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.

Wednesday, September 27, 2006

Barry Ritholz Says Amaranth's Investors Knew Damn Well It Was Likely to Blow Up

Barry Ritholz:

The Big Picture: Who's to Blame for Amaranth's Losses?: Answer: their investors.... I have spent the past 18 months or so traveling around the United States, speaking with my limited partners (i.e., investors) and with potential investors for our hedge fund.

My experience with this is why I have been watching the unfolding debacle at Amaranth Advisors’ with some bemused detachment....

[W]e have had conversations with some very intelligent people who were a pleasure to meet with; Brilliant, fascinating, successful folk with interesting lives and of great accomplishment. However, once we sat down with their financial advisors - lawyers - accountants, things became, well, repetitious. In every meeting, there were some variations on the same conversations....

What's your track record? (Good)
How much skin do you have in the game? (alot)
How is Alpha generated (our models keep us on the right side of the major trend, and avoid big counter-trend moves)
What do you think will happen to the economy and the market?
(I don't know, but here's an underappreciated possibility . . .)
What is your Gamma ? (I neither know nor care; This isn't a B-school exam)

Then comes the exact same question, which I (foolishly) answer honestly:

"What sort of performance are you looking for?"

I usually start with: "It depends upon what the market offers us; If we remain range-bound, it will be difficult to put up great numbers without a lot of leverage or a lot of risk (or both), and we don't do that. We do particularly well, however, in major dislocations or strong rallies."

My initial answer is rarely accepted....

Answer two: "What we want is irrelevant; Its what we can reasonably do while still managing risk, and not overleveraging. Our goal is to outperform the S&P500 with less risk, and in the event the SPX is negative, still have positive expectancy (i.e., be up when the indices are down)."...

Now comes THE QUESTION.... "We are looking for a number. What should we expect from you in the first 2 years?"

What they want to hear is "I am going to do 30-40% annually, fully hedged."

I don't say that, because it isn't true.... You have a few choices: you can answer the investors' questions honestly -- or to quote Ray Davies, you can give the people what they want (or think they want):

"We expect gains of 35-45%, with minimal risk or leverage. Our black box algorithms have been backtested, and generate better numbers than that, but we would rather under-promise and outperform."

Of course, that statement will be nonsense....

There are some funds that aim to fill this niche. They use lots and lots of leverage, play the highest beta moves, load up on derivatives, put up good numbers for a stretch. Eventually, they do one of two things: They take on some risk management -- lower their volatility plays, reduce leverage, aim for more sustainable gains.

Or they blow up....

So Amaranth put up great numbers for a while. And now we know how they did it: They took extraordinary risks, using lots of leverage on the highest beta trades. And when one went against them, it blew up, and they lost a few billion dollars in a week. Don't blame them. Their investors demanded huge returns, and they turned a blind eye to the inordinate amount of risk required...

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