THE IMPLOSION AT AMARANTH
, the multibillion-dollar hedge fund that dropped some 65% last week, has created a frenzy in financial circles. Politicians and pundits are already calling for an investigation, with many suggesting the massive loss as another example of why "unregulated"hedge funds
need much closer oversight.
Any rational, knowledgeable observer knows that Amaranth didn't implode because it was a hedge fund, or because it traded energy or dealt on the unregulated OTC market. The meltdown was caused for the same reason that virtually every other meltdown occurs, no matter if it's in a hedge fund, mutual fund or Aunt Tilly's E*Trade account: huge positions, massive leverage and a stubborn trader who just had to be right.
Say it with me: Size kills. Amaranth got crushed because the manager lost his discipline, not because of the market he traded or the legal framework of the organization. What destroyed Amaranth was bad investment technique not flawed regulatory oversight.
As we've been pointing out for years, you can bet long or short on any stock, bond or commodity under the sun. You could have bought gold at $700, Ford at $35 or Nortel at $80 or even natural gas at $14. Providing you didn't bet the entire farm, your lousy prognostication wouldn't have done too much damage to your portfolio.
In the coming weeks, we'll undoubtedly learn more about the events that led to the fund's $6 billion loss, but from early reports the story sounds fairly mundane. Wunderkind trader Brian Hunter appears to have made a recklessly large bet in a weak market. Regular readers know that as almost the definitive example of a low-probability trade. If you are going to risk it all, you must be prepared to lose it all. I don't know of any lucid being who'd willingly take that trade.
Given the size of the loss, media coverage and momentum stirring among politicians concerned about the "public good," you'd think the Amaranth implosion would have prompted major market upheaval or price volatility.
The natural-gas market, where the majority of losses occurred, continued uninterrupted, even as Amaranth sold its open positions to third parties. A few microcap SPAC companies, such as JK Acquisition or Star Maritime Acquisition, were volatile on the news, although none have been severely impacted. The stock, bond and currency markets in which Amaranth operated haven't skipped a beat. A dynamic and free market allowed the risk to be dissipated, prompting no systemic threat.
Of course, the risk (and reality) of loss was born by Amaranth's investors, who have seen a massive, double-digit drawdown in a frighteningly short period of time.
Yet these investors, along with most people who don't sit on a Senate subcommittee, understand that any fund hedge or otherwise involves a risk. No Amaranth investors are missing a meal tonight because of the fund's demise. They're surely not happy about the loss, but they are informed investors who were, without exception, diversified enough to withstand the loss.
Man Group, a large financial firm, had exposure to Amaranth, as did Morgan Stanley, which lost money. Goldman Sachs estimated that one of its overseas funds could lose 2.5% to 3% in September as a result of the loss. None of this has affected their stocks all are at or near either 52-week or all-time highs.
The San Diego County Employee Retirement pension fund invested $175 million with the fund, and is now tallying an almost 50% loss on the investment according to published reports. Yet the truth is it's a drop in the bucket for the $7 billion plan, which has successfully invested with numerous hedge funds in the past.
Similarly, approximately $25 million of New Jersey's $73 billion state pension plan had exposure to the fund through a diversified fund-of-funds. Assuming they write the investment off entirely, its small size will amount to no more than a rounding error for the plan. You don't think they lost many times that amount on Cisco Systems as the tech bubble deflated? The City of Philadelphia's pension plan, which invested a total of $8 million in Amaranth, expects to be out some $5 million. Yet it's a tiny fraction of the $4.6 billion in total assets thanks to a diversified strategy that invests across many funds. I'd venture they lost plenty more on shares of GE back during the bear market.
Moreover, while Amaranth (and its investors) lost big by betting on a rally, a large number of funds and aggressive traders had taken the other side of that bet. The New York Times reported that numerous commercial traders and public funds, including Andy Weissman's Energy Catalyst Fund, were on the short (winning) side of the trades. Plenty of individual investors who were short energy made money as well.
The point is that what sunk Amaranth wasn't that it was a hedge fund or that it needed better regulatory oversight, but that its management permitted recklessly large positions. That sort of approach will eventually sink any investor, be it a "sophisticated" hedge fund or Enron worker's 401(k). And although the losses were disappointing, investors were protected by including the fund as only part of a diversified portfolio. The markets were unaffected and functioned flawlessly. Shortly put, no harm was done.
As the politicians begin to circle around the easy scapegoat of "unregulated" hedge funds, however, that paradigm could easily change. Greater governmental intrusion into a perfectly functioning free market will only lead to higher costs, lower returns and more inefficient trade. The smart, principled politicos will sit this one out.
Jonathan Hoenig is managing member atCapitalistpig
Hedge Fund LLC.