The Implications of Amaranth — into the Echo Chamber

Im thinking the same thing — what can I possibly add to all thats been written about Amaranth? There have been many excellent pieces across the investment blogosphere, ranging from Trader Mike to The Stalwart. from Barry Ritholtz at The Big Picture to Bill Rempel at Bill aka NO DooDahs! (in fact, I borrowed the echo chamber idea from Bill), as well as stories in the top MSM outlets (WSJ, NYT and FT). But Id like to take this opportunity to step back, take a deep breath, and give you my sense of what went down and the potential implications for both Amaranth and the hedge fund industry (and its investor denizens) going forward. But before that, does anyone find it ironic that LTCM happened in the wake of a crisis in Asia and that today we have Thailand falling under martial law? Strange

How Could This Happen?

I think a list might be in order here:

Greed. Happens at Wall Street firms all the time where proprietary traders have massively skewed utility functions — I roll the dice big and lose, I may be disgraced and lose my job. Ill just get another one, because anyone who has traded big enough to get ousted must be good enough to work on the Street, right? Alternatively, I roll the dice big and win, I take home $25 million bucks. Sounds like a pretty good and heavily skewed return distribution to me. Even increasingly sophisticated risk management systems and processes are insufficient to stop this behavior from happening from time to time. We just dont expect to see this at a massively successful and massive hedge fund that bills itself as being multi-strategy where the partners have a lot of their own capital in the game. There is much closer alignment of motives between between the principal owner of a hedge fund and his traders than the head of a Wall Street trading department and his traders. Its not house money — its his money (or at least some of his money). One would think it would be taken care of much better than it has been at Amaranth. Why not? The only reason I can think of is pure greed.

Poor risk management. Duh. Most of the what can be said has been said. But lets be clear — this was not the issue of a rogue trader a la Howard Rubin in the Merrill Lynch MBS trade tickets-in-the-drawer scandal in the 1980s or Nick Leeson and the Barings debacle in the 1990s. This was an action taken by an individual where his bosses and risk managers knew EXACTLY what he was doing and didnt curtail his risk-taking, make him size his bets appropriately and wind down positions as they moved sharply against him. No, were doubling down, boys. We dropped a billion before and made it right back — well surely do it again here. Right? Wrong.

Poor culture. Yes, poor culture. Brians bosses KNEW he was swinging for the fences, saw the inherent volatility (natural gas, right?) and DID NOTHING ABOUT IT. Any place that lets something like this happen has a real problem, and it goes beyond risk management, its culture. All hedge funds have some degree of a greed culture, and this is one of the reasons whey theyre successful. However, one is truly successful greedy if one can continue to play the game day after day, which is not the case when lousy risk management and a culture that supports weak practices forces you to be at the mercy of your creditors, counterparties and the market.

Losing touch with the mission. Amaranth was purportedly a diversified, multi-strategy hedge fund. Its roots were that of a convertible arbitrage/merger arbitrage fund, which themselves are not terribly volatile strategies. It represented itself as being multi-strategy, and took in investor dollars on that basis. Now, their offering document might give them trememdous latitude to basically do anything they want, but thats not the point. Representing yourself as a multi-strategy hedge fund and taking positions akin to the riskiest of CTAs (please, CTAs, dont take that characterization as an insult. I know many of you and your trade sizing/stops/risk management practices are infinitely better than those on display here) is just wrong. Regardless of whether or not Amaranth survives isnt the point. How can the principals look investors in the face ever again?

Desperation. Once youre down and its really bad we all know what happens. Empirical research tells us what happens. People lose all sense of perspective and logic and begin to gamble irrationally. How can I face my investors? How can I face my friends? How can I live this down? How? How? How? It is a rapidly accelerating downward spiral out of which there is little hope for salvation. I was quoted in Reuters as saying that Fifty percent is a yardstick that some people use to say that once you have dropped that much, the game is overThe next week will be telling because if there are other positions that are directionally similar that continue to move against them, then they are going to be in deep trouble. Well, based upon the recent announcement in Bloomberg that JPMorgan and Citadel are taking over Amaranths energy trades, Id say that maximum ugliness has started to set in.

Bad due diligence practices (which was very well discussed by Barry Ritholtz in his post). Due diligence for large funds tends to be pretty pro forma. Well, as with fat tails, black swans and other chance occurrences, the Amaranths of the world do, in fact, happen, and certainly not only once in a blue moon. Investors have to bear some of the brunt of criticism here, as theyre the ones that let Amaranth have a document that could let something like this happen, as well as supporting a culture that could engage a Brian Hunter and let him trade the way he did. Lets face it, folks, hedge funds are not for kids. If you dont like the results, either accept your fate that stuff like this WILL happen, do something about it or get out. Its that simple.

This certainly isnt exhaustive but gets to the root of the important stuff Im thinking about. Now what about the implications of this little debacle?

Fund-of-hedge-funds (FOHFs) — maybe two layers of fees are worth it. So, the argument went that as institutional investors became more sophisticated and as large multi-strategy funds became more institutional, these multi-strats would eventually supplant FOHFs as the primary vehicle for institutions entry into the hedge fund asset class. You could cut out a layer of unnecessary fees, get the opportunistic asset allocation expertise of a top investment team and start generating alpha. Right? Well Amaranth really shines a bright light on the definition of multi-strategy. Should a multi-strategy fund be placing 50%+ of its capital in a single asset class, which also happens to be one of the more volatile asset classes on the planet? No. But how, as an institutional investor, can I protect against such a thing happening to me? The easiest, safest and most defensible way to accomplish this is to engage a FOHF to spread my bets. I really didnt think that the industry would go this way but with this blow-up at Amaranth, I do think that the big winner here (aside from those on the other side of the Amaranth trades) are FOHFs. I guess Christmas has come a little early this year.

New hedge fund offering documents will become increasingly restrictive. I think the market will see a change in the language of documents, particularly those who are targeting institutional investors. I cant imagine that due diligence and document review procedures wont tighten up, and that fund managers wont have sector/concentration/risk parameters of some type embedded in these documents. How else can an institutional investor be comfortable that theyre not an unwitting participant in Amaranth, The Sequel? When I ran a large trading business, the documents I had with the traders laid out some very basic and fair risk management thresholds (sector, concentration, position size, etc.) to ensure that things couldnt possibly get way off the rails. It would seem logical that new hedge fund documents would include some of these principles. As for the large, very successful and sought-after multi-strategy funds, they wont have to change anything. Supply and demand is still way out of whack, with much more capital seeking access to top managers than the capacity (or desire) of these managers to take in more funds.

Some large institutional investors agitate for a change in multi-strategy fund documents. Admittedly a low probability, but if we see a few more blow-ups of the Amaranth sort anything is possible. Threaten redemption? Nah, the top funds wont be forced into doing anything. But I thought Id put this possible tail event on the table, anyway.

The hedge fund asset class loses favor. I can certainly see that those about to enter the hedge fund asset class for the first time might think twice before taking the plunge. Nobody wants headline risk, and I am sure the folks in San Diego (who have more than enough problems already) are rueing the day they put $175 million into Amaranth. However, this is counterbalanced by the pent up demand for exposure to the asset class. This might actually drive those who might have considered going directly into multi-strategy funds into FOHFs in order to get their exposure. It cant hurt to have a fiduciary stand in the middle, right? Cant look stupid hiring one of those, right? Well see.

I dont know if this has been helpful to you but it has been to me. I truly enjoyed writing this. It has been a constructive way to get a bunch of stuff off my head that has been rattling around for the past 36 hours. Thanks for your support and your eyeballs!