Among whatever lessons the collapse of multi-strategy hedge fund Amaranth Advisors LLC has to teach traders, investors and regulators, one of them is a time-honored truism: the bigger they are the harder — and faster — they fall.
In this case “bigger” refers to the size of the bets Amaranth took in the natural gas derivatives positions relative to its own capitalization and relative to the open interest of the natural gas futures markets.
“According to published reports, Amaranth Advisors LLC employed a natural gas spread strategy that would have benefited under a number of different weather-shock scenarios. These strategies were and are economically defensible, but the scale of their position-sizing relative to their capital base clearly was not,” writes Hilary Till, a research associate at the EDHEC Risk and Asset Management Research Centre at French business school EDHEC and principal with Premia Capital Management LLC, in a case study released last week.
Further, Till notes that position-level transparency into Amaranth’s activities likely would have revealed over-the-counter (OTC) natural gas positions that were “massive” compared to prevailing open interest in the exchange-traded futures market, “which would have given an indication of how illiquid their energy strategies were.”
Till writes that risk metrics that used recent historical data would have “vastly underestimated” the magnitude of moves that would have been seen “during an extreme liquidation-pressure event.” But if risk managers at Amaranth had used scenario analyses that evaluated the range of natural gas spreads that have occurred relatively recently, “they would have realized how massively risky the fund’s structural position-taking was in its magnitude.
“According to our returns-based analyses, the fund’s positions were indeed massive relative to the open interest in the further-out months of the Nymex futures curve.”
Last month Amaranth lost about $6 billion after making large, wrong-way bets on gas markets (see NGI, Oct 2). Last week the stricken firm said it was laying off more than half of its staff to cut operating expenses while it liquidates its portfolio. A hedge fund meltdown as stunning has not been seen since the demise of bond fund Long-Term Capital Management, which folded in 1998 after losing $4.6 billion.
While a better understanding of the implications of the sizes of its positions relative to the market would have helped Amaranth, the firm also could have benefited from a lesson provided by the collapse of hedge fund MotherRock (see NGI, Aug. 7).
“There was a preview of the intense liquidation pressure on the natural gas curve on Aug. 2, the day before the energy hedge fund MotherRock announced that they were shutting down.
“A near-month calendar spread in natural gas experienced a 4.5 standard-deviation move intraday before the spread market normalized by the close of trading on 8/2/06. We assumed that this move occurred because of MotherRock’s distress.”
As Till explained to NGI, “Having large standard deviation moves is something that does happen infrequently in the hedge fund industry. Once a leveraged fund gets to a threshold amount of losses, then there’s pressure to either preserve capital, or there is pressure from investors wanting to redeem, and then the fund has to liquidate further positions. And if the fund is a large part of a market, then this creates huge price-pressure effects on whatever the asset class or investment is… That’s the mechanism for how you get these very large standard-deviation moves.”
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