EDHEC-Risk Comments on the Amaranth Case: Early Lessons from the Debacle
The following summary is based on the EDHEC-Risk position paper of October 2nd, 2006. The paper is based on the publicly known facts of that time. Since this position paper was released, new information on the case has been provided by the Wall Street Journal on January 30th, 20071; and by the U.S. Senate Permanent Subcommittee on Investigations on June 25th, 20072. This summary includes the updated information known as of the end of June 2007.
In September 2006, Amaranth Advisors, a respected, diversified multi-strategy hedge fund, lost about 70% of its $9.2 billion in assets. In this paper, noted commodities expert Hilary Till, Research Associate with EDHEC-Risk Institute and Principal of Premia Capital Management, LLC, examines how Amaranth could have suffered such massive losses and draws lessons from this debacle for investors, fund-of-funds & energy-fund risk managers, multi-strategy hedge fund managers, and the alternative investment industry as a whole.
How can a respected, diversified multi-strategy hedge fund, whose size was reportedly $9.2 billion as of the end of August 2006, lose a substantial fraction of its assets in a little over a week?
This analysis provides some preliminary answers and considers some early lessons from this debacle.
Amaranth Advisors, LLC was a multi-strategy hedge fund, which in turn was founded in 2000 by Nick Maounis and was headquartered in Greenwich, Connecticut. The founder’s original expertise was in convertible bonds. The fund later specialized in merger arbitrage, leveraged loans, blank-check companies, and in energy trading. According to Burton and Leising (2006), as of June 30th 2006, energy trades accounted for about half of the fund’s capital and generated about 75 percent of their profits.
On Monday, 9/18/06, the market was made aware of Amaranth’s distress. The founder had issued a letter to investors, informing them that the fund had lost an estimated 50% of their assets since its end-August value. Additionally, the fund had lost -$560 million on Thursday, 9/14/06 alone. The fund had scrambled to transfer its positions to third-party financial institutions during the weekend of 9/16 to 9/17. Merrill Lynch had agreed to take on 25% of the fund’s Natural Gas positions for a payment of about $250 million. The fund then lost a further $800 million through Tuesday, 9/19/06, due to the Natural-Gas market moving severely against its positions. On Wednesday, 9/20/06, the fund succeeded in transferring its energy positions to JP Morgan Chase and Citadel Investment Group at a -$2.15 billion discount to their 9/19/06 mark-to-market value. By the end of September, the fund’s losses totaled $6.6 billion.
According to published reports, Amaranth Advisors, LLC employed a Natural Gas spread strategy that would have benefited under a number of different weather-shock scenarios. These strategies were and are economically defensible, but the scale of their position-sizing clearly was not.
For example, the U.S. Senate report on the debacle noted that in late July 2006, Amaranth’s natural-gas positions for delivery in January 2007 represented “a volume of natural gas that equaled the entire amount of natural gas eventually used in that month by U.S. residual consumers nationwide.” (Italics added.)
While a July 2007 EDHEC-Risk article will briefly address some of the public-policy considerations that arise from this debacle, as of the end-of-September-2006, there were six early lessons that investors could draw from Amaranth’s collapse:
- 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;
- 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;
- Risk metrics using recent historical data would have vastly underestimated the magnitude of moves that can occur during a critical liquidation cycle;
- 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 caught how massively risky the fund’s structural position-taking was in its magnitude;
- It is essential for a commodity trader 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, a trader needs to understand what flow or catalyst will allow a trader out of a position; and
- 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. According to estimates in Till (2007) , commercial hedgers were the likely beneficiaries of 2/3 of the price-pressure effect caused by Amaranth’s unwind.
Ultimately one would hope that the market-place would provide a sufficient disciplining mechanism in preventing future Amaranths. After all, no hedge-fund investor would want to see 70% of their investment lost in the course of one month. Perhaps the lesson for global investors in 2006 and 2007 will be that value matters: one should not pay historic levels for forward U.S. winter Natural Gas prices relative to non-winter months, which was Amaranth’s key risk position; just like one should not invest in the U.S. sub-prime mortgage market without adequate compensation for default risk.
References
1 Davis, Ann, Gregory Zuckerman, and Henny Sender, “Hedge-Fund Hardball: Amid Amaranth’s Crisis, Other Players Profited,” Wall Street Journal, 1/30/07.
2 "Excessive Speculation in the Natural Gas Market," Staff Report of the Permanent Subcommittee on Investigations, Committee on Homeland Security and Government Affairs, United States Senate, 25 June 2007.
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