Hilary Till, Research Associate with the EDHEC Risk and Asset Management Research Centre and Principal of Premia Capital Management, LLC, examines the Amaranth debacle.
In a little over a week, Amaranth Advisors, a respected, diversified multi-strategy hedge fund, lost 65% of its USD 9.2 billion assets. In a paper entitled 'EDHEC Comments on the Amaranth Case: Early Lessons from the Debacle', noted commodities expert Hilary Till, Research Associate with the EDHEC Risk and Asset Management Research Centre and Principal of Premia Capital Management, LLC, examines how Amaranth could have suffered such massive losses and draws lessons from this debacle for investors, funds of fund & energy fund risk managers, multi-strategy hedge fund managers, policy makers, and the alternative investment industry as a whole.
Ms Till finds that the fund employed a Natural Gas spread strategy that would have benefited under a number of different weather-shock scenarios. These were economically defensible, although the scale of their position-sizing relative to the capital base clearly was not. Using a returns-based analysis to infer the sizing of positions, it is found that the Amaranth's energy portfolio likely suffered an adverse 9-standard-deviation event on the Friday (September 15th) before the fund's distress became widely known. Ms Till draws six early lessons from the debacle:
- Investors would not have needed position-level transparency to realize that Amaranth's energy trading was quite risky. A monthly sector-level analysis of their profits and losses (p/l) would have revealed that a -24% monthly loss would not have been unusual;
- If investors did have position-level transparency, they would have likely noted that the fund's over-the-counter Natural Gas positions were massive compared to the prevailing open interest in the exchanged-traded futures market, which would have given an indication of how illiquid their energy strategies were;
- Risk metrics using recent historical data would have vastly underestimated the magnitude of moves during an extreme liquidation-pressure event;
- If the fund's risk managers had employed scenario analyses that evaluated the range of Natural Gas spread relationships that have occurred in the not-too-distant past, they would have caught how massively risky the fund's structural position-taking was in its magnitude;
- It is essential for a commodity trader to understand how their positions fit into the wider scheme of behaviors in the physical commodity markets: before initiating any large-scale trades in the commodity markets, a trader needs to understand what flow or catalyst will allow a trader out of a position; and
- Amaranth was indeed likely to have been providing an economic service for physical Natural Gas participants; this hedge fund provided liquidity for physical-market participants who could then lock in the value of forward production or the future value of storage. But even so, like Long Term Capital Management, the scale of Amaranth's spreading activities was much too large for its capital base.