I last discussed the hedge fund model with you in post of August 6 & 7. In general I am a big fan of this approach because in theory it should align investors and managers in terms of both risk vs. reward. Meaning that it rewards absolute performance (i.e. the manager gets paid a percentage of the profits) and punishes unnecessary risk (the manager is punished when he makes no money). I am not a fan of the way the model is being currently practiced. The problem is its "heads I win-tails you lose" approach used by many managers towards their clients. Yesterday's blow up by Amaranth Advisors, LLC is as good a way as I can tell to illustrate what is wrong here and to show the outsized risk that funds are taking in order to generate return for their clients. It is a risk that for the most part the funds themselves do not share. Let me explain.
Amaranth, a hedge-fund manager with an estimated $9 billion in assets, told investors its two main funds fell almost 50% this month because of a plunge in natural gas prices. Last month, MotherRock LP, a $400 million fund run by former NY Merc President Robert "Bo" Collins, went bust after natural-gas futures fell 68% from their Dec. 13 peak. We discussed Motherrock on August 6. Also for purposes of disclosure, Lumen Capital Management, LLC runs a small private fund which is not currently open to new investors.
Amaranth in a letter to clients disclosed yesterday that it had turned a 22% gain in 2006 into a 35% loss as of September 15. While it is not currently possible to know exactly the magnitude of Amaranth's losses we can use some of their own reports to show an illustration of what has gone wrong here and how even over a multiyear period this can be a rotten deal for investors of a fund that may have had no real control over its risk.
For the purpose of a simple illustration let's say that at the beginning of 2005 Amaranth had 7.5 billion in assets which had grown to 9 billion dollars by the end of the year as (again for examples sake) Amaranth had posted a 20% return. For the example lets also stipulate that Amaranth allowed no new money to come into the fund or let any money leave. Assuming Amaranth had a typical structure that allowed it to take 20% of the profits of the previous year, Amaranth would have been entitled to approximately 1.5 BILLION dollars of the fund's money.
Using my 9 billion number & Amaranth own admissions, the fund would have had assets 11 billion in August (22% gain) and would currently be worth approximately 7.15 billion (the 35% loss). Total net loss of 3.85 billion. As Doug Kass over at the Street.com noted today "the reported loss in a 30-day period dwarfs the l osses at Long Term Capital in 1998. For that matter, it dwarfs the losses in the Ford Motor Company (F) over the last decade". If Amaranth cannot recover from this type of decline it will likely shut its doors by the end of the year. Assuming this loss is fixed, an investor of Amaranth at the beginning of 2005 would have lost almost 5% and paid the owners of Amaranth 1.5 billion plus management fees and expenses for the privilege ounderperformingng the S&P 500 by almost double digits. Actually if you say that Amaranth returned 20% in 04 as well {and again we do not know how they did-their results could have been better or worse} then over a 3 year period the fund still underperformed the S&P 500.
Absent some extraordinary circumstance it is unlikely that the principals of Amaranth will have to give back any of the profits they made during this period.
Kass (a hedge fund manager himself-and one highly critical of the current state of his industry) has stated that "the hedge fund industry's Dirty Little Secret is that they are, in the main, long-biased leveraged pools of capital. In essence, the hedge fund industry has (adjusted for leverage) produced below-normal returns while taking abnormal risks. And they have taken lucrative fees from this strategy -- so lucrative, that outsized risks have often replaced common sense and good investment judgment. "
Others are saying almost the same thing regarding Amaranth's risk profile: "{Amaranth's declines} came as the result of misplaced bets on the direction of natural gas prices.....The stunning reversal came as gas prices plunged last week amid a growing surfeit of natural gas and crude oil at the end of the summer driving and air-conditioning seasons and the absence of hurricanes the likes of which sent prices soaring last year year....But what's truly stunning is the sheer size of the loss. To take a $2 billion-plus hit implies an extraordinary position amassed with heavy leverage. Having such a huge concentration in one of the most volatile and illiquid markets, natural gas, is especially shocking-Barron's Up & Down Wall Street Daily 9/19/06.
Today there are over 7,000 "hedge funds which at the end of the day mostly correlate to the S&P. Kass calls them at this time one big asset class. Again quoting Kass. "The days of the A.W. Jones and Benjamin Graham template of individual stock picking have been thrown out in the new hedge fund era of derivatives and high risk taking (in which a magazine, Traders Monthly, highlights the most successful practitioners in front of their Aston Martin, often coupled with a beautiful blonde model). Buffett is implicitly vilified while the proprietary traders and hedge fund cowboys become icons. Marhedge, a leading hedge fund database, has selected Amaranth as one of the top three multi-strategy funds in the country for 2006.
There is in my opinion a place and argument to be made for hedge funds but the current set up-where funds reap all of the rewards and none of the risk needs to be rethought.
*Kass is quoted from "All Quiet on the Amaranth Front", 7.36 AM. 9/19/09. He is published at both Street Insight" writing columns for both "Market Insight" & "the Edge". "Street Insight" is a subsidiary of "Thestreet.com". Arcticles quoted are subscription based only.
