Hedge funds became far more numerous and grew to manage far more money in the 1990s and 2000s. As they have grown, successful hedge fund managers and their analysts and traders have become a new personality in finance and successful funds more well-known. Yet, there have been many failures to complement the successes. One of the former was the failure of Amaranth Advisors, a hedge fund that collapsed in 2006 after a foray into trading energy futures contracts that was short lived.
Amaranth
The Greenwich, Connecticut based hedge fund Amaranth Advisors was founded in 2000. It was a multi-strategy fund, one active in unrelated types of trades and given considerable discretion by its investors. Initially, the fund specialized in trading convertible-bonds, debt securities that can be converted to shares. Hedge funds are interested in these bonds because they can profit from differences between the price of the bonds and the price of the shares into which they can be converted. This strategy made up the majority of Amaranth’s portfolio in the early days and is emblematic of the sorts of opportunities hedge funds love.
Amaranth had a successful start. In 2002, when the stock market was down and even the average hedge fund return was a loss of 1.5%, Amaranth achieved an 11.33% return; 2003 and 2004 were also good years. On these gains, Amaranth made a 20% incentive fee, on top of a fee of 1.5% on assets under management. It was not just the profits that got all of the attention, supposedly. While earning these returns, Amaranth reported having good risk management practices but then the fund migrated to trading energy commodities and these practices would seem absent, or at least very defective, thereafter.
Brian Hunter was an energy trader for Amaranth and eventually became its co-head of commodities trading. He joined the hedge fund in 2004, initially working from the fund’s Greenwich offices. He previously ran a natural gas trading unit at Deutsche Bank, an employer he went on to sue over a disputed bonus. After a year, Hunter relocated, along with four other natural gas traders at Amaranth, to Calgary, Alberta, his home city.
Under Brian Hunter, Amaranth was profitably trading off of differences in natural gas prices in the futures market, contracts to deliver natural gas at various future dates. The fund also bought options to buy or sell natural gas at prices currently less advantageous than could be had in the market, known as ‘out-of-the-money’ options. Delving into these trades was hardly something Amaranth was engaging in alone; there was strong growth in the number of energy-related hedge funds during this period and the money invested in these energy-oriented funds more than doubled over just two years, 2004 to 2006. Thus, a market traditionally accessed by utilities and energy producers now had more financial market participants.
Profitable Storms of 2005
In 2005, Brian Hunter placed bets for Amaranth that would pay off if natural gas prices rose. The year ended up being a disruptive one for the energy industry, including natural gas producers and consumers. Notably, Hurricane Katrina was just one major storm in an unusually tempestuous Atlantic hurricane season and hurricanes stall natural gas production in the U.S., raising prices.
Thus, Amaranth’s trades turned out well that year. In fact, Amaranth made a $1.26 billion trading gain in energy and commodities in 2005. So, while the average hedge fund had a mediocre year, Amaranth realized an 18% gain. Since it was his trades that drove the outperformance, Hunter negotiated an increase in his share of Amaranth’s operating profits from 7.5% to 15%. The magazine Trader Monthly estimated that Brian Hunter made between $75 and $100 million that year.
Costly Quiet of 2006
In 2006, Amaranth had $9.2 billion in assets under management and the fund kept the same sort of bets in place that had made it so much money the previous year. These were highly levered bets that natural gas prices would rise or at least that the difference between certain natural gas futures prices would rise. It was possible to obtain more leverage on commodities trades than those in other strategies and banks had been very willing to finance commodities-trading hedge funds like Amaranth. High leverage meant small changes in price could lead to large profits or losses.
By now, Amaranth was a large player in the market for natural gas in the United States. The hedge fund accounted for 40% of all of the outstanding contracts for winter deliveries of natural gas on the New York Mercantile Exchange. Indeed, in August 2006, the New York Mercantile Exchange even ordered Amaranth to reduce its exposure to two futures contracts, natural gas futures for September and October 2006 delivery. The hedge fund complied but simply shifted its trading activity to another exchange, the Intercontinental Exchange.
On the back of its energy trading, 2006 was shaping up to be at least as good of a year as 2005. Natural gas prices were more volatile than usual in the aftermath of the disruptions of the prior year. Early in 2006, prices continued to normalize after peaking the prior year but mid-2006 still saw more gyrations than usual in natural gas. This sort of activity can be very advantageous for hedge funds. Indeed, most of Amaranth’s gains (but also its losses) in the spring of 2006 were attributable to its energy trades; overall, the fund was up 20% in the first half of the year with energy trading driving most of the gains. By this point, its former key focus area, convertible bond arbitrage, shrank to just around 2% of Amaranth’s portfolio.
Recall that Amaranth’s trades were generally bets on rising prices or on relationships between prices that generally moved in a favorable direction for Amaranth when natural gas prices were rising. However, natural gas prices fell by two-thirds between the start of the year and September. No storms of note came in 2006, making the year unusually quiet in the Atlantic; as a result, natural gas supply remained high and there was actually a growing glut of natural gas in storage. Amaranth’s trading was increasingly at odds with the market as the year went on. Other hedge funds were betting that natural gas prices would fall, a view that when traded on creates a self-fulfilling prophesy as eager sellers become more numerous than buyers. These funds expected the storage glut to worsen as elevated electricity demand from household air conditioning dissipated after the summer ended.
As it happens, Brian Hunter increased the fund’s exposure to trades that would pay off only if prices rose, a contrarian position and one met skeptically by his peers. Rightfully so because natural gas prices fell as the quiet Atlantic hurricane season came to an end and many expected a warmer winter, which would reduce demand for natural gas. Natural gas for October delivery fell from $8.45 per million BTUs in late July to just under $4.80 in September. Amidst these movements, in August 2006, a small hedge fund called MotherRock, imploded after making bets similar to Amaranth’s.
Spread Reversing
In one trade, Brian Hunter bet that the spread in natural gas prices for deliveries in March and April 2007, an approximate measure of the difference between winter and summer prices, would rise. This trade involved buying more expensive March 2007 natural gas futures and selling cheaper April 2007 futures. Instead of Hunter’s expectations being realized, the spread fell.
The spread in price between those two contracts was as high as nearly $2.50 per million BTUs in July 2006, unusually high compared to prior years, but fell to less than 60 cents in September. Between August 31 and September 21, 2006, the price of natural gas for March 2007 delivery fell approximately 25% but the price for delivery just one month later had fallen by only half as much. So, the difference in price between the usually-more-expensive winter contract and the usually-cheaper summer contract had shrunk.
Others trading natural gas futures were vaguely aware of Amaranth’s own activity and saw the signs of trouble. The hedge fund’s lenders demanded that loans used to finance the trading activity be repaid. Perhaps expecting Amaranth would have to unwind its trades, demand for the sort of positions Amaranth held was sparse; after all, why buy now when those positions might be bought cheaply as the fund liquidates. This meant Amaranth could not exit its positions on favorable terms.
Losses
Other energy traders familiar with Brian Hunter’s trades reckoned that he might have lost 30% in the third week of September alone. In just one day, Thursday, September 14, Amaranth lost about $560 million on natural gas trades. Amaranth also spent that day selling assets to repay its lenders that were calling in their loans. Over the weekend of September 16-17, banks convened at the offices of the hedge fund to explore purchasing its trading book.
No deal came that weekend. However, Amaranth announced on Wednesday, September 20 that its energy portfolio was sold to JP Morgan and Citadel, another hedge fund manager. By now, the fund had lost about $6 billion within the first three weeks of September; this amounted to about 65% of the fund’s money according to a September 20, 2006 letter to its investors. What a swift change this was; just before its collapse, the fund was reporting a 25% gain for the year.
Investors suffering the losses included the pension fund at 3M and the San Diego County employees’ retirement fund. That said, only about 6% of Amaranth’s funds came from retirement plans. Most of Amaranth’s funding came from ‘fund-of-funds’ which make investments in multiple hedge funds so that most of its end investors probably lost just a few percent of their investment thanks to this diversification.
Lesson
The advent of hedge funds has been felt in financial markets as a myriad of new hedge fund strategies complement traditional investment opportunities. They add diversification opportunities, generate returns in novel ways, and maybe make markets more efficient. However, the leverage these funds often employ, the complexity of their operations, and the combination of multiple hedge funds’ money in the same trades also introduce new risks.
Even more than in ordinary financial markets, hedge funds have left their mark on other industries like insurance or energy. The latter was the playground of Amaranth Advisors. To some extent, Amaranth was the victim of a market for natural gas changing precisely because of its own activities and those of similar funds. Various observers have attributed some of the volatility of energy markets to the trading activities of hedge funds and these were the source of Amaranth’s undoing. Rather than increase efficiency, especially when the trading of multiple funds is considered together, prices can be made more discontinuous and uncertain.
More from the Tontine Coffee-House
Read about other hedge fund predicaments: the failure of Long-Term Capital Management in 1998, the ‘Quant Quake’ of 2007, and the Volkswagen short squeeze of 2008. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
Further Reading
1. Anderson, Jenny. “Betting the House and Losing Big.” The New York Times, 23 Sept. 2006.
2. Barrionuevo, Alexei, and Clifford Krauss. “The Big Loser Is Known, but What About the Big Winners?” The New York Times, 20 Sept. 2006.
3. Chincarini, Ludwig. “A Case Study on Risk Management: Lessons From the Collapse of Amaranth Advisors L.L.C.” Journal of Applied Finance, Spring 2008.
4. Davis, Ann, et al. “What Went Wrong at Amaranth.” The Wall Street Journal, 20 Sept. 2006, p. C1.
5. “Flare-up.” The Economist, 21 Sept. 2006.
6. Senate Bipartisan Staff Report. Excessive Speculation in the Natural Gas Market. Senate Committee on Homeland Security and Governmental Affairs; Permanent Subcommittee on Investigations, 25 June 2007.
Consider Subscribing:
