15. Woodstock for Hedge Funds

In and around New York’s Helmsley building, Stanford Connecticut, or London’s St James and Mayfair (known as “Hedge Fund Alley”), brass plates acknowledge congregations of hedge funds. The funds are frequently named after birds of prey—“falcon,” “peregrine,” or “osprey.” Other names conjure images of solidity, Wesley R. Edens’ Fortress or Kenneth C. Griffin’s Citadel. The word “capital” is ubiquitous. If private equity, securitization, and derivatives were alchemy, then hedge fund managers had to be the alchemists of the age of capital.

Journalist Martin Baker described the formula for hedge funds:

Take a speculative cocktail shaker. Add four parts public ignorance and 33 parts greed. Toss in a little perceived genius. If you don’t have any freshly ground perceived genius to hand, a little dried genius status will do. Season generously with mystique. Add apparent publicity shyness to taste. Serve in opaque tumbler of awed, ill informed media coverage.¹

Hedge fund managers: “considered [themselves] part of the new era and the new breed, a Wall Street egalitarian, a Master of the Universe, who was only a respecter of performance.”² The original Masters of the Universe were HeMan and his Friends in the 1980s popular children’s cartoon. Tom Wolfe used the term to satirize his bond trader protagonist in Bonfire of the Vanities. In 2009, Lloyd Blankfein, CEO of Goldman Sachs, unconsciously borrowed from Wolfe to justify bumper profits: “performance is the ultimate narrative.”³ By the new millennium, Wolfe admitted that hedge fund managers had superseded bankers as the new Masters of the Universe.

Keeping Up with the Joneses

Hedge funds came to prominence when Soros broke the Bank of England and the pound sterling on Black Wednesday, September 16, 1992. Founded in 1970, Soros’ Quantum Fund sold short the pound sterling to profit from a fall in the UK’s currency. After vain attempts to defend the currency, the UK devalued the pound, handing Soros a $1.1 billion gain. George Soros later stated:

Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont [the UK chancellor] said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell.⁴

Black Wednesday cost the UK taxpayer an estimated £3.4 billion.

The idea of a hedge fund is attributed to Alfred Winslow Jones, an academic, diplomat, steamboat purser, and journalist. Jones sought profits while minimizing risk of losses from unpredictable market movements. In the 1950s he began buying undervalued stocks and selling overvalued stocks—an equity long-short strategy. The shorts hedged the longs, reducing exposure to general market movements, hence the moniker—hedge fund. Jones outperformed other mutual funds handsomely over a long period.

As the short positions were around 50 percent of the value of the longs, risk was reduced but not eliminated entirely. Jones bet that the market would go up. Jones also used leverage. If he was long $1.5 million and short $1 million, then the total exposure to stock price movements was around $2.5 million on $0.5 million of net risk. Jones received 20 percent of performance. He invested his own money in the fund. Later, anticipating future developments, Jones acted as an incubator for two employees who left to set up their own funds, and transformed his fund into a fund-of-funds, investing in other hedge funds with different expertise and investment styles.

In the late 1960s, Carol Loomis, a Fortune journalist, published an influential article about Jones’ fund. Others copied Jones’ hitherto secret investment strategies. By 2008, there were more than 8,000 hedge funds with more than $1,500 billion in assets under management (AUM) around the world.

In Search of Moby Dick

Today, 30–40 percent of hedge fund money comes from the usual suspects—the simply wealthy, Mafia barons, drug lords, arms merchants, and despotic dictators of tin-pot countries. The rest comes from pension funds, insurance companies, mutual funds, foundations, endowment funds, and banks.

Investors were initially attracted by stellar returns. Investments were segmented into beta (market returns) and alpha (outperformance). Alpha was Captain Ahab’s Moby Dick, the “white whale of the investment community—coveted, precious, sought with a maniacal fury.”⁵ A core portfolio targeted beta using index-tracking funds, like exchange-traded funds with low costs, to closely match market moves. A satellite portfolio, consisting of actively managed funds or alternative investments, chased alpha. Investors lashed themselves to hedge funds, seeking outperformance.

Few traditional investment managers outperform the market, after trading costs and fees, over long periods. If you outperform, then people give you more money to invest, which reduces flexibility—the winner’s curse. Large funds also create diseconomies of scale: every time a large investor tries to trade, the market moves against them. Investment managers tried to beat benchmarks, usually a diversified index like a stock market index. If the portfolio was down 50 percent but the benchmark fell 53 percent, then the fund manager outperformed by +3 percent. In contrast, hedge funds focused on absolute returns, trying to make money under all market conditions.

In the early 1990s and again in the early 2000s, equity markets were moribund and interest rates were at record lows. Forced to look elsewhere, investors increased investment in hedge funds.

Suspicious of new products, traditional institutions reluctantly entered new markets to boost declining returns. Not allowed to buy structured securities, short sell, leverage or use derivatives, conservative funds gave money to hedge funds that could. The new mantra was “hedge funds for everybody.”

Style Gurus

Hedge fund managers argued that only they knew what they do, reminiscent of a prospectus from the 1920s: “the credit and status of the company are so well known that it is scarcely necessary to make any public statement.”⁶ At a 2009 Congressional Inquiry, Citadel’s Ken Griffin argued against disclosure by comparing it to “asking Coca-Cola to disclose their secret formula to the world.”⁷

One manager explained his investment strategy as throwing light on “fragmented information” and “opaque” track records. George Soros was honest:

I don’t have a particular style of investing or, more exactly, I try to change my style to fit the conditions...I assume that markets are always wrong.... Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded.⁸

Hedge funds pursue high absolute returns, whilst trying to reduce risk, by combining long and short positions that move in opposite directions as markets move. Leverage is used to increase earnings.

Equity long-short funds follow Jones’s model. Some funds match exactly, while others take views on the likely trend, known as the portion outside the hedge. Stock selection uses fundamental analysis or quantitative models to identify over and undervalued stocks.

Market neutral or relative value funds arbitrage market inefficiencies. There’s fixed income arbitrage, convertible bond arbitrage, derivative arbitrage, MBS arbitrage, capital structure arbitrage, and arbitrage arbitrage. All use quantitative analysis to identify small, low-risk pricing discrepancies, amplified by leverage to generate high returns.

Event-driven funds take advantage of mergers and takeovers (risk arb) or bankruptcy (vulture funds or distressed debt trading). Event-driven trading uses knowledge of regulations, legal documentation, and (sometimes critics suspect) inside information to make profits. Investment periods can be long and, as the name implies, there is “event risk” (a merger not proceeding).

Quantitative funds use computer-driven trading strategies. Trend-following models identify the market’s mo (momentum) and ride the bucking bronco bareback. Sophisticated models identify undervalued and overvalued securities. Algorithmic trading, known as algo, black-box, or robo trading, uses computer programs to decide timing, price or quantity of trading orders. It divides large trades into smaller trades or vice versa to manage market impact and risk. It generates small but frequent returns by providing liquidity to other buyers and sellers.

Macro funds make large, speculative, leveraged bets on currencies, stocks, interest rates, and commodities. Strategies are based on fundamental analysis, computer-generated trading signals, market price action, and a certain vibration in the intestinal tract. According to Dion Friedland, chairman of Magnum Funds, macro hedge funds are: “mammoth and quick, keen and powerful, sudden and aggressive; they go for the kill, they want it all, not content with only a mere morsel of their prey.”⁹

As opportunities within their expertise dry up, single strategy hedge funds undertake other strategies—known as style drift. Over time, hedge funds became multistrategy. In his 1940 book Where Are The Customer’s Yachts? Fred Schwed, Jr. anticipated hedge fund investing: “At the close of day’s business they take all the money and throw it up into the air. Everything that sticks to the ceiling belongs to the clients.”¹⁰

In 2010, Paul the Octopus established a prefect record, predicting winners in the Football World Cup. Bloomberg reported that Paul raised $2 billion in seed funding for a new hedge fund. The backer was reported as saying that:

He is an octopus but his track record is great. It may be just pure luck to you, but we call that alpha in our business and it is no more stupid an idea than correlation trading or structured credit arbitrage. Besides, as a spineless bottom feeder we think he will be a natural with investors.¹¹

Magic Wand

While some do show high returns, hedge fund returns on average appear only slightly higher than that available on the broader stock markets.¹²

Percentage returns can be misleading. In its first 18 years, Julian Roberston’s Tiger Fund generated returns of 30 percent per annum. In its last two years, the fund made losses of 50 percent. Taking the losses into account, Tiger returned 25 percent per annum over its life. Starting life in 1980 with $10 million, it had $22 billion under management by 1998. The fund’s highest percentage returns were on a small dollar base. The losses came from a larger base (a 50 percent loss on $22 billion is a loss of $11 billion). Tiger may have lost more dollars than it made over its life.¹³

Historical returns exclude funds that fail or no longer accept new investment—survivorship bias. Only funds with a successful track record report performance—backfill bias. The difference between the best and worst performing funds is large. For investors seeking alpha, high average returns are meaningless, like a comfortable average ambient temperature where your feet are in the oven and your head is in the refrigerator.

A confluence of events boosted hedge fund returns. Macro funds benefited from the growth of emerging economies, the end of communism in Eastern Europe, world trade and deregulation of financial markets. Soros’ currency profits came from the collapse of a flawed system for European currencies. In 1997/8, hedge funds made substantial returns when pegged Asian currencies collapsed. In recent years, many macro funds, like the fabled Quantum and Tiger Funds, restructured or disappeared.

Some hedge fund managers are exceptionally skilful. Soros, Tudor Jones, and James Simons, an ex-mathematics professor and former code breaker, have outstanding records. For others, investment Viagra boosted performance.

Some, like the Bear Stearns hedge funds, used leverage to increase returns. In 2009, in a Freudian slip, George Soros referred to Long Term Capital Management (LTCM) as “leveraged capital.”¹⁴ Others increased returns by investing in illiquid or complex securities.

Some managers seek an information edge. The credo of SAC, a hedge fund operated by billionaire art collector Steve Cohen, is: “Get information before anyone else.”¹⁵ Hedge funds test the boundary of insider trading and market abuse.

In 2010, U.S. Federal Investigators began investigating a spider-web of insider trading, involving billionaire investor Raj Rajaratnam, founder of the Galleon hedge fund. For hedge funds, insider-trading profits offered large returns as they receive a share of trading profits, and artificially enhanced returns attract more investments generating higher management fees. The alleged inside information came from lawyers at Ropes & Gray, a prestigious corporate law firm, a senior executive at IBM, a partner at Ernst & Young and a director at the big management consulting firm McKinsey. Although not identified by name, two traders at SAC were also accused of involvement.

The biggest name caught up in the investigation was Rajat Gupta who it was alleged had passed on information to Rajarantnam. Gupta had been McKinsey’s global managing director for almost a decade until 2003 and remained on its partnership board until 2007. Gupta faced civil insider trading charges for allegedly sharing secret information acquired as a board member of Goldman Sachs and Procter & Gamble. Robert Khuzami, director of enforcement at the Securities and Exchange Commission, described Rajaratnam as “a master of the Rolodex” rather than “a master of the universe.”

The investigation focused on expert network firms, which provided “independent investment research.” Redefining the concept of expertise, these firms seemed to specialize in matching insiders with traders hungry for privileged information, routinely allowing access to non-public sensitive inside information on sales forecasts and earnings. The investigations recalled the investigations and convictions of Ivan Boesky and Michael Milken for corruption on Wall Street in the late 1980s. Regulators suggested that the practice was so widespread as to verge on a “corrupt business model.”¹⁶

Some fund managers dispense with pretence and fabricate returns. In 2008, Bernard Madoff confessed to an investment fraud totaling more than $60 billion, involving nearly 5,000 clients. Madoff’s hedge funds, operating from three floors of the Lipstick Building, generated solid returns, trading stocks, and options. In reality, since the mid-1990s, Madoff had operated a Ponzi scheme.

Lucky Man

Jones charged 20 percent of performance, but no management fee, and paid expenses from his performance fee. Traditional hedge funds charged 1 percent management fee and a performance fee of 20 percent of returns above a benchmark, the watermark. There was also a high watermark. If it makes losses, then the fund must recoup these before performance fees resume.

Funds now routinely charge 2 percent and 20 percent with no watermark. Hot hedge funds charge even more: 5 percent of assets and 35 percent of profits, 4 percent of assets and 44 percent of profits. One manager candidly admitted: “A hedge fund is just an excuse to charge two and twenty; they do not do anything else very different.” A cartoon shows a road sign for Connecticut, home to a large number of hedge funds: “Entering Greenwich, speed limit 2 percent and 20 percent.”¹⁷

Performance fees and the manager’s investment in the fund supposedly align the interests of investor and the manager. In fact, the fee structure favors the manager. Assume a $100 million fund where the manager’s fees are 1 percent and 20 percent of performance. The manager has a $5 million (5 percent) interest in the fund. If the hedge fund loses $20 million (20 percent), then the manager loses $1 million (20 percent of $5 million) offset by the management fee received (1 percent of $100 million equaling $1 million). If the hedge fund makes $20 million (20 percent), then the manager earns $4 million (20 percent of $20 million) plus the management fee ($1 million)—a 100 percent return. The Economist described it as “catch two-and-twenty.”

Many investors use FoFs (fund-of-funds) to screen and select portfolios of hedge funds. Where investing in hedge funds, diversification makes no sense, earning average or worse returns. The investor pays a fee to the FoF manager (1 percent of AUM and 10 percent of performance) as well as the hedge fund manager’s fee (2 percent and 20 percent). FoF might stand for “fee-of-fees.”

Skewed payoffs for the manager encourage aggressive risk taking.¹⁸ The economist Thorstein Veblen identified this: “It is always sound business to take any obtainable net gain, at any cost and at any risk to the rest of the community.”

In 2007, three hedge fund managers took home more than $1 billion. At the congressional inquiry into the industry, Maryland Democratic representative Elijah Cummings reported that his neighbor asked him: “How does it feel to be going before five folks that have gotten more money than God?”¹⁹

It is unclear whether well-performed managers are lucky or skilful. Bill Miller’s Legg Mason Value Trust Fund, one of the world’s biggest funds, beat the S&P 500 Index for 15 consecutive years from 1991 to 2005. Paeans to his legend, investing style, and success were duly penned. Miller’s performance faltered during the financial crisis. Echoing the author Nassim Taleb, Michael Mauboussin, one of Miller’s colleagues observed: “We have difficulty in sorting skill and luck in...business and investing.”²⁰

Investors look for the idiot savants of money management. Unfortunately, they frequently trusted idiots without the savant. In selecting fund managers, investors should have followed Napoleon’s approach to selecting generals: “Are you lucky?”

Sharpe Practice

Investors use Sharpe or information ratios to measure investment performance. Assume risk-free government securities yield 5 percent and hedge fund A has returns of 20 percent with a volatility of 10 percent while hedge fund B has returns of 15 percent and a volatility of 5 percent. The Sharpe ratios are respectively:

Hedge Fund A = [20%—5%] / 10% = 1.5

Hedge Fund B = [15%—5%] / 5% = 2.0

Despite lower absolute performance, B provides investors with greater returns relative to risk.

Sharpe ratios are ex post (based on actual risk) rather than ex ante (expected risk). Actual returns should be compared to expected risk at the time the position was taken. Insufficient attention is paid to the asymmetry of hedge fund returns, which do not follow the familiar bell-shaped normal distribution. Risk models grossly underestimate tail risk, exposure to large price moves. Traders arb internal risk metrics to inflate risk-adjusted returns to increase bonuses. Real hedge fund risks—correlation, liquidity, complexity, and model risk—are not measured properly.

If the portfolio of long and short positions is perfectly balanced and prices move identically, then the gains and losses should cancel out, reducing risk but earning zero return. To make money, the correlation, the relationship between the long and short securities, must change. Correlation may move unfavorably—the asset you are long falls in value; the asset you are short rises in value, triggering losses. Models based on historical price movements do not properly capture this correlation risk.

Risk models assume that investors can buy, sell, hedge, or borrow whatever is required. This liquidity risk is compounded by leverage. Hedge funds trade on margin, putting up a small fraction of the value of the asset as collateral. If prices fall, then the hedge fund must post more collateral. If losses exceed the hedge fund’s ability to meet margin calls, then the position must be liquidated, realizing losses.

To value and hedge positions, funds use quantitative models that are sensitive to minor changes in parameters and inputs. While prices scroll across computer screens every second of every day, few instruments actually trade with sufficient liquidity to allow positions to be valued against actual prices. Hedge funds do not measure the possibility of model failures when quantifying risk. They follow actress Tallulah Bankhead’s advice: “If I had to live my life again, I’d make the same mistakes, only sooner.”

Hedge funds buy or sell mispriced securities, reducing risk through an offsetting trade. If market prices converge, then the trader unwinds their trades at a profit. If the market prices do not correct, then the trader may have to hold the position to maturity, up to 30 years. Given risk horizons of 6–12 months, changes in market values, margin calls, and investor redemptions make it difficult to manage this risk.

Adjusted properly for leverage, liquidity risk, model errors, and complexity, most hedge funds return, at best, the same as or frequently less than traditional investments. Sharpe practice not only underestimates risk but also overstates returns.

Embedded

Hedge funds are courtesans, high-class prostitutes whose clients come from the wealthy. Banks are the pimps and bordello keepers. As Forbes magazine noted: “It’s easy to guess who is likely to make most money in the long term.”²¹

Banks have prime brokerage units that settle and clear hedge fund trades as well as financing hedge funds. Banks make capital introductions, raising capital for hedge funds (for a fee of 2–4 percent). They set up incubators to help budding traders create hedge funds, including training in etiquette at formal lunches and investor communications. Banks invest in and trade with hedge funds. They trade derivatives on hedge funds.

Lending money to hedge funds provides the major part of the profits. Lending is through repos (repurchase agreements), where the bank lends money against the value of securities. Alternatively, derivatives are used. The hedge fund lodges cash or securities equal to a small percentage of the face value as surety.

To reduce risk, banks use a haircut or over collateralization. Banks estimate the worst-case daily change in the value of positions to cover the risk. Event risk, where the value of the position changes a lot quickly, is difficult to measure. Competition reduces the haircuts. LTCM was special, not requiring any haircut. As one observer asked: “Would hedge funds even exist without a fatty dollop of moral hazard somewhere along the great protein chain of lending?”²²

At their peak, hedge funds accounted for 30–40 percent of total investment bank earnings. Citadel paid $5.5 billion in trading costs to investment banks,²³ the largest portion being interest on borrowings. Citadel’s total and net assets were $166 billion and $13 billion respectively. Trading costs totaled one-third of net assets.

Bank dealings with hedge funds frequently entail conflicts of interest. Senior bank executives, who were personal investors in LTCM, negotiated its bailout. It was all part of the “special” relationship.²⁴

Banks copied from the best and brightest, creating internal hedge funds to replicate successful trading strategies borrowed from smart hedge funds. Once their own risk limits were full, they marketed the strategies to other banks and hedge funds. Even if the hedge fund failed, banks made money buying the positions at distressed prices. Banks provided a true cradle-to-grave service for hedge funds.

In the Long Run, We Are All Dead

LTCM was known as Salomon North, reflecting its Greenwich, Connecticut base. After leaving Salomon Brothers in 1991 following a trading scandal, John Meriwether established LTCM in 1994 with capital of $4 billion. Investors paid a 2 percent management fee and 25 percent incentive fee on earnings after a threshold level of return.

The operation sought to replicate Salomon Brothers’ successful fixed income arbitrage unit. Joining Meriwether were key Salomon traders Eric Rosenfield, Lawrence Hilibrand, Victor Haghani, and Greg Hawkins. Nobel Prize winners Robert Merton and Myron Scholes, as well as former Fed vice-chairman David Mullins, also joined. The principals invested, in some cases their entire wealth, in LTCM. They bristled with indignation at suggestions that LTCM was a hedge fund.

LTCM’s strategies were vague, emphasizing research, sophisticated analysis, proprietary modeling, relative value, and convergence trading. It identified small pricing discrepancies between securities, taking advantage of opportunities when prices deviated from long-run equilibrium values, due to short-term market disturbances. LTCM purchased cheap, underpriced securities, hedging with short sales of expensive securities with similar characteristics. Profits were made when pricing differences corrected. The fund did not take directional risks and outright positions, reducing risk and allowing the use of leverage, up to 25 times, to accentuate returns.

When an investor questioned how the fund would earn high returns with low risk, the abrasive Scholes snapped: “because of fools like you.”²⁵ Scholes told his old mentor at the University of Chicago, Merton Miller: “think of us [LTCM] as a gigantic vacuum cleaner sucking up nickels from all over the world.”²⁶ LTCM was trying to pick up nickels in front of a bullet train.

In 1995 and 1996, the fund generated returns of more than 40 percent per annum, using trading strategies perfected during the Salomon years. In 1997, U.S. stocks returned 33 percent, LTCM’s returns fell to 17 percent. To improve performance, LTCM increased leverage, returning $2.7 billion of its accumulated capital of $7 billion to investors. LTCM broadened into credit spread trading, volatility trading, and equity risk arbitrage.

In 1998, LTCM lost 92 percent of its capital. The Asian monetary crisis created uncertainty, a general aversion to risk and a flight to quality. Sensing an opportunity, LTCM placed bets on credit spreads (the margin between corporate bonds and government bonds) and stock volatility. The market dubbed LTCM the “Central Bank of Liquidity and Volatility,” a risk re-insurer.

In May/June 1998, LTCM took a big loss in mortgage-backed securities. In August 1998, when Russia defaulted on its debt, LTCM took more losses. On August 21, LTCM lost $550 million, mainly on its credit spread and equity volatility positions. LTCM needed cash to cover losses. The unflappable Meriwether advised that: “we’ve had a serious markdown but everything’s fine with us.”²⁷ LTCM discovered what John Maynard Keynes knew: “the market can remain irrational longer than you can remain solvent.”²⁸

On September 2, 1998 John Meriwether advised investors that LTCM had lost 52 percent of its value:

As you are all too aware events surrounding the collapse of Russia caused large losses and dramatically increased volatility in global markets.... Many of the fund’s investment strategies involve providing liquidity to the market. Hence, our losses across strategies were correlated after-the-fact from the sharp increase in the liquidity premium: the use of leverage has accentuated the losses.

LTCM sought new investment from investors: “Since it is prudent to raise capital the fund is offering you the opportunity to invest on special terms related to LTCM’s fees.”²⁹ There were no takers.

On September 18, 1998 Bear Stearns was rumored to have frozen the fund’s cash account, following a large margin call. On September 23, 1998 AIG, Goldman Sachs, and Warren Buffet made an unsuccessful offer to buy out LTCM’s partners and inject $4 billion into the fund. Facing the specter of a massive default affecting the entire financial system, the New York Federal Reserve brokered a recapitalization of LTCM. Fourteen banks invested $3.6 billion in return for 90 percent of LTCM. Keynes was correct: “There is nothing so disastrous as a rational investment policy in an irrational world.”³⁰

The Game

At the beginning of 1998, LTCM’s risk models showed that there was a 1 percent chance of losses exceeding $45 million. After May/June 1998, LTCM reduced risk limits to $35 million. Yet in August 1998, LTCM’s daily profits and losses were up to $135 million. By September 1998, LTCM’s profit and loss was moving $100 million to $200 million daily, three to six times the limit.

Risk models underestimated volatility and used incorrect correlation. The principals were blind to the dangers of a firm reliant on borrowed money holding large positions. LTCM held 10 percent of the entire global dollar interest rate swap market. To reduce positions rapidly, LTCM sold liquid positions first, leaving only illiquid positions. Closing out large or illiquid positions increased losses.

While trading at Salomon Brothers, the purpose of specific trades—client or proprietary—was not apparent to the market. At LTCM, all trades were proprietary. Dealers had worked out LTCM’s trading strategies, replicating them using their bank’s money, or selling the ideas to other hedge funds and banks. Everybody tried to exit the crowded trade at the same time.

Rumors of LTCM’s problems triggered more selling, anticipating LTCM’s need to sell its massive portfolio. Traders tried to force LTCM into default and purchase its portfolio at distressed prices. LTCM’s Victor Haghani commented later: “It was as if there was someone out there with our exact portfolio only it was three times as large as ours and they were liquidating all at once.”³¹

As losses mounted, LTCM had to meet margin calls on its positions. Louis Bacon, the principal of Moore Capital, once remarked that: “There are those who know that they are in the game; there are those who don’t know they are in the game; and there are those who don’t know they are in the game and have become the game.”³² By late 1998, LTCM were the game. In the end, LTCM simply ran out of cash.

The More Things Change

Amaranth was a $9.2 billion multistrategy hedge fund named after the Greek amarantos—“one that does not wither” or “the never-fading flower.” In August/September 2006, Amaranth lost $6 billion, almost twice the loss when LTCM collapsed.³³

Starting life as a low-risk convertible arbitrage fund, Amaranth was a recent entrant into volatile energy trading. In 2005, Brian Hunter, a 32-year old Canadian in charge of Amaranth’s energy trading, used derivatives to bet successfully that natural gas prices would rise following Hurricane Katrina. Hunter placed a similar but larger bet in 2006. Another trader sent Hunter the following message: “Brian, what the hell is going on out there, rumor is you are getting even more rich!!! According to the market you are brilliant!!!!!! Can do no wrong ever!”³⁴

Amaranth bought natural gas for delivery in March 2007, while selling it for delivery in April 2007. Historically, natural gas prices increase during winter, and fall after March as demand for heating decreases. In early September 2006, natural gas prices fell as supply exceeded demand. Hunter bet that a hurricane or a cold winter would push natural gas prices upward. An uneventful hurricane season meant that the difference in natural gas prices for delivery in March and April 2007 (the spread) fell. Amaranth’s position, which profited from widening spreads, showed losses as the March/April spread narrowed from 2.05 points on September 1 to 0.75 points on September 18.

Like LTCM, Amaranth believed that it was involved in low risk trading. But it was exposed to correlation, changes in the relationship between the two components. Correlation changes rapidly, like a piece of elastic snapping. On September 22, 2006 Nick Maounis, chief executive of the fund, announced: “A series of unusual and unpredictable market events caused the funds’ natural gas positions, including spreads, to incur dramatic losses.”³⁵ Maounis noted: “Although the size of our natural gas exposure was large, we believed, based on input from both our trading desk and the stress testing performed by our energy risk team, that the risk capital ascribed to the natural gas portfolio was sufficient.”³⁶

Amaranth had a large, concentrated position in natural gas, representing 10 percent of the global market in natural gas futures. Bruno Stanziale, a former colleague, commended Hunter’s contribution in helping the market and gas producers to finance new exploration: “He’s opened a market up and provided a new level of liquidity to all players.”³⁷ Stanziale had confused Hunter with Mother Teresa.

When losses occurred, Nick Maounis reprised the aria made famous by the principals of LTCM in 1998: “The markets provided no economically viable means of exiting those positions. Despite all our efforts, we were unable to close out the exposures in the public markets.”³⁸

As news got around of Amaranth’s problems, traders took advantage:

When people get a sense that someone is on the ropes, they’re going to exacerbate the problems that he has. Those with risk capital are going to short whatever he has, believing the guy will have to capitulate and that they will be there to take his capitulation selling.³⁹

In the end, Amaranth was forced to transfer its energy positions to JP Morgan and Citadel at a $1.4 billion discount to their mark-to-market value. Amaranth provided the following analysis: “We did not expect that the market would move so aggressively against our positions.”⁴⁰

Sophisticated fund-of-funds and investors such as Goldman Sachs, Morgan Stanley, Credit Suisse, Bank of New York, Deutsche Bank and Man Group, failed to pick up any problems at Amaranth. In a speculative environment, critical ability greatly diminishes. Most people fail to look beyond the profits. In better times, Amaranth had given out gift chess sets inscribed with the words of grandmaster Alexander Kotov: “It often happens that a player carries out a deep and complicated calculation, but fails to spot something elementary right at the first move.”⁴¹

Hedgestock

In 2006, hedge funds staged Hedgestock, 2 days of “networking and finance.” The title paid homage to Woodstock, the historic three days of peace, love, promiscuity, rock ‘n’ roll, drugs, and shockingly bad dancing on Max Yasgur’s farm in Bethel, New York in 1969. Adam Smith understood “networking”: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in conspiracy against the public, or in some contrivance to raise prices.”⁴²

Hippies celebrated the counterculture movement at Woodstock. Hedge fund managers advertised their movement—alternative investments. It was “the age of money” not “the age of Aquarius.” Hedgestock’s “free market” message was far removed from Woodstock’s message of “free love.”