Despite Amaranth’s $6-billion one-week loss in September, the largest in hedge fund history, industry sources agree that the effect was little more than a blip. The fund did not default on any of its counterparty obligations, and the impact on global financial systems was essentially negligible. However, the sheer size and speed of Amaranth’s losses spotlight the very risky pursuit that hedge fund investing can still be.
In the wake of the headline-grabbing meltdown of Long-Term Capital Management (LTCM) a decade ago, which nearly imploded the world’s financial markets, hedge fund managers and the prime brokers that serve them have sought to avoid a repeat of such a crisis. Securities regulators also have been looking at hedge funds to figure out both how to guard against systemic risk and to protect investors who can’t seem to get enough of managers in this market.
Over the past decade, progress has been made. Controls have been implemented to decrease some of the larger risks and improve risk-management procedures, and leverage has been reduced. Also, liquidity mismatches, which arise when managers invest in illiquid and inefficient markets but the underlying investor bases have weekly or monthly redemptions windows, have been mitigated. Methods include required holding periods that are now quarterly, annual, and even multiyear; restrictions on withdrawals such as gates (limits on the percentage of fund capital that can be withdrawn); and relatively large redemption charges that penalize withdrawals taken in the first year (or first few years).
HUGE CASH INFLOWS. Return expectations are now much lower compared to the high double-digit expectations (granted, frequently reached) of the late 1990s. Also, the lack of strong and sustained market trends, as well as of range-bound markets, has done a lot to push hedge fund managers to diversify their investment strategies as well as the instruments in which they invest.
The market has responded with huge cash inflows, yielding pools of assets that the most recent published reports put at a cumulative $1.3 trillion and growing fast, as well as substantial activity in exchange-traded funds, which hedge funds use extensively to gain market exposure. Although recent returns have trailed the global equity markets’, hedge funds’ longer-term risk-adjusted absolute return approach continues to attract assets. With the perception of greater safety and rationality, even pension funds and endowments are allocating a portion of their assets to hedge funds. What was once a market dominated by high-net-worth investors is now dominated by institutional investors.
However, there are no rules to prevent a fund’s traders from placing audaciously large bets with assets on hand, no matter what the fund’s investment style is supposed to be. According to published reports, that’s exactly what happened at Amaranth. Although it was styled as a multistrategy diversified fund, it invested more than 50% of its assets in the energy sector.
One Costly Mistake
In the current low-return environment, the pressure on many hedge funds to gain outsize returns has caused some managers to drift into areas where they’re not very experienced. And with so many hedge fund managers chasing all the same pickings, it’s tougher to find a sure bet. (More than the number of managers, it’s probably the amount of assets, availability of analytical tools that were once proprietary, and overall low volatility across a number of asset classes that have pushed down returns.)