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Alternative Investments - February 16, 2007

Interview with Hilary Till

In this month's interview we speak to Hilary Till, Principal of Premia Capital Management, LLC, and a Research Associate with the EDHEC Risk and Asset Management Research Centre, about her research projects, the lessons to be drawn from the Amaranth case nearly six months later and current investor interest in commodities.

Hilary Till

You joined the EDHEC Risk and Asset Management Research Centre as a research associate last year. Could you tell us why you accepted the offer to join EDHEC's research team?

Hilary Till: Joining EDHEC’s research team was part of a natural progression in my career.

After obtaining a Master’s degree in Statistics from the London School of Economics, I worked as a quant for futures-and-options traders in Chicago in the late 1980s. During that time, I wondered what the key was for consistent success in leveraged derivatives trading. At the time, hedge funds were not yet on anyone’s radar screen.

When my husband and I moved to Boston in the early 1990s, I worked at Harvard University’s endowment, again as a quant. At that time, the endowment’s management company was involved in just about every arbitrage and relative-value strategy that existed across asset classes.

It was from this experience that I began to realize that each of Harvard Management Company’s strategies had a fundamental, identifiable structural “edge” (or advantage) that arose from performing some economic function such as in effect providing liquidity or selling insurance.

Therefore, articles on hedge funds from the mid-1990s onward that categorized hedge-fund strategies as absolute-return vehicles, which do well regardless of market environment, did not seem to provide the right interpretation of these strategies.

In contrast, researchers from Duke University, the London Business School, Georgia State University, the University of Massachusetts-Amherst, and the EDHEC Risk and Asset Management Research Centre did seem to provide the right conceptual framework for understanding hedge funds.

Authors from these institutions came up with empirically successful models for explaining hedge-fund returns in terms of a relatively small number of risk factors and rule-based strategies. In EDHEC’s case, hedge-fund returns were distilled into a set of principal components. These factors are now known as “alternative betas” or “exotic betas” (rather than structural “edges,” as a futures trader from Chicago might call them.)

This interpretation of hedge funds was quite revolutionary several years ago, but is now broadly accepted.

Because I am a founding principal of a Chicago derivatives trading firm, I have been able to write articles on academic research that I find insightful, and which others might also find insightful, without the restrictions that sometimes occur when one is employed at large financial institutions.

In 2003, I summarized the leading hedge-fund research for a peer-reviewed journal under a grant from the Foundation for Managed Derivatives Research. It was natural to include research from Noël Amenc, Lionel Martellini and François-Serge Lhabitant in this review article, which was published the following year in the Journal of Alternative Investments.

Later I participated as a panelist in both the 2004 and 2006 EDHEC Hedge Fund Days conferences in London and was impressed by the quality and breadth of these conferences. I also had the opportunity to meet with members of the EDHEC-Risk team at both conferences, so I was happy to accept the offer of joining the team as a research associate last summer.

Your position paper on the major losses at the hedge fund Amaranth last September, EDHEC Comments on the Amaranth Case: Early Lessons from the Debacle, was widely covered in the international press. Four months later, what are the main conclusions that can be drawn? Is it simply that the alternative investment industry now has the wherewithal to absorb major hedge fund failures, or are there other key lessons to be learned?

Hilary Till: Before going into the report’s conclusions, I would like to give some background on this paper.

Given my experience in the U.S. commodity futures markets, Professor Frédéric Ducoulombier recommended that I write a report for EDHEC on the early lessons from the Amaranth case. Professor Ducoulombier then worked with me in broadening the content of the article so that the report would provide useful insights to investment professionals who are not necessarily commodity experts. We finalized this paper during the week that followed the public reports of the debacle.

Underlying the paper is a returns-based analysis for determining what Amaranth’s key risk positions were and what the magnitude of these positions were. The report focuses on the multi-strategy fund’s natural gas positions since it was these strategies that were apparently the main source of the fund’s mid-September losses.

I have a structural belief that most hedge fund strategies can usually be explained by a limited number of (possibly obscure) strategies or risk factors. This is usually not obvious to market participants since a fund’s strategies are typically opaque, and an analyst typically does not have the luxury of receiving timely performance data in order to perform a returns-based analysis, which could, in turn, infer exposures.

Also, even if one has access to timely performance data, it is not obvious which exposures best explain performance data unless one’s dataset contains some instances of dramatic market moves. Put more simply, if one’s performance data consists of slight changes, and the candidate exposures only have slight changes, then it will be quite difficult for most regression or optimization procedures to resolve what caused the fund’s slight performance changes. As my colleague at Premia Capital, Joseph Eagleeye, has stated, it is mainly when there are inflection points in a fund's P&L that the fund's exposures reveal themselves.

As the Amaranth debacle was unfolding, there were news reports early on that noted the types of natural-gas-spread strategies that the multi-strategy fund had engaged in and also pinpointed the timing of the fund’s losses with their magnitudes. So much information was publicly provided early on that one was provided with two equations in two unknowns in order to solve for Amaranth’s position sizes in the natural gas market.

(One actually had a third equation of previous profits that enabled one to double-check whether the inferred position sizes still approximately matched up with the publicly disclosed information. Indeed, this was case.)

One caveat in the EDHEC report is that the strongest point we can make about our analysis is that our inferred positions were highly correlated to Amaranth’s natural gas positions while not claiming that the report had determined the fund’s exact positions.

Once one had an idea of the magnitude of Amaranth’s key risk positions, one could proceed to state a number of early lessons about the case, which are included in the EDHEC report of October 2nd 2006. This report in turn was cited by the European Central Bank’s Financial Stability Review in December.

The EDHEC report discusses a number of early lessons regarding the debacle, including:

  1. Investors would not have needed position-level transparency to realize that Amaranth’s energy trading was quite risky. A monthly sector-level analysis of their profits and losses (p/l) would have revealed that a –24% monthly loss would not have been unusual;

  2. If investors did have position-level transparency, they would have likely noted that the fund’s over-the-counter natural gas positions were massive compared to the prevailing open interest in the exchange-traded futures market, which would have given an indication of how illiquid their energy strategies were;

  3. Risk metrics using recent historical data would have vastly underestimated the magnitude of moves during an extreme liquidation-pressure event;

  4. If the fund’s risk managers had employed scenario analyses that evaluated the range of natural-gas-spread relationships that had occurred in the not-too-distant past, they would have seen how massively risky the fund’s structural position-taking was in its magnitude;

  5. It is essential for commodity traders to understand how their positions fit into the wider scheme of behaviors in the physical commodity markets: before initiating any large-scale trades in the commodity markets, traders need to understand what flow or catalyst will allow them out of a position; and

  6. Amaranth was likely indeed providing an economic service for physical natural gas participants; this hedge fund provided liquidity for physical-market participants who could then lock in the value of forward production or the future value of storage. But even so, like Long Term Capital Management, the scale of Amaranth’s spreading activities was much too large for its capital base.

Can we say four months later that these lessons are still valid?

In the main, the answer is yes.

Regarding the first lesson, one should caveat that investors were constrained in exiting the fund by the notice and liquidity provisions of their investment contracts.

According to news reports from the middle of October 2006, the prominent fund-of-funds, Fauchier Partners, had redeemed from Amaranth in December 2005, but that was because of red flags raised during their qualitative due diligence process, rather than because of a jump in volatility in the fund’s p/l.

Regarding the third lesson, Amaranth’s losses in mid-September were indeed likely massive compared to the fund’s recent daily volatility. That said, one should not conclude that large standard-deviation moves such as occurred with Amaranth are as unlikely as say a catastrophic meteor strike. Instead, the fund’s very large moves in portfolio performance illustrate the impact of an extreme liquidation scenario once a highly leveraged fund becomes distressed.

Such scenarios have been formally modeled in the past for highly-leveraged funds. Once a fund crosses a threshold of losses, a cycle of investor redemptions occur (and/or the fund’s prime brokers demand the reduction of leverage), and the fund’s Net Asset Value thereby declines precipitously as the fund sells off holdings in a distressed fashion. Thus, a “critical liquidation cycle” begins, which in turn has been modeled as being short a barrier put option. This was done specifically by Clifford de Souza and Mikhail Smirnov in 2004. This framework appears to be quite appropriate for the Amaranth case.

Are there any new conclusions that we can draw about this case?

Yes, one can see signs of an emerging maturity in the hedge-fund industry although we have to be careful about how far-reaching our conclusions are.

In Amaranth’s case, the natural gas curve stabilized one day after the fund’s positions were transferred to JP Morgan and Citadel Investments during the third week of September. These two financial institutions took on Amaranth’s distressed positions at a substantial discount to the positions’ mark-to-market value.

That JP Morgan and Citadel took on Amaranth's energy book en masse could be a preview of how the markets will handle future hedge-fund liquidations.

In the middle of October, Hedge Fund Alert reported that an investment bank was packaging up the assets of various hedge-funds-in-distress to sell on to investors. This is a much preferable route compared to an individually distressed hedge fund trying to quickly sell its assets on the open market. Such a mechanism means that investors in hedge-funds-in-distress could receive much more of their money back, and with less of an adverse impact on whatever the asset class or investment is that the hedge fund is specializing in.

If the capital markets can develop smooth mechanisms for transferring whole portfolios of hedge-funds-in-distress, then one may not see the continuation of large-scale distressed liquidations as with Amaranth (and Long Term Capital Management.)

In the long-only world, the transferring of portfolios from one active manager to another by pension funds and other institutional investors is already very well developed to minimize price-pressure effects. The development of similar mechanisms is and will be a very positive development for the hedge fund industry.

Now, even with this preliminary conclusion, one should still be cautious about concluding that the alternative investment industry has the wherewithal to absorb major hedge fund failures.

In the Long Term Capital Management crisis, the hedge-fund-in-distress had positions that were highly correlated or identical to the core positions held by leveraged, money-center banks.

In the Amaranth crisis, the fund’s key risk positions were deferred calendar spreads in the U.S. natural gas derivatives markets; these are not positions that are central to the risk-taking activities of the main international banks. Therefore, the impact of Amaranth’s losses was largely confined to its investors.

Also, it is likely that physical natural-gas market participants were the ultimate risk takers on the other side of Amaranth’s trades, and so benefited from the temporary dislocations that ensued from the fund’s distress. In other words, it does not appear that the commercial natural-gas industry was damaged by this financial crisis; in fact, commercial-market participants likely benefited.

A true test of the alternative investment industry’s robustness would have to be one where a large hedge fund not only became distressed, but also held substantial positions that were highly correlated to those held by the major international banks.

You recently conducted the sold-out Advanced Commodities Investing seminar in London. To what do you attribute this surge of interest in commodities investing?

Hilary Till: Yes, in late January, I conducted an advanced seminar on commodity investing at the Dorchester in London with Professor Lhabitant on behalf of EDHEC’s Asset Management Education effort.

I think the interest in our seminar can be attributed to three factors:

  1. The five-year annualized returns for commodities, as represented by the Dow Jones AIG Commodity Total Return Index, have been about 16% per year;

  2. As Professor Lhabitant has stated, investing in commodities represents a call option on Asian growth; and

  3. The debate on how best to obtain exposure is definitely not resolved, leading to a need (and demand) for investor education.

The seminar covered these issues, and these issues are also covered in the forthcoming (2007) Risk Book, Intelligent Commodity Investing, which I co-edited with my colleague, Joseph Eagleeye.

What is your current research focus, and what are the main research projects that you are lining up for 2007?

Hilary Till: I am currently focusing on the term-structure properties of commodity futures markets.

As part of this focus, I recently co-authored an article with Barry Feldman of the Russell Investment Group and Prism Analytics on “Backwardation and Commodity Futures Performance: Evidence from Evolving Agricultural Markets.” This article was published in the winter 2006 Journal of Alternative Investments. In this research, we examined the utility of term-structure as a timing indicator for commodity investing, based on examining agricultural futures data from 1950 through 2004. We found that term structure only became a meaningful indicator at five-year time horizons.

In 2007, I plan on extending this research to the energy markets by examining optimal structures for investing in the petroleum derivatives markets, which (a) minimize the negative carry currently associated with such investments, and (b) preserve the event-risk-hedging properties of such an investment.

I also have a long-standing interest in the alternative-beta topic, having first published articles related to this theme in 2001, so I would expect to continue to contribute to an understanding of this area in future work.

About Hilary Till

Hilary Till is a co-founder of Premia Capital Management, LLC in Chicago and an internationally acknowledged expert in the field of commodities trading and natural resources futures markets. Formerly equity derivatives analyst and commodity futures trader with Harvard Management Company, and then senior vice president and head of the Derivative Strategies Group with Putnam Investments in Boston, Ms. Till has a B.A. in Statistics from the University of Chicago and an M.Sc. in Statistics from the London School of Economics. She studied at the LSE under a private fellowship administered by the Fulbright Commission.