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EDHEC Comments on the Amaranth Case: Early Lessons from the Debacle

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EDHEC Comments on the Amaranth Case: Early Lessons from the Debacle EDHEC RISK AND ASSET MANAGEMENT RESEARCH CENTRE 393-400 promenade des Anglais 06202 Nice Cedex 3 Tel.: +33 (0)4 93 18 78 24 Fax: +33 (0)4 93 18 78 40 E-mail: [email protected] Web: www.edhec-risk.com EDHEC Comments on the Amaranth Case: Early Lessons from the Debacle Hilary Till Research Associate, EDHEC Risk and Asset Management Research Centre, and Principal, Premia Capital Management, LLC Abstract We examine how Amaranth, a respected, diversified multi-strategy hedge fund, could have lost 65% of its $9.2 billion assets in a little over a week. To do so, we take the publicly reported information on the fund’s Natural Gas positions as well as its recent gains and losses to infer the sizing of the fund’s energy strategies. We find that as of the end of August, the fund’s likely daily volatility due to energy trading was about 2%. The fund’s losses on 9/15/06 were likely a 9-standard-devation event. We discuss how the fund’s strategies were economically defensible in providing liquidity to physical Natural Gas producers and merchants, but find that like Long Term Capital Management, the magnitude of Amaranth’s energy position-taking was inappropriate relative to its capital base. 2 About the author Hilary Till is the co-founder of Premia Capital Ms. Till has recently authored and co-authored Management, LLC, a principal of Premia Risk chapters in The New Generation of Risk Consultancy, Inc., and a research associate with Management in Hedge Funds and Private Equity the EDHEC Risk and Asset Management Research Investments (Euromoney, 2003), Intelligent Hedge Centre. Fund Investing (Risk Books, 2004), Commodity Trading Advisors: Risk, Performance Analysis, and A Chicago-based proprietary trading firm with a Selection (Wiley, 2004), Core-Satellite Portfolio focus in natural resources markets, Premia Capital Management (McGraw Hill, 2005), Hedge Funds: Management, LLC specialises in detecting pockets Insights into Performance Measurement, Risk of predictability in derivatives markets using Analysis, and Portfolio Allocation (Wiley, 2005), statistical techniques. Premia Risk Consultancy, The Handbook of Inflation Hedging Investments Inc. advises investment firms on derivatives (McGraw Hill, 2006), Hedge Fund & Investment strategies and risk management policy. In Management (Elsevier, 2006), Portfolio Analysis: addition, Ms. Till sits on the advisory board of the Advanced Topics in Performance Measurement, Risk Tellus Natural Resources Fund, a fund of hedge and Attribution (Risk Books, 2006), Fund of Hedge funds. Before co-founding Premia Capital, Ms. Funds: Performance, Assessment, Diversification Till was chief of derivatives strategies at Putnam and Statistical Properties (Elsevier, 2006). Investments where her group was responsible for the management of all derivatives investments Ms. Till is a member of the curriculum and in domestic and international fixed income, examination committee of the Chartered tax-exempt fixed income, foreign exchange, and Alternative Investment Analyst Association® and global asset allocation. Prior to joining Putnam a member of the hedge fund specialisation exam Investments, Ms. Till was an equity derivatives committee for the Professional Risk Managers' analyst and commodity futures trader with Harvard International Association. Management Company, the investment manager for Harvard University’s endowment. Ms. Till has a B.A. in Statistics from the University of Chicago and an M.Sc. in Statistics from the Ms. Till has written articles on commodities, risk London School of Economics where she studied management, and hedge funds published in the under a private fellowship administered by the Journal of Alternative Investments, AIMA Journal, Fulbright Commission. Derivatives Quarterly, Quantitative Finance, Risk Magazine, Journal of Wealth Management, and the Singapore Economic Review. She has served as a referee for the Financial Analysts Journal. 3 Introduction How can a respected, diversified multi-strategy that it will be cheap in the summer if there is a lot hedge fund, whose size was reportedly $9.2 billion of supply, but expensive by a certain point in the as of the end of August, lose 65% of its assets in winter. Mr. Hunter closely watches how weather a little over a week? affects prices and whether conditions will lead to more, or less, gas in a finite number of underground This analysis will provide some preliminary storage caverns.” answers and consider some early lessons from this debacle. “Bruno Stanziale, a former Deutsche Bank colleague and now at Société Générale, works with energy Amaranth Advisors, LLC is a multi-strategy hedge companies that need to hedge their [forward] fund, which was founded in 2000 by Nick Maounis production. In an interview in July, he contended and is headquartered in Greenwich, Connecticut. Mr. Hunter was helping the market function better The founder’s original expertise was in convertible and gas producers to finance new exploration, bonds. The fund later specialized in leveraged loans, such as by agreeing to buy the rights to gas for blank-check companies, and in energy trading. delivery in 2010. ‘He’s opened a market up and According to Burton and Leising (2006), as of June provided a new level of liquidity to all players,’ Mr. 30th of this year, energy trades accounted for about Stanziale said.” half of the fund’s capital and generated about 75 percent of their profits. “[Amaranth’s energy book] was up for the year roughly $2 billion by April, scoring a return of Davis (2006) has thus far provided the most 11% to 13% that month alone, say investors in the complete picture of Amaranth’s energy strategies. Amaranth fund. Then … [the energy strategies] … The following paragraphs quote from her article. had a loss of nearly $1 billion in May when prices of gas for delivery far in the future suddenly collapsed, Davis reported that Brian Hunter, Amaranth’s head investors add. [The energy traders] won back the energy trader sometimes held “open positions to buy $1 billion over the summer …” or sell tens of billions of dollars of commodities.” Mr. Hunter was based in Calgary, Alberta. On Monday, 9/18/06, the market was made aware of Amaranth’s distress. It turns out the fund “Mr. Hunter saw that a surplus of [natural] gas lost about 35% of its assets during the week of this summer [in the U.S.] could lead to low prices, September 11th. It lost -$560 million on Thursday, but he also made bets that would pay off if, say, a 9/14/06 alone. hurricane or cold winter sharply reduced supplies by the end of winter. He was also willing to buy The fund scrambled to transfer its positions gas in even further-away years, as part of complex to third-party financial institutions during the strategies.” weekend of 9/16 to 9/17, but was unable to do so. On Wednesday, 9/20/06, the fund succeeded “Buying what is known as ‘winter’ gas years into the in transferring its energy positions to JP Morgan future is a risky proposition because that market has Chase and Citadel Investment Group at an apparent many fewer traders than do contracts for months -$1.4 billion discount to their 9/19/06 mark-to- close at hand.” market value. This meant that the fund’s investors had lost about -$6 billion or -65% since the end “Unlike oil, [natural] gas can’t readily be moved of August. about the globe to fill local shortages or relieve local supplies.” Given these facts, we can draw six preliminary lessons about what happened at Amaranth. “Traders like Mr. Hunter make complex wagers on gas at multiple points in the future, betting, say, 4 1. Lessons for Investors Full and timely position transparency would not In summary, an examination of the fund’s monthly have been necessary to raise a red flag about the sector-level p/l would have been sufficient to fund’s Natural Gas trading. raise a red flag. Since May, investors knew the energy portfolio That said, an analysis of the fund’s liquidity risk had typical up or down months of about 11%. would have benefited from an understanding of The monthly volatility of the energy strategies the precise positions of the fund. therefore had been about 12%. Therefore, it would not have been unusual for the fund’s energy trades to lose -24% in a single month, corresponding to a two-standard-deviation event. 5 2. Lessons for Fund-of-Fund Risk Managers One would expect that the fund did not entirely This procedure is described in Appendix A: Reverse- accumulate its Natural Gas positions through Engineering Amaranth’s Natural Gas Positions. the exchange-traded futures markets; one might assume that a meaningful fraction of its Natural We do not represent that our analysis shows the Gas strategies was also acquired through the Over- fund’s actual positions. Instead, our returns-based the-Counter (OTC) derivatives markets. analysis shows positions that, at the very least, were highly correlated to Amaranth’s energy Even if a substantial amount of the Fund’s strategies. positioning was through the opaque OTC markets, an examination of the notional value of Amaranth’s According to our returns-based analysis, the fund’s positions versus the open interest in the back-end positions were indeed massive relative to the open of the New York Mercantile Exchange (NYMEX) interest in the further-out months of the NYMEX futures curve would likely have shown that the futures curve. fund’s positions were massive relative to the prevailing open positions in the futures markets. This would have provided a red flag of the liquidity (or lack thereof) of the fund’s positions. After the fact, we can do a returns-based analysis of what the likely sizing of the fund’s positions were, based on the publicly reported strategies of the fund, and what the publicly stated path of the strategy’s p/l had been since June.
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