why buy a hedge fund? Better returns, they say - though hedge fund returns have been so abysmally low that their money would have slept sounder tucked up in a cozy money market account. Different market, they argue - claiming that the new conditions demand provocative trading rather than stodgy buying-and-holding.

Don't marry your stocks, they warn. Just shack up for a few months and unload them when the next hottie comes along; that's what the celebrity hedgies do. But filling your portfolios with fast moving floozies is no way to make money; they've all been on the street too long already...they're overpriced and overworked. And when the market goes down, they'll go down faster and further than more. The hedge funds have smarter managers, claim investors. And here, finally, they might have a point. Who but a real sharpie could have come up with such a clever scheme? Hedge fund clients might be dripping in red the past few years, but the fund managers themselves are in clover.

If vanity were gravity, Greenwich, Connecticut would be a black hole. The puffed-up twits who manage most hedge funds contribute to more unwarranted bluster per square foot there than in any place outside North Korea. Greenwich sucks in money from all over the financial world and turns it into...nothing.

In this respect, Amaranth is only following the hedge fund playbook. Deals for hedge bosses are so sweet that Warren Buffet claims the funds aren't really investment vehicles at all but compensation strategies - ways to keep star managers in their multimillion dollar digs while the funds themselves turn in lower and lower returns...sub-10% on average, and in some cases, pushing below 5%, according to the Hedge Fund Index. In fact, in 2005, some 848 hedges closed down their business, says one consultancy firm, Hedge Fund Research Inc.

Is it just a case of too much of a good thing diluting the returns? Could be.

When Alfred Winslow Jones coined the term in 1949, hedge funds operated on the margins of the investment world. "Hedge fund" then simply meant a portfolio of stocks with long and short positions, the shorts acting as a hedge against losses in the longs.

Today, the term better describes the legal structure of the groups - private, and limited to a specific number of investors, with a minimum of $1 million in assets - and the actual strategies employed vary dramatically - from commodity trading to distressed investing.

And today, hedge funds have spread like a tropical parasite so that there are now 8000 or so of them, infesting even institutional investors and pension funds, and sucking in total assets of about $1.2 trillion. Meanwhile, hedge funds specifically engaged in energy trading - like Amaranth - have proliferated - soaring from about $5 billion to a stratospheric $100 billion.

You'd think this would give at least the pros in the business some pause. Yet, Morgan Stanley, for example, pumped five percent of its $2.3 billion fund of hedge funds into Amaranth. And, Goldman Sachs' fund of hedge funds also admitted that an anonymous energy-related investment - guess who? - had wiped off a chunky three percent off its monthly return.

Hubris and excessive risk run through the entire sorry episode. Hunter himself was borrowing $8 for every $1 of Amaranth's own funds, while taking positions ten times larger than veteran energy trader, Goldman, and twice the size of the next biggest trader. Hunter also expanded Amaranth's natural gas holdings so that they became half the firm's entire exposure, where they had once been only 7%.

Like LTCM - the energy firm that blew up in 1998 - Amaranth held such large positions in the market that it could not unravel its positions. Like LTCM, Amaranth seemed certain it would never fail and boasted of its "fearlessness" on its website. Like LTCM, Amaranth was hazy about what it was doing and how...

But unlike LTCM, the financial community is reacting with odd indifference to Amaranth's fiasco. Peter Fusaro, co-founder of the Energy Hedge Fund Center, which tracks 520 energy hedge funds, shrugs that Amaranth is "a hiccup." Amaranth's blow-up doesn't affect as many institutional investors and banks and other financial VIPs, as LTCMs did. Only its rich clients have to endure the pangs of portfolios sliced neatly in half.

Maybe so.

Maybe not.

We think of the typical hedge fund manager. Not yet 30, no experience of a real bear market, let alone a credit contraction...the man thinks only of the new house he will build in Greenwich, Connecticut, if his bets pay off. He imagines that he will take his place alongside George Soros and the Quantum Fund.

More likely, he will join Nicholas Maounis in the pigweed.

Bill Bonner & Lila Rajiva
email: DR@dailyreckoning.com
website: The Daily Reckoning

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