Hedge, I win... Fail, You Lose
It recently came to the attention of the public that the hedge fund Amaranth Advisors managed to lose $6 billion in just a few days, due to a miscalculation of the price of natural gas futures. We aren’t all that surprised. Hedge funds are notorious for sucking up investors’ money – and turning it into nothing. Read on…
1. Also called pigweed.
2. An imaginary flower that never fades.
Last week investors found to their chagrin that the Greenwich, Connecticut genus of the pigweed, is not only far from imaginary, it can fade out at lightning speed. Hedge fund Amaranth Advisors managed to lose $4.6 billion – about half its entire value – in a matter of just a few days through a sensational miscalculation of the price of natural gas futures in the spring of 2007. Today’s news tells us the figure has now grown to $6 billion.
Star trader Brian Hunter bet the farm on the idea that the gap between the March 2007 natural gas price and the April 2007 would increase. Instead, it fell from about $2.60 per 1,000 cubic feet to about 80 cents, wiping out Amaranths’ 20 plus percent yearly returns, in one fell swoop, to a 35% loss.
Hunter, a Canadian, had made millions for the firm after natural gas prices exploded in the wake of Hurricane Katrina. He was thought to be so savvy about gas futures that his bosses at Amaranth let him work out of his home in Calgary, where he drove a Ferrari in the summer and a Bentley in the winter. The jazzy wheels matched the snazzy wheeling…and the honeyed dealing at the American energy fund, where 1.4% of net assets went for "bonus compensation to designated traders" and another 2.3% was doled out for "operating expenses." When an account made a net profit, the manager took care to cut himself up to 1.5% of the account balance per year in addition to a 20% cut of its net profits – less the traders’ bonuses and operating expenses. But when the account lost money, the managers suffered no penalty, though the investors still remained on the hook for the operating expenses and possibly for trader bonuses as well.
What kind of a gig is that? Where investors have to pay to play and then pay to lose, as well? What can investors be thinking when they see their accounts shrivel like anorexics on a fat farm while their managers grow sleek and prosperous in their Greenwich pads?
The hedge fund world is famously populated by math whizzes, each one claiming to have solved Poincare’s Conjecture. But the important math of hedge funds is very simple: it’s heads I win, tails you lose.
The typical fund charges 2% of capital, plus 20% of the gains above a benchmark, often the risk-free rate of return – say around 5% today. So, a fund with a 10% return charges its clients 2% of capital…plus, another 2% (20% of 10%) for the performance. Even a fund that is able to do twice as well as the benchmark – a difficult feat – only leaves the investor with a 6% return, net.
A common pattern is that for four years in a row, the fund gets twice the return as the risk-free rate and every fifth year it suffers a 10% loss. When this happens, the fund managers do not send out a letter offering to share 20% of the loss. No, they are happy to take a percentage of the profits, but not the losses. So, in the four fat years, the fund builds up…with the managers taking their cut. But in the fifth year, investors take all of the loss, effectively magnifying it, making a dollar of loss equal to $1.25 of gain.
The essential math is not only easy…it is perverse. As demonstrated by Amaranth, fund managers have every incentive to take wild gambles. If the gamble pays off, they become rich and famous. If it does not, they are still the same math prodigies they were before. It is like playing strip poker with a beautiful woman. When you lose a hand, you take off your shirt. But when she loses, she puts on a leather coat.
Why do investors think they can get anywhere in such a game? The quick answer is that investors are not thinking.
In the late stages of empire, thinking becomes a vestigial function – about as useful as an appendix…and as liable to be cut out in a crisis.
Instead, investors rationalize…and theorize…to justify the excesses and extravagances of the imperial economy. Why buy a hedge fund? Better returns, they say – though hedge fund returns have been so abysmally low that their money would have slept sounder tucked up in a cozy money market account. Different market, they argue – claiming that the new conditions demand provocative trading rather than stodgy buying-and-holding.
Don’t marry your stocks, they warn. Just shack up for a few months and unload them when the next hottie comes along; that’s what the celebrity hedgies do. But filling your portfolios with fast moving floozies is no way to make money; they’ve all been on the street too long already…they’re overpriced and overworked. And when the market goes down, they’ll go down faster and further than more. The hedge funds have smarter managers, claim investors. And here, finally, they might have a point. Who but a real sharpie could have come up with such a clever scheme? Hedge fund clients might be dripping in red the past few years, but the fund managers themselves are in clover.
If vanity were gravity, Greenwich, Connecticut would be a black hole. The puffed-up twits who manage most hedge funds contribute to more unwarranted bluster per square foot there than in any place outside North Korea. Greenwich sucks in money from all over the financial world and turns it into…nothing.
In this respect, Amaranth is only following the hedge fund playbook. Deals for hedge bosses are so sweet that Warren Buffet claims the funds aren’t really investment vehicles at all but compensation strategies – ways to keep star managers in their multimillion dollar digs while the funds themselves turn in lower and lower returns…sub-10% on average, and in some cases, pushing below 5%, according to the Hedge Fund Index. In fact, in 2005, some 848 hedges closed down their business, says one consultancy firm, Hedge Fund Research Inc.
Is it just a case of too much of a good thing diluting the returns? Could be.
When Alfred Winslow Jones coined the term in 1949, hedge funds operated on the margins of the investment world. "Hedge fund" then simply meant a portfolio of stocks with long and short positions, the shorts acting as a hedge against losses in the longs.
Today, the term better describes the legal structure of the groups – private, and limited to a specific number of investors, with a minimum of $1 million in assets – and the actual strategies employed vary dramatically – from commodity trading to distressed investing.
And today, hedge funds have spread like a tropical parasite so that there are now 8000 or so of them, infesting even institutional investors and pension funds, and sucking in total assets of about $1.2 trillion. Meanwhile, hedge funds specifically engaged in energy trading – like Amaranth – have proliferated – soaring from about $5 billion to a stratospheric $100 billion.
You’d think this would give at least the pros in the business some pause. Yet, Morgan Stanley, for example, pumped five percent of its $2.3 billion fund of hedge funds into Amaranth. And, Goldman Sachs’ fund of hedge funds also admitted that an anonymous energy-related investment – guess who? – had wiped off a chunky three percent off its monthly return.
Hubris and excessive risk run through the entire sorry episode. Hunter himself was borrowing $8 for every $1 of Amaranth’s own funds, while taking positions ten times larger than veteran energy trader, Goldman, and twice the size of the next biggest trader. Hunter also expanded Amaranth’s natural gas holdings so that they became half the firm’s entire exposure, where they had once been only 7%.
Like LTCM – the energy firm that blew up in 1998 – Amaranth held such large positions in the market that it could not unravel its positions. Like LTCM, Amaranth seemed certain it would never fail and boasted of its "fearlessness" on its website. Like LTCM, Amaranth was hazy about what it was doing and how…
But unlike LTCM, the financial community is reacting with odd indifference to Amaranth’s fiasco. Peter Fusaro, co-founder of the Energy Hedge Fund Center, which tracks 520 energy hedge funds, shrugs that Amaranth is "a hiccup." Amaranth’s blow-up doesn’t affect as many institutional investors and banks and other financial VIPs, as LTCMs did. Only its rich clients have to endure the pangs of portfolios sliced neatly in half.
We think of the typical hedge fund manager. Not yet 30, no experience of a real bear market, let alone a credit contraction…the man thinks only of the new house he will build in Greenwich, Connecticut, if his bets pay off. He imagines that he will take his place alongside George Soros and the Quantum Fund.
More likely, he will join Nicholas Maounis in the pigweed.
Bill Bonner and Lila Rajiva
The Daily Reckoning
September 22, 2006
Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).
In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions.
The latest news tells us that hedge fund Amaranth is now down $6 billion.
The most amazing part of this story is the blasé way in which the financial markets took the news. When Long Term Capital Management went bust the whole world shuddered…and the New York Fed rushed to save the day. And, then, there was not even half as much money at stake.
It’s time to hedge against the hedge funds, we conclude. More below…
As you will see, Hedgefundland is a kind of alternative universe where none of the usual laws of nature seem to apply. In the rest of the universe, people trust age, experience and humility…but in Hedgefundland (much like Dotcomworld, which was discovered 10 years earlier), it is the callow twits and the over-confident twenty-something blowhards who get the money. And in the rest of the universe, people want to make money…in Hedgefundland, they seem happy to lose it.
But we do not live in Hedgefundland; we live in the real world. And it is strange enough for us.
One of the strangest things about it is how the opinion leaders have duped the average citizen. And when they didn’t mislead him, he misled himself. In the bright, daylight years following Ronald Reagan’s ‘Morning in America,’ he may not have thought he was getting richer…but he definitely believed he should. So, he spent more…he worked more…he lived bigger and bigger, until he was so big, he was ready to explode.
From the Arizona Republic comes this report:
"Lost in the debate over whether we’re better off today is the inexorable widespread decline of job quality. Yes, the American economy is creating jobs, although at an ominously slower pace the past few years, but what kind of jobs?
"Call-center jobs, which can be some of the better positions in the vaunted service economy, pay an average of $10.71 an hour.
"Yet that’s far below the $13.75 needed to keep a family of four above the poverty line. The average Ford factory worker makes $31.64 an hour.
"No wonder most Americans have seen their earnings stagnate the past six years and watched as health care, pensions and other benefits are taken away.
"In the 1980s, many people could watch the pain in the Rust Belt, when hundreds of thousands of steelworkers lost their jobs, and say, ‘Serves ’em right.’
"But the same destabilizing forces have since swept a host of industries that support middle-class jobs, including such white-collar bastions as banking."
Losing ground is the sort of thing that people might get cheesed off about…if they came to believe it was happening. But for the moment, the voters still seem to believe in the American Dream. If they work hard enough…and if they put their money into a balanced portfolio of equities and real estate…they will be able to live the good life.
Well, the hard work hasn’t paid off for the last 30 years…nor have equities given much in the way of return since 1998…but housing has come through. An aggressive speculator could have flipped and house-hopped his way into big money over the last five years.
Alas, now it’s getting harder and harder to make a buck in housing too.
Contra Costa Times:
"Solano County sales also dropped 34.3 percent, and sales appreciated 1.9 percent, the lowest rate since August 1999. The median price in the Bay Area rose a scant 0.2 percent," said DataQuick spokesman Andrew LePage.
"To us, this is a leveling off," LePage said. "Some counties will see their median home (price appreciation) dip below zero. We think the market is heading into a lull while buyers and sellers work out what the price level is."
For more news, we turn to our small cap superstar:
James Boric, reporting from Charm City…
"…In today’s era of overhyped profit expectations, a 13% annual return may not turn most novice investors on. But to the seasoned professional, this is an accomplishment worthy of great praise…"
For the rest of this story, see today’s issue of The Sleuth
And more miscellaneous thoughts…
*** A dear reader writes:
"If the USA is such a terrible place to do business, how can a company like Google go from a market value of $0 to $144B in 8 years and during the Internet depression no less?
"Do you have the balls to answer this publicly in your Lew Rockwell column?"
*** Why wait for Lew Rockwell? We will answer it right here.
Who ever said the United States was a terrible place to do business? It’s a great place to do business…depending on what kind of business you’re doing. The Japanese are exporting so many automobiles, for example, that their trade surplus – already the world’s highest – practically doubled. But American manufacturers can’t make any money.
On the other hand, we wouldn’t want to be in the business of hustling zero-interest, payment optional, negative amortization mortgages in Switzerland or Germany. But in America, they fly off the shelves like the latest Britney Spears album.
Generally, our personal experience is that America is an easier place to do business than other countries. This may reflect nothing more than the fact that it is the market we know best. In France, Spain, Italy…not to mention India…we are foreigners. "You gotta know the territory," they say in the Music Man.
Besides, the United States is an easier place to start a business for the simple reason that Americans will buy anything. Who else would buy drink coolers for their cars…air-conditioned doghouses…and heated toilet seats? If Americans will buy Neg Am mortgages, hedge funds and chocolate cereals, is there any product so lame, so unnecessary and so stupid that it can’t be sold in the good, ol’ US of A?
*** Last night, we did our parental duty. We went to a PTA meeting. It was nothing like PTA meetings we had been to in America. Both parents of practically every student were there…mothers neatly coiffed and carefully dressed – not a single fat one among them, and some very pretty – and then, the fathers arriving a little later in their business suits.
As near as we can tell, our children go to an elite, Catholic school in a nice part of Paris. The qualifier "as near as we can tell" merely confesses that we are foreigners, and even after 10 years, are not entirely sure how things work.
But like PTA meetings everywhere, the gathering was mostly a waste of time. Blah…blah…blah…after a few minutes we were taking notes for today’s Daily Reckoning and trying to remember where we left our car keys.
After three or four presentations by school headmasters and administrators, we followed along to a classroom where Henry’s teachers introduced themselves. Each one gave a short presentation, explaining what they intended for our children to learn this year…and what they expected from us as parents. In every case, we were supposed to make sure Henry gets to bed on time – after about three hours of homework – and that he eats a good breakfast before setting off for school in plenty of time to get their before the bell rings. If he is unable to go to school, we are to call in advance…and then, when he returns, we must write an explanation in his little "carnet." The carnet is very important…it is to be carried at all times by the student. It is the means of communication between parent and teacher…and also a record of the entire goings-on at the school…tests, trips, vacations, and so on.
The teachers were almost all women and almost all lived up to the caricatures of their professions. His German teacher, for example, was a very well proportioned blond woman with a wide face and a heavy accent. She looked and sounded like the sort of woman you would find behind those ads that say "Mistress Helga Promises to Teach You Some Discipline." We looked down…and yes, she was wearing black leather boots.
By contrast, his English teacher had no accent at all – except for the Parisian tendency to put a rising ‘en’ on the end of each sentence. But she looked as though she might have come from Cheshire or Stratford upon Avon…with long brown hair and a longish, vaguely Laura Ashley dress.
"Oh, you met her," Henry said when we returned home. "She doesn’t like my accent."
"What’s wrong with your accent?" we wanted to know. "You don’t have an accent. You speak standard, middle-American English."
"Well, that’s what she doesn’t like. She wants me to speak English English. She thinks I’m pronouncing things incorrectly."
"Then you should explain…correct her…"
"I tried that…"
"She gave me two hours of detention…"