Amaranth Advisors

Did They Cook The Goose?

Philippa Aylmer
Originally published in the October 2006 issue

It’s a pity that Brian Hunter and the management of Amaranth Advisors had not learnt from that famous Aesop fable. There are some similarities in the ‘Amaranth debacle’ and the story about the goose that laid the golden eggs. In its haste to become rich, Amaranth Advisors has become poor.

On 21 September 2006, Amaranth Advisors, the $9.5 billion hedge fund, announced that it had lost almost 65% of its assets on a bet on the natural gas market. The biggest energy trading disaster happened through what some have called a series of classic rogue trading mistakes and a complete breakdown in risk control. After an intense period trying to salvage what they could for investors, on Friday 6th October, news started filtering out that Amaranth Advisors was going to shut down leading to hundreds of job losses. According to reports, Amaranth has been forced to sell, at a loss, its energy book to JP Morgan Chase and Citadel.

Despite the shock, the news did not cause panic in the markets. Comparisons were made with LTCM and with rogue trader, Nick Leeson, but of the $600 billion natural gas market, Amaranth had a 1% share. While the losses are undoubtedly huge, there was no systemic risk. But there are many unanswered questions. Apart from the investors themselves, the SEC is investigating and the Federal Reserve is said to be taking an active interest.

The losers

Until September, Amaranth Advisors had an excellent reputation. As a result, the losers read somewhat like a hedge funds who’s who. It was a firm of 3-400 employees, a good track record, and there appeared to be no reason to dispute the trading decisions. Banks such as Morgan Stanley and Goldman Sachs, pension funds; the San Diego County Employees Retirement Association, Man Group; all are said to have had stakes in the fund. The London Stock Exchange-listed Goldman Sachs Dynamic Opportunities Fund owned 5% of the funds’ assets, and reported a potential loss of up to $15 million from their $500 million fund. There are suggestions that Man has lost a great deal more.

Clearly these major players would not have invested if they had foreseen what was going to happen. But retrospective research from Edhec, the risk and asset management centre, has shown that investors would not have needed position-level transparency to realize that Amaranth’s energy trading was quite risky. An analysis showed that a -24% loss was considered quite normal for the fund. And if investors did have position-level transparency, they would have noted that the fund’s over-the-counter natural gas positions were massive in comparison to the prevailing open interest in the exchanged-traded futures market, according to the business school’s recent paper ‘Edhec comments on the Amaranth case: early lessons from the debacle.’

What went wrong?

True, a series of bad bets by Brian Hunter did incur huge losses for Amaranth, but as Peter Fusaro, co-principal of the Energy Hedge Fund Centre, which tracks 525 energy hedge funds, comments: “The key to the ruin of Amaranth is the level of the fund’s leverage. To have five times leverage is extraordinary for an energy hedge fund. It was the most highly leveraged fund in the business. Despite Hunter’s track record, it calls into question the risk management processes. Did they take into account the risks of energy trading? In this market, one always knows one’s positions. It all comes down daily in mark to market.”

“In its haste to become rich, Amaranth Advisors has become poor”

Markets are by nature unforgiving and as electronic trading increases, energy trading markets have become faster and more volatile. Fusaro also points out that while they had long positions in gas last year when prices were at an all time high, the mild winter eroded prices and “in fact they started losing money at the beginning of 2006.”

Thirty-two year old Hunter was an experienced trader and very successful, trading from his home town of Calgary, with the head office in Greenwich. Notwithstanding Amaranth’s debatable domestic arrangements, it was a bad bet on the hurricane season that ruined Hunter, according to Russell Corn, managing director of Diligence, a corporate intelligence agency.

The US Hurricane Centre predicted that it would be another big hurricane season. It does not predict the strength of hurricanes, but Hunter anticipated hurricanes similar to those of last year. He took a massive bet and lost. “There is no reason to believe that his information was not correct, but what ruined Amaranth was that the risk management team should not have allowed it such heavy exposure.”

Edhec’s commodities expert, Hilary Till, has drawn much the same conclusions. She states that the spread strategy itself was defensible, but the scale of Amaranth’s spreading activities was much too large for its capital base. The extent of the exposure was too great for the balance sheet. Rival counterparties such as big banks or BP could afford greater exposure and hedge funds trade in a different way. “Hunter did not understand that he was running a small business with attendant risks,” says Fusaro.

Once again, the finger points to the risk management process. Did it fail, were the signs ignored, or was it just not up to the job? Scenario analyses that evaluate the range of natural gas spread relationships that had previously occurred could have highlighted the high risk position of the fund.

Lessons to be learnt

The markets have not reeled in shock from Amaranth’s demise, but news of its losses have thrown hedge funds back out into the limelight, and once again their methods are being questioned.

Apart from the SEC and Federal Reserve involvement, investors will no doubt begin extensive analysis on the trading practices, risk management and their own due diligence processes. If nothing else, the Amaranth affair should encourage a period of reflection.

For Amaranth, was the summer of 2006 about being greedy or was it just trying to save its skin? In 2003, Amaranth was ranked the 73rd largesthedge fund in the Institutional Investor Hedge Fund 100, but by 2004, it had jumped to 41st place, with assets of $4 billion. A year and a half later, assets under management had nearly doubled again. It was a fast growing organization, highly successful with high returns. Ambitious, yes: Hunter and his team had made some great returns in 2005. But in 2006 Amaranth killed its advantage

There is no doubt that hedge funds entering the energy market will make massive returns. But as Fusaro states in no uncertain terms, “It is a high risk market with multiple risks: related, political and event risk. To succeed you have to understand the risks of energy trading. These are the most volatile commodity markets on earth” From a man who has spent the last 30 years tracking energy hedge funds that is sound advice.