In September the US Hedge fund Amaranth collapsed losing $6.5 billion dollars over a couple of weeks when its positions in natural gas futures turned bad. With prices falling, Amaranth was unable to off load its position and the losses continued to mount.
While it didn’t cause the sort of near disaster that the LTCM collapse triggered, it did wipe out almost the entire value of the fund which has now been taken over. Here is how the CEO of Amaranth described it:
In September 2006, a series of unusual and unpredictable market events caused the Funds’ natural gas positions (including spreads) to incur dramatic losses while the markets provided no economically viable means of exiting those positions. Despite all of our efforts, we were unable to close out the exposures in the public markets.
Market conditions deteriorated rapidly during the week of September 11. Material losses began early in the week, and we accelerated our efforts to reduce our exposures. On Thursday, September 14, the Funds experienced roughly $560 million in trading losses on their natural gas positions. We continued to attempt to reduce our natural gas exposures, while also selling other positions to raise cash in order to meet margin calls. As news of our losses began to sweep through the markets, our already limited access to market liquidity quickly dissipated.
The fund lost an average of $420 million per day for the first 14 trading days of September, totaling a final loss of around $6 billion.
How does this happen? Hedge funds employ smart people to model the risk on such deals to ensure this type of thing doesn’t occur. While I don’t know what exactly the fund used they should have had some sort of measure like Value at Risk (VAR), and stress tests to try and detect the possibility of such an event occurring. From the statement issued by Amaranth it seems they indicate that such systems failed to detect the possibility.
Our September losses were caused by a combination of highly unusual market behavior – not simply adverse price movements — that not only eroded the energy book’s capital but also virtually eliminated the firm’s liquidity. We had not expected that we would be faced with a market that would move so aggressively against our positions without the market offering any ability to liquidate positions economically.
We viewed the probability of market movements such as those that took place in September as highly remote, and our energy-risk models correspondingly discount the Funds’ exposures to the losses associated with such scenarios. In addition, the trading desk expressed confidence that we would be able to achieve our position reduction goals economically and expeditiously. But sometimes, even the highly improbable happens. That is what happened in September.
One way of looking at this is that this was a failure of their risk management system, but an alternate view is given by Nassim Taleb, a critic of systems such as VAR. On his webpage Taleb writes, quoting the same Amaranth message as above:
How risk managers can cause blowups: “It was not, however, for lack of applying resources or personnel to energy risk analysis that our funds experienced this severe drawdown. (…) we have assigned full-time, well-credentialed and experienced risk professionals to model and monitor our energy portfolio’s risks.”
False sense of security and illusions of knowledge: The problem, of course, is that most of these “hedge fund analysts” giving money to funds use “Nobel crowned” methods that resemble astrology, and use them to allocate to these people. They apply complicated “optimization” methods from past data –but they do not look into the funds’ positions to see if there is a vulnerability to the Black Swan (something that takes 3 minutes). Portfolio theory and “risk management” as practiced by the hedge fund consultants and “allocators” are intellectual frauds.
In Taleb’s view all risk models will be incomplete in measuring the true risk and it is the false confidence given by these models that are a large part responsible for such events. If we believe our models do reflect reality then we will not look at scenarios not predicted by them and therefore discount the possibility of them existing.
In my opinion this sort of thing does not invalidate VAR, but rather is a warning of its limitations. It is not the all encompassing measure of risk, and this is something that risk managers should be aware of. However, I’ve discussed before if the NAB had paid attention to it they could have avoided worst parts of the FX options debacle. VAR is a useful measure of risk, but its not everything.