September 29, 2006
Amaranth hedge fund losses
How in the world did hedge fund Amaranth Advisors manage to lose $6 billion in September on natural gas trading?
The traditional notion of a "hedge fund" was that, by simultaneously buying and selling related securities, the fund could maintain a portfolio with the particular risk-return characteristics desired by its clients and earn some extra profit from securities that the market has temporarily misvalued. Long Term Capital Management, which succeeded and then failed in 1998, both in spectacular fashion, prided itself on doing just that. And it's a perfectly reasonable strategy, as long as you don't try to carry it too far.
If I were looking for such a play in recent months, I might well have picked the divergence between natural gas and oil prices, as indeed I argued in a post on May 21 that the natural gas - crude spread had diverged from its long-run tendency. An aggressive hedge fund manager who took my analysis to heart might have tried to make money off it by buying a long-term futures contract on natural gas and selling an offsetting contract on crude oil.
Feeling a little guilty, I was curious to see how badly someone who followed such advice would have been slaughtered. If you'd gone out and bought a June 2011 natural gas contract (the longest maturity contract avoiding the winter seasonal) the day after my post on May 22, the price would have been $6.70 per thousand cubic feet. To unwind the contract, by selling it back to the market at yesterday's price, would only net $6.50 per thousand cubic feet, meaning you lost 20 cents per thousand cubic feet, or about $2,000 on a standard contract of 10,000 million BTU.
But the nature of the hedge is that you were also supposed to sell an oil futures contract at the same time. On May 22, the June 2011 crude futures contract sold for $68.75 per barrel, which you could have closed out yesterday by buying at $63.29, a gain of about $5.50 per barrel, or $5,500 on a standard 1,000 barrel contract. So on balance, the hedging strategy-- simultaneously buy natural gas and sell crude-- would have put you ahead $3,500.
Well, that's a relief-- whatever Amaranth did to lose $6 billion, it wasn't by incorporating Econbrowser advice into standard hedge fund strategy. But what was it doing instead?
Let's say you didn't hedge at all, but just bought the natural gas futures, and moreover managed to pick the worst possible day to do so, namely September 20 at $7.07 per 1000 cubic feet. Then you're just plain out $6,000 per contract. However, note that the bottom line on the above graph, labeled "open interest", indicates that the total number of June 2011 contracts currently outstanding is less than 1,000. Even if Amaranth had been the buyer of every single one of these, they still couldn't have lost more than $6 million, or 3 orders of magnitude less than what they did.
To lose bigger sums, you'd need to be trading in the nearer-term contracts with bigger volumes. Brad DeLong reports that one of Amaranth's games was selling the April 2007 contract and buying the March 2007 contract. With a $3.50 decline in the latter during September, if you held every single one of the 90,000 outstanding contracts, you could lose $3.1 billion. Shorting the April contract would have given you some hedge, cutting your losses to $1.6 billion. I conclude with DeLong and also Nate Hagens at the Oil Drum that the numbers imply that Amaranth must have held a very significant portion of the outstanding volume of a number of different contracts.
I'm guessing that Amaranth may have also been playing this game with other instruments. Selling far-out-of-the-money puts is another strategy that an unscrupulous hedge fund manager could use to assemble a nice track record for a while. For example, if you sell an option that entitles the other party to force you to buy natural gas from them at $8, if they choose, then as long as natural gas stays above $8, you've simply raked in cash with no losses. If all your investors see is the bottom line, you'll look great, until the day of reckoning comes when natural gas actually does fall below $8 and you'll then have to pay up big time.
Of course, if anybody ever audited Amaranth's holdings, they would have seen what was going on immediately, and indeed NYMEX apparently inferred from the volumes that something was wrong and warned Amaranth to reduce its positions. But the way the hedge fund game is often played, foolishly credulous investors never get to see the books and base their decision simply on the fund's track record and slick sales pitch. I have to join Big Picture and Motley Fool in blaming the folks who supplied Amaranth with capital, rather than the managers themselves. Anyone who tells himself that 35% annual returns with no risk are there to be obtained by some unseen hedge-fund magic is soon to be parted from his wealth.
When you hold a significant portion of the outstanding contracts, you have the potential to move markets in a big way when you liquidate, making your swan song all the more dramatic when it comes. This is what happened to Long Term Capital Management, and it seems likely that a significant part of the September volatility in the graphs above is directly due to Amaranth.
I have often argued (e.g. , ) that as long as speculators make a profit, their actions tend to be stabilizing, as they have helped direct resources to where they are most needed. But by that metric, we got $6 billion worth of destabilization out of Amaranth last month. And when I hear a story like this, my first instinct is that there could well be a lot more of this going on. Amaranth's staggering losses leave me more open to the claim that a significant part of the general commodity price increases we have seen in recent years might be the result of actions by speculators who are destined to earn spectacular losses.
Does this suggest some policies we ought to be taking to regulate hedge funds? From a legal perspective, these are often construed simply as partnerships. How in the world would the government presume to dictate whether a small group of investors can buy or sell futures contracts with their own money? Furthermore, if we agree that the basic problem is that the destabilizing funds are going to end up like Amaranth, you'd think losing $6 billion ought to be a pretty strong incentive all by itself.
But then I saw this detail, which brings the story closer to home. It seems that $175 million of the cash that Amaranth had to play with came from the San Diego Employees Retirement Association, which may have lost $87 million on their Amaranth investment.
It seems outrageous to me that a public pension fund would be investing its money in this sort of scheme. However, I could well imagine that the incentives for the pension fund manager are for exactly what a risky hedge fund delivers-- a short-run historical track record of unusually good returns, as long as nobody pays too close attention to exactly how you got it.
So here's a regulatory proposal that I could support-- no more than 10% of any pension fund's holdings can be invested in institutions whose balance sheets have not been subjected to an arms-length audit.
Posted by James Hamilton at September 29, 2006 10:00 AMdigg this | reddit
" For example, if you sell an option whereby someone else could buy natural gas from you at $8, if they choose, then as long as natural gas stays above $8, you've simply raked in cash with no losses. If all your investors see is the bottom line, you'll look great, until the day of reckoning comes when natural gas actually does fall below $8 and you'll then have to pay up big time."
Hmm, this part may have to be reworded. You must have meant "the right to sell natural gas to you at $8".
Posted by: HZ at September 29, 2006 10:35 AM
A comment on your previous analysis of natural gas vs crude prices: While in this analysis you had them buy a distant contract, your previous chart seemed to be using a front month. Using the averagge of a 12 month strip instead of the front month contract would probably lead to more accurate analysis in the future. (And using a non front year strip helps net out specific weather events)
Posted by: Agent00yak at September 29, 2006 10:35 AM
Thanks for catching that HZ. I've corrected the error.
Posted by: JDH at September 29, 2006 10:44 AM
Firstly, as Amaranth lost 6.5B someone else must have made that much money. If the winners were hedge funds, then overall effect on the economy would be close to nil -- other than that it xfers wealth from investors to fund managers (fees) and governments (taxes). If the winners were producers (a likely scenario since most producers hedge part of their production), then you have a good point as they may have been encouraged to over-produce by a false price signal.
Secondly, I live in San Diego and I am outraged by what the county pension fund has done. They were already having a underfunding problem before this happened. We can expect to see more of this: as public pension funds fall behind in funding they get more desperate and resort to magic. Pension fund boards should really read John Bogel. As a whole they are the big gorrilas and there is no way they can all earn above market returns. Looking to hedge funds merely benefits the fund managers.
Posted by: HZ at September 29, 2006 10:49 AM
HZ, my primary concern is indeed with the allocative and distributional effects of the natural gas prices themselves, rather than with the particular transfer of wealth between the buyers and sellers of futures contracts. If trades by Amaranth in this volume have been a factor that has helped determine recent natural gas prices, I am taking the losses by Amaranth as an indicator that these prices were incorrect representatives of the true supply and demand situation. And the problems with incorrect prices have to do not just with the allocative incentives for producers, but also a wealth transfer, for example, away from elderly people trying to keep their homes warm with natural gas. Being also myself a resident of San Diego, I share your particular concern about the transfer of wealth away from San Diego taxpayers and pensioners. But the bigger issue, as you note, is not the paper wealth lost by Amaranth but rather its potential broader implications.
Posted by: JDH at September 29, 2006 11:13 AM
Seems like they should call them speculation funds rather than hedge funds.
Posted by: Hal at September 29, 2006 02:03 PM
It is indeed believed that a) Amaranth/Hunter were an absolute bully in March/April spreads, b) that A/H had substantial OTC positions and that as a result c) the big winners are neither other HFs or producers, but big banks with the capacity to write that kind of volume in those sorts of forward contracts.
In re SD, I disagree in the abstract, though I agree on these particulars. Pension fund and endowment portfolios have a place for absolute return strategies, indeed even for high-risk ones. Yale has a 25% total allocation, but then, Yale outperforms. On these particulars, I both find SDCERA's 2.5% of assets in Amaranth on the high side for such a speculative fund. Moreover, Blackstone's pullout shows top due-diligence people not only could but did react to signs of trouble. My bet is that SDCERA got too close to its alpha engine, and neglected to check the clunking sound its piston gave out this July.
Posted by: wcw at September 29, 2006 02:28 PM
The term hedge fund is a commercial term used to refer to investment vehicles that are exempt from the Federal Investment Company Act, the law that regulates mutual funds, because of the way they are organized (Sections 3(c)(1) and (7)). The exemption allows them to use trading strategies and other business tactics that are not allowed to regulated mutual funds, including using leverage, short-selling and commodities trading.
The term hedge fund does not limit the investment charter of these entities, which, if it is limited, is only limited by the contract among the investors and managers, and not by law, as is the case with mutual funds, banks, insurance companies, etc.
Other vehicles, such as venture capital funds and LBO funds use the same legal structure as hedge funds. The differences among them are ones of investment strategy.
Posted by: Robert Schwartz at September 29, 2006 02:45 PM
(re: wcw on pension funds) There are plenty of absolute return funds out there (PIMCO comes to mind) and even better you can also invest passively in an index so that you don't need exposure through a high cost and secretive hedge fund. In the end this pension investing business does not make much sense on a national level - financials all net out on a national level anyway. We should just decide, through a political process, to dedicate a certain portion of GDP to our retirees, a la Social Security. To me pension investing has little useful economic function because there is not much accountability -- witness Calpers' various agendas. 401K is a lot better and can satisfy the part of us that is against egalitarianism.
(re: price volatility) On the other hand the failure of Amaranth gives me faith in the market. The power of market is awesome. With the spike in oil & gas prices everyone and his brother seem to be out there prospecting (or had been). I also remember how the California power crisis drove such a frenzy of building power generators that in one year we reversed the deficits accumulated from decades. Paul Krugman was arguing for price caps at the time. While that is a very seductive argument at the time it now appears that could have been counterproductive. As for price volatility experienced by end users: over long term we do want users to change their consumption patter if there is a change in production capacity; in addition the utilities should shoulder the responsibility of smoothing out some of the extremes in short term volitility.
Sorry for the longish comment.
Posted by: Anonymous at September 29, 2006 04:18 PM
Forgot to put in my handle. I wrote the longish post, if anyone cares :-)
Posted by: HZ at September 29, 2006 04:21 PM
Back to the original question...how did they lose this much money? In a few weeks no less. Nobody has really explained what happened here. It appears that A/H attempted to "corner" a spread trade. If that was the case they ended up holding the bag on a trade that no one else really cared about. Who really cares about the march april gas spread??? Only the poor suckers left holding the bag on a massive "airport trade". Buying up a ton of open interest in a thinly traded market is insane. What are the odds someone would be this dumb and manage that much money? Throw in the fact that he was fired by a previous employer for taking outsize risks. This was a ticking time bomb. I am quite frankly surprised he was not trying to corner FCOJ or Lumber.
Posted by: Mike at September 30, 2006 04:03 AM
The smoking gun for Amaranth's near fatal wound was first pointed out by Russ Winter who noted how Goldman Sachs Gamed the Gas futures-
"Goldman Sachs elected in July to arbitrarily game their widely followed commodity index. Illustrating how this can be done, and with no questions asked, they suddenly changed the unleaded gasoline component of the index from 8.45% to 2.30%, right at a point in time when speculative funds were heavily long. In addition GS blew up the arbs with this jewel,
"On July 12, 2006 Goldman, Sachs & Co. announced that, for the roll occurring in September 2006 (the September Roll) in relation to the Goldman Sachs Commodity Index (GSCI) futures contract expiring in October 2006, it would roll the existing portion of the GSCI that is attributable to the Reformulated Gasoline Blendstock for Oxygen Blending (RB) futures contract on the New York Mercantile Exchange but would not roll any portion of the GSCI that is attributable to the New York Harbor Unleaded Gasoline contract (HU) contract into the RB contract."
Goldman Sachs made a tidy profit at the expense of your pension funds, and lowered gas prices right in time for the elections, sweet!
Posted by: Alan Greenspend at September 30, 2006 04:47 AM
Oof. One more hit the SD Pension fund didn't need.
Can San Diego do anything right these days? Oh, I forgot - we're surrounded by corrupt Republicna politicians, so I guess not....
Posted by: donna at September 30, 2006 09:31 AM
Yes, the eternal question: to what extent are today's commodity (oil & gas) prices determined by speculation? We'll probably never know.
Here's some speculation. Natural gas prices are almost entirely determined by supply and demand. Last year's spiking prices induced firms to search for more gas, which they found, hence the reduction in price. With this price reduction, many such firms are reducing or stopping to increase their capital budgets.
The larger story buried in this speculation seems this: though we have, as evidenced by price movements, accessible new supplies of natural gas (the tapping of which, I might digress to add, leads to ever faster running-to-stay-in-place), we have no equivalent for oil. Which is why oil prices have not followed the same track as gas prices. Which is why "inflation" is still rising.
Go Ben go!
Posted by: Thomas James at September 30, 2006 10:21 AM
Oh, and by the way, the upshot of my speculation above is that Amaranth simply misread the supply situation. Tsk tsk.
Posted by: Thomas James at September 30, 2006 10:23 AM
With these financial instruments (futures contracts), no one seems to have a need to hoard the underlying physical asset. So the speculators are merely betting on directionality, without creating artificial shortages. Didn't someone try to corner physical silver once (in the 80s?)? Now that would be truely distortionary.
Posted by: HZ at September 30, 2006 11:55 AM
Amaranth was done in by a squeeze delivered by the coordinated efforts of a couple of the best nat gas players in the business. This will all come out in the near future.
They got themselves into this mess by putting on a HUGE spread position that everyone in the industry knew about, and when it started going against them, they tried to force the market their way by making it HUGER rather than take the loss. The coup de gras was having to dump the position at an even steeper discount to a hedge fund and investment bank to avoid bankruptcy and a total wipe-out. Classic case of greed, stupidity and survival of the fittest.
Posted by: Col Sanders at September 30, 2006 07:59 PM
"Coup de gras"?
If you're doing that on purpose, I applaud you :-)
Posted by: bartman at October 1, 2006 01:20 AM
My experience with hedge funds falls into two camps.
One. "True" unlevered hedge funds (no or little systematic risk) generate modest returns that are hard to market to the public since 2-6% over t-bills gets no one but the most sophisticated plan sponsors excited (too bad San Diego wasn't a little more sophisticated).
Two. The few skilled investors that could make a true hedge fund are probably too busy building their long only products. After all, skilled investors realize that the typical 2% base fee/ 20% of profits deal is incompatible with a pure hedge t-bill plus 2-6% alpha return world. Rational fees would resemble the fees on long only products. Many in the equity markets(myself included) find it more lucrative to just do the plain old vanilla business.
Posted by: toddleem at October 2, 2006 06:14 AM
A technical note: Position limits imposed by NYMEX, and other formal exchanges, would likely make it difficult for one firm to hold the vast majority of outstanding contracts. For example, with Natural Gas futures, Nymex has a flexible position limit, after which "accountability" is required:
"Position Accountability Levels and Limits
Any one month/all months: 12,000 net futures, but not to exceed 1,000 in the last three days of trading in the spot month."
In other contracts, there might be specific limits for both hedgers and speculators, with speculators subject to lower limites.
Recent news reports are suggesting that Amaranth also had large positions in the less regulated OTC futures market -- see: WSJ Sept 27 "Is Energy Trade On OTC Platform Too Wild?"
Posted by: John Elder at October 2, 2006 08:11 AM
I understand that they were long winter / short summer spreads in 2006, 2007 and 2008. In addition to the large positions held on NYMEX (who met with them and advised that they were near or over the exchange limits on at least one occasion) they had equally large positions on ICE (Inter-Continental Exchange) and more importantky, imho,in the effectively unregulated over the counter energy bazzar. That's where the r-e-a-l leverage comes from.
Posted by: dvegadvol at October 2, 2006 10:08 AM
the County pension scheme is $7.7bn. $175m is 2% of its value.
It's ludicrous to argue that a $7.7bn pension fund shouldn't take risks with alternative asset classes.
That said, it seems an excessive commitment to one fund.
The overall asset allocation of 20% in alternative investments is high, *however* the latest investment thinking of the leading endowments in the country (David Swensen at Yale, Harvard Endowment, Ontario Teachers Superannuation Fund) is that 20% is an appropriate overall level of investment in alternative assets (or more-- timber is a particular favourite of the cognescenti-- timber has outperformed all other asset classes in the last 30 years).
Alternative assets would include all assets: private equity, timber, commodities, hedge funds, etc.
So the issue is more the concentration *in one fund* than the actual exposure to that sort of investment. And we would need a lot more data before we could assess whether County of San Diego had been imprudent and in violation of fiduciary duty.
I get much more worried by funds that are 70-80% in equities, not an uncommon weighting these days. Or big weightings in commercial property (do we never learn?).
Even so, losing $100m is not a big loss in the context of a $7.7bn fund. Overall the fund made 14.7 per cent. return last year, which is a pretty good return for a fund of that size in 2005.
See Swensen, David 'Pioneering Portfolio Management'-- Swensen is, arguably, the most successful endowment manager in the history of endowment management.
Posted by: Valuethinker at October 2, 2006 01:25 PM
Valuethinker, I suggested 10% as a limit not on a single investment, nor as a limit on all "alternative" investments combined, but rather as a limit on the sum of all investments that are in unaudited enterprises.
The lack of an arms-length audit is my principle concern here.
You're right there is a separate issue of the amount invested in any one fund and I would certainly suggest on this second question that 2% even in the safest blue-chip source is too high for a fund as big as the county pension fund. Diversification is the one very clear principle that a fund like this should surely be following.
Posted by: JDH at October 2, 2006 01:43 PM
"no more than 10% of any pension fund's holdings can be invested in institutions whose balance sheets have not been subjected to an arms-length audit"
All the hedge funds and limited partnerships that I have looked at/invested in for various employers over the years have had annual audited financials - often by one of the Big 4 (or 6 or 8 or whatever it was at the time). I don't know about Amaranth, but if San Diego was investing in unaudited pools, they deserve to be hung out to dry. It's also true that auditing doesn't provide much value or security to LPs, especially if the manager employs dynamic high-turnover strategies.
Posted by: KevinT at October 2, 2006 03:16 PM
Kevin, are you saying that for the funds you invested in, you would know the specific gross exposures, e.g., long 50,000 March 2007 natural gas contracts, and so on?
Posted by: JDH at October 2, 2006 03:24 PM
OK I hear where you are coming from. I guess I had assumed Amaranth had audited positions, just not ones which were current (audits coming only once a year)?
On fund exposure in general, a private equity fund that would not be an excessive amount, in the sense that PE funds have long, slow return profiles (they typically are not fully invested for 5 years, and not wound up for 10). 2% would still be too high, but not for a 'Fund of Funds' vehicles.
San Diego clearly thought Amaranth was a 'Fund of Funds' ie invested in many subsidiary funds in different asset classes.
Very good point re the difficulty in using audits to assess risk in a Hedge Fund, given that the typical HF turns its portfolio over perhaps 200 or 300% per annum.
James and KevinT
I think we are all agreed it is very bad practice to invest public pension fund money in unaudited pools of assets. Even if the audits are only annual, the discipline, in these post Enron days, of confronting an auditor and answering her questions, is a good one for any investment vehicle and its management.
That said, I know enough about auditing to say that if your goal as a fund is to pull the wool over someone's eyes, you can.
Posted by: Valuethinker at October 4, 2006 12:15 AM