Amaranth Advisors Hedge Fund Ruined by Ignoring ‘Risk of Ruin’
By Michael on Sep 19, 2006 in Stock Market
I finally got around to reading about the blowup of Amaranth Advisors hedge fund. I’m astounded that some of these supposedly sophisticated hedge funds apparently have no clue about such basic concepts like money management, position sizing and ‘risk of ruin‘. The disaster at this fund is a great illustration of why I’ve always said that and understanding of money management and risk management are the most important aspects of trading. Here are some excerpts from the article (emphasis is mine):
Of all the traders gambling big sums on energy, a 32-year-old Canadian named Brian Hunter made some of the brashest bets and the fastest money.
Brash, eh? Let’s look at the definition of brash, just to be clear — impulsive, brazen, Heedless of consequences, presumptuously daring . Enough said!
At the end of August, trading natural gas, he was up approximately $2 billion for the year. Then Mr. Hunter lost roughly $5 billion, in about a week.
His losses savaged returns for Amaranth, dragging its assets under management down to $4.5 billion from $9 billion at the start of September.
Those are some incredible swings for a fund that I guess was around $7 billion to start. That can’t be safe. 
“The cycles that play out in the oil market can take several years, whereas in natural gas, cycles take several months,” Mr. Hunter said in an interview late in July, when his returns were looking rosy. “Every time you think you know what these markets can do, something else happens.“
Hmm, if things are so unpredictable maybe you should be trading smaller. 
I guess Brian and Amaranth never heard of Black Swans.
At that time, Mr. Hunter had more than $3 billion of bets outstanding, investors familiar with the funds’ holdings say.
So he had somewhere around 50% of the fund in play on natural gas. Most sensible traders won’t risk more than 2% of their account in any one sector / instrument. There’s no telling how much of Anaren’s capital was actually at risk because apparently Brian didn’t use stops or have a point where he’d know he was wrong and exit.
continued taking positions some other traders had abandoned as too risky.
Remember, he’s brash!
Backed by borrowed money and a deep-pocketed fund, Mr. Hunter took on more exposure to certain futures contracts than do some big investment banks employing more than 100 energy traders, say several traders and ex-colleagues. He sometimes held open positions to buy or sell tens of billions of dollars of commodities.
Apparently the fund’s pockets weren’t that deep. I hope those positions were hedged since they were using a lot of margin and apparently holding for long periods of time.
He was up for the year roughly $2 billion by April, scoring a return of 11% to 13% that month alone, say investors in the Amaranth fund. Then he had a loss of nearly $1 billion in May when prices of gas for delivery far in the future suddenly collapsed, investors add. He won back the $1 billion over the summer, only to lose that and much more last week.
His swift reversal calls into question how well some hedge funds grasp the risk they are taking in the now-popular energy markets. Vince Kaminski, a risk-management expert who protested chancy trades while at Enron Corp. and until recently was at Citigroup Inc.’s commodities desk, said yesterday that it is dangerous to take giant positions in relatively shallow markets, which certain months are in gas futures. “This is a typical mistake of inexperienced and aggressive traders,” he said. Mr. Hunter “appeared to have a position that the entire market knew about. The markets are very cruel.” Citing a well-known epigram, Mr. Kaminski added, “‘The market can stay irrational longer than you can stay solvent.‘”
Obviously this fund had no clue about their risk!
Nick Maounis, Amaranth’s founder and chief executive, said in August that more than a dozen members of his risk-management team served as a check on his star gas trader. “What Brian is really, really good at is taking controlled and measured risk,” Mr. Maounis said.
Damn, they actually had a risk-management team? Scary.
As for Brian being “really good at taking controlled and measured risk”, look what happened at his previous employer, Deutsche Bank:
In December 2003, just as his group was close to ending the year up $76 million, he claimed in the suit, things went awry. In a single week, they had losses of $51.2 million, he said in the suit. He blamed “an unprecedented and unforeseeable run-up in gas prices”
There he goes blaming his troubles on that darn unpredictable market. Hmm, maybe that’s why people take measures to control their risk!
Mr. Hunter wanted to make bigger bets in his main market, gas. He had an ability to keep calm with huge bets on the line and markets were going berserk.
I bet he was calm since it wasn’t his own money on the line!
Although Mr. Hunter had fared well, many traders say he was acquiring positions that were too large to get out of if the market turned — including a bullish bet on winter gas.
Another aspect of position sizing… why would you ever take such large positions? That makes no sense. Good thing that risk-management team was on the job. 
The sad thing is that all of this drama could have been avoided if these guys simply had an understanding of the concept of “risk of ruin“:
The risk of ruin is the chance that standard deviation will destroy your bankroll before you have a chance to win at the levels you expect. Remember, the edge that you have is just like the edge the casino has - anything could happen in the short term.
[SNIP]
To avoid risk of ruin, make sure that your bet size is a small (very small) percentage of your overall bankroll. If you have a $10,000 bankroll, and you’re betting $1000 per hand at blackjack, then you probably won’t be playing long, no matter how well you count cards or how well you’ve mastered basic strategy.
On the other hand, if you have a $10,000 bankroll, and you’re making $10 bets on hands of blackjack, you’re going to have a lot better chance of finishing your trip to the casino a winner instead of a loser. The bigger your bankroll in comparison to your average bet, the lower your risk of ruin.
Here are some other useful articles on money management and risk of ruin:
- Money Management by Bennett McDowell — “Money management in trading involves specialized techniques combined with your own personal judgment. Failure to adhere to a sound money management program can leave you subject to a deadly “Risk-Of-Ruin” exposure and most probable equity bust.”
- Risk of Ruin — “Again this should be obvious: The smaller the amount you risk for any one trade relative to your capital base the lower the risk of ruin.”
To Trade or Not to Trade? The Real Question Is How Much? by Teresa Lo — ” Risk management. Money management. Trade size. Position size. Optimal f. Kelly Criterion. Collectively, these phrases determine a trader’s ultimate fate.” and ” In trading, there is a well-defined line between aggressive and insane risk-taking.”
If it isn’t already obvious, the primary goal is to stay in the game & live to trade another day. If you can do that and have a decent strategy (with a positive expectancy) the profits should take care of themselves.
Tags: Expect_the_Unexpected, Hedge Funds, Money Management, Position Sizing, Risk, Risk Management, Risk_of_Ruin
32 Comment(s)
By max on Sep 19, 2006 | Reply
How does this monkey get to manage so much money?
He should be ashamed of himself and his crapy risk management team!
By max on Sep 19, 2006 | Reply
I mean realy come on! Your half-ass is managing billions of dollars invest 50 bucks on Tharps book!!!
By Mousefinger on Sep 19, 2006 | Reply
Nice write up Mike. For some reason, all of this doesn’t surprise me. I suspect there are a few loose cannons in the Gold/Metals market as well (didn’t China lose their butts on a huge Copper short?). The real question is: will this clown be held responsible? Not having read the article, was he fired, or do they think he can make the 5 billion back next week?
At least it looks like my winter heating bill will be half of what it was last year.
By JC on Sep 19, 2006 | Reply
Mike,
Excellent post. It’s amazing that this guy was still able to take a position at this hedge fund (especially after his debacle at Deutsche). It’s kind of scary to think how many people like Mr. Hunter there are out there.
This game is all about risk management, yet this guy seems to disobey every rule that us “small” guys live on.
Looks like we have another candidate for “Trader Blowups 2006″…
By Michael on Sep 19, 2006 | Reply
Mousefinger,
He’s still employed and driving his Ferrari and Bentley around!
He was also on the 2005 Trader Monthly 100. Easy come, easy go.
By Jamie on Sep 19, 2006 | Reply
Thanks for the article Mike. Another brashy Canuck. I heard on CNBC that he earned a bonus of $75M last year for his brashy trades. As far as I can tell, this guy’s not a trader, he’s a gambler.
By Andy on Sep 19, 2006 | Reply
I think the trader is getting to much negative attention here it should be the funds management who are the ones to blame. They are the ones who gave Mr. Hunter the ability to take such large positions is the first place. Hiring him after his Deutsche Bank problems should given them even more reason to carefully watch him but their oversite still should of prevented this. I would not be surprised if he was encourgaed to take the positions he did.
Andy
By C. H. on Sep 19, 2006 | Reply
If anything, I’d say their risk management team is a total failure. Most traders will leverage to the max, and take the riskiest trade they can get their hands on, looking for home runs. What’s the worst thing that can happen to them? Well, losing their jobs! If you ask me, that’s one attractive risk/reward scenario. I can tell you that I’ll be doing the same if I’m managing OPM.
I’m certain these traders (who blow up) know about the risk, and they do understand money management. Most of them practice it because they are on a short leash, and the risk management team is watching over the shoulder. How do you expect Hunter to nail that $100 million bonus if he manages the portfolio as if it has his mom’s money?
By Duru on Sep 20, 2006 | Reply
Thanks Mike for the editorial!
By joey b on Sep 20, 2006 | Reply
Don’t say they’re ruined…they aren’t.
By eR0CK on Sep 20, 2006 | Reply
Exceptional post Mike. It’s nice to learn from other mistakes rather than our own. This only emphasizes the important aspects of trading you stress nearly everyday!
-Erich
By Michelle on Sep 20, 2006 | Reply
Good luck with the webhosting change.
Hedge funds, like some entertainment companies, cultivate superstars, and then discard the ones that completely blow up (like Mel Gibson), and go find another one. Star traders are the rock stars in the world of investing. So I agree with Andy in part, the management played a big role in this debacle.
By Bill a.k.a. NO DooDahs on Sep 20, 2006 | Reply
I’m hearing over and over that this wasn’t a directional trade, but a bet on continued convergence/divergence of different related entities, long/short different far-into-the-future contracts. If I’m not mistaken, this is similar to the strategy that blew up LTCM (where the bet was con/di-vergence on interest rates).
My feeling is these are negatively-skewed, high-batting average strategies - precisely the kind that are likely to produce many months of fairly consistent outperformance punctuated by an occasional blowup. Such strategies tend to have a high Sharpe ratio …
By giltomms on Sep 20, 2006 | Reply
Hi all, i’m gianluca from Italy….
anyone has a performance table or a graph, over last years, of this “disaster” ?
By dccountry on Sep 20, 2006 | Reply
The guys at Amaranth had everyone fooled in believing that they actually made any money. With the size of the position they put on (my guess around 250,000 contracts) they basically moved the illiquid market in his favor. If they would have tried to unwind the spectacular paper gains in August they would have moved the market against himself just like what is happening to him today. Their goal was to survive to the end of their fiscal year and get paid huge cash performance bonuses and leave this huge position still on the books. They got into a roach motel where it was easy to get in but impossible to get out. Even great trading firms like Goldman and Morgan Stanley never take bets even a tenth the size of this incomphrensible non-diversified zero-sum bet the ranch wager.
By dccountry on Sep 20, 2006 | Reply
You have to ask yourself how is the recipient of the Amaranth positions Citadel and JP Morgan going to get out of this huge and long-tenored trade? I sure they took over the positions at an extremely favorable price. They are smart enough not to hold such a sizable position. They are now long winters and short summers in 2007, 2008 and 2009 and maybe even further. the back end just doesn’t trade that often, and when it does all the professional trader know about it move move their bids further away. I guess they”ll have to “leg” into the trades by taking one side at a time and run front to backs. Amaranth will have loss and hopefully the others won’t lose anymore. I’m sure Citadel and JP Morgan will book huge gains on their new position and over time will lose money as they unwind it.
By dccountry on Sep 20, 2006 | Reply
Its a zero-sum game in the futures markets. For every winner there is a loser. However, there are transaction costs. So as a whole the expected value of trading will be less than zero. So I can’t understand why people pay management fees of 2% of assets and 20% performance fees so the hedge fund manager can bet red or black or odds or evens.
By dccountry on Sep 20, 2006 | Reply
The tradition of billion dollar megalosers in commodities continues. First there was MG (out Germany) with $3bn in losses, then Mitsubishi and Mr. Nakamura in copper and then there was the power/energy trading companies of El Paso, Enron, Williams, Dynegy, Duke and TXU (Europe). This won’t be the last one. With the downturn in crude I wonder who is going to be next?
By dccountry on Sep 20, 2006 | Reply
Surely, the government regulators and legislators must be wondering how much Amaranth and this pack of energy hedge funds has influenced the price of natural gas. Look at the dramatic fall in the past few weeks. Every other drop of this magnitude has been after it was deemed there was enough gas for the balance of the winter season. Watch out for a tax on energy trading. It would reduce the incentive to trade and the volatility. On the flip side it would not help our energy dependence on the Middle East, Russia, Venezuela and the like.
By Michael on Sep 20, 2006 | Reply
Andy and C.H., very true. They’re all at fault.
C.H., excellent point about running OPM.
Joey,
I think they are runied. If they calculate their fees based on a high-water mark then it’s likey game over for them. They’d be better off liquidating and starting over.
By aardvark on Sep 21, 2006 | Reply
The best time to harvest Amaranth leaves is when the plant has stopped flowering and started producing grain. Up to 25% of the total leaves the plant produces (about 10 leaves) can be cut without affecting the plant’s grain production. About 5 tons of leaves can be harvested per hectare, a very large amount considering what an excellent food source amaranth leaves provide.
The best time to harvest Amaranth positions is when they are deeply underwater and are producing massive downside deviation. Up to 65% of the value of the fund(about 10 natural gas positions) can be cut without affecting the funds overall survival. About $5bio can be harvested by those on the other side of their trades, a very large amount considering how big Amaranth once was.
Hmmmmm
By dccountry on Sep 21, 2006 | Reply
NG in the winter months Nov-Mar for yrs 2007/2008/2009 are getting crushed and they are still overvalued. I’m guessing Citadel/JPM are hurting from this as well. All the long NG hedge funds must be hurting also. They will also find it very difficult to extracate themselves from the backend of the curve.
The Amaranth trade idea was to be long the winter months (Nov-Mar) and short the summer month (Apr-Oct). In th winter natural gas is totally inelastic if there is cold weather and the psychology of inadequate supplies for the remainder of the heating season. If cold weather come early then the doomsdayers say there won’t be enough storage and prices are bid up. Last winter was an example. If there is a series of cold string prices rise and at the end of the winter storage could be completely depleted. An example is Feb/Mar 2003. Prices moved up $5.00/MMBtu one day, but settled $2.50 only $2.50 higher. That’s why Amaranth wanted to long the winter. As a weak hedge they short the summer (Apr-Oct). Demand for injection gas is spread throughout the summer and peak usage for electricity demand occurs in July/Aug. This part of the curve doesn’t rise as fast as the winter in a upward moving market. This was their hedge. They also put on Mar/Apr spread trades. In Feb 2003 this spread absolutely skyrocketed over $3.00 in one day.
The NWS issued a El nino forecast for this winter, gas storage is at an all-time record, the spreads were out of whack and combination of this and the market know Amaranth had this hand led to their downfall. The copmplete downfall was a result their total lack of risk control. NO ONE has ever has a position of this size in such a volatile and illiquid market. My guess is they had on 250,000 + spread contracts. A big swinger would have maybe a 10th of the size. Remember the founder was a convertible bond guy who happened to be trading in a bull market and never having know the other side. Make sure your hedge fund manager has been in commodities and is experienced. There are enough of them so do youe due diligence.
By Jack Doueck, Stillwater Asset Backed Strategies on Sep 22, 2006 | Reply
As investors hurt by Amaranth this month sort through the damage, here are some principles they may want to have in mind:
It goes without saying that a good hedge fund investor has to pick good funds to invest in. The key, though, to success in this business, is not to choose the best performing managers, but actually to evade the frauds and blowups.
Frauds in this business can take on the form of a misappropriation of funds, as in the case of Cambridge, run by John Natale out of Red Bank NJ, or a misreporting of returns as in the case of Lipper, or Beacon Hill, or the Manhattan Fund, or a host of others.
Blowups usually occur when a single person at the hedge fund has the power to become desperate and “bet the ranch” with leverage. The classic example of this week of Amaranth. Amaranths investors will be seeking answers to questions including: to what extent did leverage and concentration play a role in recent out-sized losses.
With both frauds and blowups, contrary to public opinion (and myth), size does NOT matter: Beacon Hill was $2 Billion, Lipper was $5 Billon, Amaranth was $9 Billion).
How do we avoid these two pitfalls of investing in hedge funds?
The answer is long and complex. It takes years to walk on the high wire and not fall off. If you’re a long term hedge fund investor and you haven’t been burned by one or both of these, you’ve been either incredibly skilled or incredibly lucky. I should know, for I have been burned by both of these. We have invested billions of dollars in hedge funds over the last ten years in this business. We have done well despite our battle scars and thankfully we have been blessed with a lot of good luck from above.
Suffice it to say that this should be the main question investors should be focused on as they interview and select hedge funds to entrust their dollars to.
Jack Doueck
Stillwater Asset Backed Strategies
Stillwater Capital
By Michael on Sep 22, 2006 | Reply
Excellent points Jack. You make a good case for doing due diligence on funds as well as diversifying among several funds.
By hammer on Sep 24, 2006 | Reply
Amaranth told one story and did another thing. In May when they lost a $1 billion they said they were going to reduce their risk. From the looks of it they actually increased their risk with more size and less diversification. There’s only so many ways they could trade natural gas. Either the price goes up or down, volatilty goes up or down, and spreads go up or down. These things often happen in the same direction. Although they said it wasn’t a directional bet; it was really a directional bet on a spread. How was this infamous Mar/Apr spread goping to blow out instead of collaping like it did unless the market was moving up. The spread was definitely less risky than trading outright flat price. But given they had +250,000 spreads on every move was risky. The last guy who tries to corner the market, or “bully” the market was Bunker Hunt. He was the only guy in prior history who lost billions of his wealth in trading commodities.
Normal trading strategies using sell stops didn’t apply to them. They had on so much size on that they couldn’t sell fast enough to get out of the way. The position took them 2 years to build up. There was no way they were going to unwind it in a day or a week.
By Kelley Ritchey on Sep 26, 2006 | Reply
I’m surprised the focus is on the trader and not the risk management team. This was reportedly a multi-strategy fund. From their website: “Amaranth’s investment professionals deploy capital in a broad spectrum of alternative investment and trading strategies in a highly disciplined, risk-controlled manner.”
Maounis talks of the improbable move in natural gas as justification for the losses, but the thing that is most striking is that it appeared that there was a huge directional bet made. Were the risk managers on an extended vacation while trader Hunter put on trades from his Calgary base? Did Calgary experience a huge September snowstorm that wiped out all communication?
I guess multi-stratgy means more than one strategy, so Amaranth meets the definition, but natural gas is a volatile commodity. Maybe it deserves some allocation, but 50% of a multi-strategy fund?
You got to be kidding me!
By Michael on Sep 26, 2006 | Reply
Kelley,
I’m not sure whose focus you’re talking about but I’m with you 100%. That’s why I start off by saying “hedge funds” don’t understnd basic principles like position sizing. And I also referred to the lack of oversight by the risk management team later.
By hammer on Sep 26, 2006 | Reply
Kelley, your right the fund should have been advertised as a energy commodities fund with some minor focus on debt-trading. Maybe only 58% of the capital was allocated to natural gas, but on a risk adjusted Value at Risk it probably represented 80-95% of the firm’s capital. Plus there were other commodities they could have traded such as oil, copper and gold which also had justifable fundamentals that warranted price increases.
If Hunter was an orange juice or a pork belly trader would he have bet the ranch on that one commodity? What multi-strat firms have this strategy with combining large commodities business with tame debt markets. Investors should pay attention.
By Alice on Sep 28, 2006 | Reply
Risk of ruin was ignored because if you only bet 1% of your wad, even if you get a 100% return, it won’t give the kind of return you want on the other 99% of your portfolio. ‘Multi-strategy’ seems to have been a misnomer. Accordingly, I don’t see how Amaranth can hold investors to any applicable lock-ups, as the magnitude of losses means the promise of diversity of investor assets was ignored.
By john on Sep 29, 2006 | Reply
Amaranth pushed these spreads to over 2 std. over any mean estimate. Almost all hedge funds…including Citadel were short this so by taking over the positions they simply cover the short and go long. The real sh1t hits the fan in a hurricane season with major shortage in storage…thats what they bet on…the spread would have gone from 3 tro 10 plus…u cant even price it in!
By hammer on Sep 29, 2006 | Reply
john, you’re right, BUT there was no storage shortfall, instead this is year because of the previous warm winter and moderate summer and lack of hurricanes was in polar opposite to what Amaranth was betting on. They got into a roach motel position. It got so big and Hunter couldn’t get out without suffering huge large losses. He had a good 2 years pushing the markets around. Now he’ll live the rest of his life in infamy as the “6 billion dollar man.”
By money fellow on Oct 25, 2006 | Reply
thanks a lot Mike