From the December 01, 2006 issue of Futures Magazine • Subscribe!

A billion here, a billion there...

Hedge funds are a little like referees and umpires, you don’t pay attention unless they do something wrong. Well, since the collapse of Long-Term Capital Management, no hedge fund has received as much ink as Amaranth Advisors. Losing $6 billion dollars in a little more than a week’s time will do that.

Much of the early attention focused on boiler plate warnings regarding hedge fund risk coming from usual sources. While something seriously went wrong with this $9 billion fund, its high profile investors were too smart to have invested in a fund that would lose 65% of its value in a couple of weeks on a simple long natural gas bet. That is not to say that there weren’t warning flags that were missed.

For example, Amaranth was purported to be a multi-strategy hedge fund. Multi-strategy funds don’t lose 10% in a month in one market, let alone 65% in a week. Amaranth appeared to have fallen in love with the energy sector and its all-star 32-year-old trader Brian Hunter. Another warning should have been its reported double-digit drawdown in May.

Deconstructing Amaranth

Hilary Till, principal at Premia Capital Management LLC and research associate at the Edhec Risk and Asset Management Research Centre, attempted to deconstruct Amaranth’s positions in a paper for Edhec. Till compiled all of the public information on Amaranth and was able to come up with a returns-based analysis of the fund’s energy strategy.

Simply stated, Amaranth had a natural gas spread strategy that stood to benefit from a couple of different weather related scenarios. They shorted summer and fall gas contracts and went long winter contracts. The strategy would have benefited from another active hurricane season (see “Long hurricanes,” above). Till suspected they were also long March gas and short April gas, a position that would benefit from an unseasonably cold winter as storage facilities would have become depleted at the tail end of the season (see “Chasing spring,” below). Amaranth appears to have put these positions on for every year out to 2011.

Till says there were two rationales for the fund’s strategies. “The rationale for the bear-calendar spreads is related to the tendency over the last two years for the calendar spreads to go beyond full-carry levels by September. About a week after Hurricane Katrina hit the bear-calendar spreads became profitable because of the disruption to seasonal storage operations. The curve eventually went into further contango. The rationale for the March-April spreads may have been as follows. The March contract expires at the end of February. If one has an extremely cold winter, even if one starts out with a lot of natural-gas-in-storage, it is possible to have a stock-out situation by the end of February. If this scenario occurs, there is no cap on how much March can rally with respect to the rest of the curve. The March-April spread may be interpreted to have historically had a long-option-like payoff profile.”

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