Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Tuesday, September 19, 2006

Annals of Financial Legerdemain: Natural Gas Futures and the Mystical Power Grain of the Aztecs

The Economist writes about hedge funds and others:

Economist.com: The industry is splitting in two--and investors are gambling on the expensive bit: IT HAS never been easier to pay less to invest. No fewer than 136 exchange-traded funds (ETFs) were launched in the first half of 2006, more than in the whole of 2005.

For those who believe in efficient markets, this represents a triumph. ETFs are quoted securities that track a particular index, for a fee that is normally just a fraction of a percentage point.... No longer must investors be at the mercy of error-prone and expensive fund managers.

But as fast as the assets of ETFs and index-tracking mutual funds are growing, another section of the industry seems to be flourishing even faster.... "[A]lternative asset investment" (ranging from hedge funds through private equity to property) grew by around 20% in 2005, to $1.26 trillion. Investors who take this route pay much higher fees in the hope of better performance. One of the fastest-growing assets, funds of hedge funds, charge some of the highest fees of all....

If the fee paid to the fund manager increases, the return achieved by the average investor must decline. After fees, hedge-fund returns this year have been feeble. From January 1st through to August 31st, the average hedge fund returned just 4.2%, according to Merrill Lynch, less than the S&P 500 index's 5.8% total return.

So why are people paying up?... That such fees endure might suggest investors can identify outperforming fund managers in advance. However, studies suggest this is extremely hard.... [E]ven where you can spot talent, much of the extra performance may be siphoned off into higher fees.... And yet investors may be willing to gamble, despite the higher fees, because they desperately need high returns.... Peter Harrison, chief executive of MPC, a fund manager, says that American pension funds have analysed their liabilities. "They need more than 6% to make up the shortfalls in their funds. Whether they earn alpha or not, they have to roll the dice and try to get it."...

[I]nvestors will probably keep pursuing alpha, even though the cheaper alternatives of ETFs and tracker funds are available. Craig Baker of Watson Wyatt, says that, although above-market returns may not be available to all, clients who can identify them have a "first mover" advantage. As long as that belief exists, managers can charge high fees.

And its writing is followed by the near-implosion of Amaranth. Which raises the threshold question, "Why in the Holy Name of the One Who Is would anybody invest in a fund named after the mystical power grain of the Aztecs?"

A Hedge Fund%'s Loss Rattles Nerves - New York Times: By GRETCHEN MORGENSON and JENNY ANDERSON: Amaranth Advisors, based in Greenwich, Conn., made an estimated $1 billion on rising energy prices last year. Yesterday, the fund told its investors that it had lost more than $3 billion [i.e., 30%] in the recent downturn in natural gas and that it was working with its lenders and selling its holdings "to protect our investors." Amaranth's investors include pension funds, endowments and large financial firms like banks, insurance companies and brokerage firms. The Institutional Fund of Hedge Funds at Morgan Stanley was an investor in Amaranth; as of June 30, it had a stake valued at $124 million....

[L]ast week, Charles H. Winkler, chief operating officer at Amaranth, had met with prospective investors at the Four Seasons restaurant in Manhattan and reported that his fund was up 25 percent [$2.5 billion] for the year, according to a meeting participant. Days later, rumors began circulating that Amaranth was losing money in one of its natural gas bets, a trade that had generated enormous profits for the fund in recent years. Late in the week, the fund's traders began dumping large stakes in convertible bonds and high-yield corporate debt, securities that could be sold without disrupting the market.

Mr. Winkler did not return a phone call seeking comment.

The scale of Amaranth's losses -- and how quickly they appear to have mounted -- was the talk of Wall Street yesterday.... Amaranth's woes are largely the result of a decline in [futures] natural gas prices that began [sic; should be "begins"] in December [2006], well before the spring months of March or April [2007] when they typically fall off. Amaranth's biggest stake was a combination bet on the spread between natural gas futures prices for March 2007 and those for April 2007. Amaranth had often bet that the spread on that so-called shoulder month -- when natural gas inventories stop being drawn down and begin to rise -- would increase.

But instead the spread collapsed. In the last six weeks, for example, the spread between the two futures contracts ranged from $2.50 at the end of July to around 75 cents yesterday....

The natural gas market is exceptionally volatile, making it an ideal playground for hedge funds that thrive on wide price movements in securities. Natural gas prices are subject to more severe swings than oil, in part because gas cannot be stored easily....

Amaranth was founded six years ago by Nicholas M. Maounis, a former portfolio manager who had specialized in debt securities at Paloma Partners, another large hedge fund.... In his letter to investors, Mr. Maounis, 43, wrote: "In an effort to preserve investor capital, we have taken a number of steps, including aggressively reducing our natural gas exposure."

Amaranth has additional offices in Houston, London, Singapore and Toronto and employs 115 traders.... Its energy portfolio has been overseen by Brian Hunter, a trader who joined the fund from Deutsche Bank in 2004 and conducts trades from his hometown of Calgary, Alberta. Mr. Hunter made enough money at Amaranth in 2005, an estimated $75 million to $100 million, to place him among the 30 most highly paid traders in Trader Monthly magazine....

Last week, in a speech in Hong Kong, the president of the Federal Reserve Bank of New York, Timothy F. Geithner, said greater attention needed to be paid to the margin requirements and risk controls in dealings with hedge funds...

The Fund of Hedge Funds at Morgan Stanley presumably sent a dozen people to do due diligence at Amaranth before it invested its bit of a billion in Amaranth. It's unclear what more Tim Geithner and his people could do. And Amaranth's problems are not related to exposure to systemic or systematic risk.

What did go wrong with Amaranth? If the numbers reported are correct, Amaranth lost $5 billion in less than two weeks.

Natural gas is traded in contracts of 10 billion BTUs--the rough equivalent in energy of 1700 barrels of oil. (One BTU is the amount of energy to raise 1 pound of water 1 degree fahrenheit.) Natural gas is priced in dollars-and-cents per million BTUs. So Morgenson and Anderson's fall in the spread from $2.50 to $0.75 is a reduction of $17,500 per contract. To lose five billion requires that you have been long 290,000 March and short 290,000 April contracts--a notional principle equivalent to three days' worth of the world's total energy consumption.

My suspicion is that there was a "valuation issue." That Amaranth was such a big player in this market that the current spread was simply what Amaranth had made its last trades it. And so if its traders wanted to make it look good on any particular day, all they had to do was buy a little more March gas at a higher price and sell a little more April gas at a lower price, mark their total positions to the market in which they are price setters--and voila! Big profits!

Whether the people doing this knew what they were doing--and whether their bosses knew what they were doing--and whether this is what they were doing--these are all open questions.'

But Nicholas Leeson's $1 billion loss betting on NIKKEI derivatives has now been eclipsed.

The world uses about 1 quadrillion BTUs of energy a day.

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