The HedgeSPA team comments on “Hedge Hogs”, a new book by Barabara T. Dreyfuss.

– Historical Hedge Fund – 

The amaranth flower symbolized immortality and was used to decorate images of the gods and tombs in ancient Greece. Unfortunately, Greenwich, Connecticut-based multi-strategy hedge fund Amaranth Advisors LLC failed to live up its legendary name and turned in one of the largest hedge fund collapses in history.

In a passage in her new book “Hedge Hogs”, Barbara T. Dreyfuss tells the story of Amaranth’s spectacular collapse. She describes the “cowboy” traders in the fund and how staff left the firm over their concerns prior to the blow up. On page 172, she further talks about the large New York-based investment management firm BlackRock, Inc., paid early redemption fees to exit Amaranth shortly before its collapse.  In reality, two large institutional investors BlackRock and Blackstone Group L.P., originally one company, got out about the same time. When Blackstone subsequently publicized their timely exit, it drew the attention of US regulators curious to understand the sister companies’ exceptional investment foresights.

The New York Times described Amaranth’s “multi-strategy portfolio approach to investing that allows nimble portfolio managers to seize opportunities in whatever markets seem to be most promising at the time.” Indeed, the firm claimed to be a “market neutral” fund. However, trader Brian Hunter’s disastrous bet on natural gas futures (losing over $6 billion) revealed the firm’s risk exposures to be neither multi-strategy nor market neutral.

– BlackRock Gets Out – 

Given Amaranth’s 30% return in 2005, there was reasonable suspicion that the fund may have been taking excessive risks to generate returns. On Christmas Eve of that year HedgeSPA CEO Dr. Bernard Lee, then part of BlackRock’s portfolio management group, made a visit to Amaranth’s office. What was supposed to be a routine due diligence visit became a full day affair for Dr. Lee, as he tried to better understand how the liquidity risk inherent in a number of outsized positions in natural gas was driving the impressive if not unusual returns, when Amaranth did not have access to pipelines and storage facilities like other typical producers.

Using an award-winning methodology developed in Dr. Lee’s doctoral dissertation and deployed at BlackRock and now at HedgeSPA, his analytics revealed that although Amaranth was yielding exceptional returns, its implied return (or break-even return) was even higher.  In other words, despite its seemingly spectacular performance results, Amaranth was not generating enough returns to pay for the outsized risk that it took.  Consequently, Dr. Lee along with a few portfolio team members recommended a full exit from Amaranth in early 2006, by paying punishing early redemption fees.

– Historic Collapse – 

Indeed, the market was turning bearish with increasing supplies of natural gas and diminishing threat of another severe hurricane season. As the price of natural gas took a free fall, Amaranth’s losses grew up to $6 billion and the firm collapsed in September 2006.  The fact that some large investors managed to get out ended up costing a number of Chief Investors Officers their jobs.

Dreyfuss brings light to the story of one of the hedge fund industry’s most dramatic failures, but it also places the tale in proper historical context and shows how superior analytics can be used to detect problems ahead of their happening, instead of suffering from costly mistakes.

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HedgeSPA – 29 May 2013