Chances are, if you're remotely interested in the world of investing, you've been as stunned by the news regarding Amaranth as I have. For those of you who don't pay attention to the public equity markets with regularity, Amaranth was a high-flying hedge fund that managed to lose more than $3 BILLION in a matter of two weeks when it's bets on natural gas futures went against the former star fund. The fallout has been far-reaching, as Amaranth's LPs begin to come out of the woodwork to acknowledge their exposure to the fund's losses. As one might imagine, a blowup of this magnitude invites plenty of discussion.
For my money and time, the best perspective I've seen on the Amaranth situation was by Barry Ritholtz:
- Big Picture Speculator: Whose To Blame for Amaranth's Losses?
As a hedge fund manager who has undergone the process of courting LPs, I can tell you that Barry's perspective is spot on.
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, and I am forced to go to a 2nd and 3rd option:
"Give us more details on what you want to do. What performance would you be happy with?"
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)."
"So you are a relative (rather than absolute) performance fund?"
Answer 2b: "Well, most funds actually are, despite their claims of absolute performance regardless of market conditions. Consider the mediocre performance numbers from most funds recently when the market's been range-bound. Its been pretty weak, and that's no coincidence. There are only a handful of true absolute performance funds with great long term track records (and if you are talking to me, its because you cannot get into them)."
Now comes THE QUESTION. This is the one that gets people into trouble:
"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. (God bless Jim Simons, who actually can honestly say that). That's what too many investors are looking for; its nothing more than the greed factor at work. They don't say it explicitly, but its true: We want you to outperform the long term S&P500 benchmark by 300-400% annually (and we don't care about mean reversion). We really don't care how you do it. We want outsized profits. WE WANT THE LATE 1990S AGAIN.
Money raisers and some GPs have long ago figured this out. 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 for 99.8% of the people who utter it. The vast majority of funds will not out-perform the indices dramatically year after year. We were fortunate -- we ended up with investors who understood this; Then again, we are a small fund, and not a $9B giant.
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.
As the market volatility has ebbed, and the number of hedge funds (and the total assets under our collective management) has skyrocketed, it's become increasingly more difficult for even the best performing funds to generate alpha. As a result, some funds are taking more aggressive approaches to generate market-beating returns.
The Myth of the Efficient Frontier
I'm not going to pretend that all fund managers and strategies are created equal. It's certainly possible to generate better returns with a similar risk profile (or worse returns with a less risky profile), but the Amaranth debacle illustrates just how much risk aversion and profiling is NOT effectively utilized by a lot of the people and institutions that claim otherwise. Basic portfolio management theory speaks of the efficient frontier; under what expected return could Amaranth's LPs have justified the inherent risk profile?
Note: Running a close second to Barry's take on this situation was Roger Ehrenberg's take.
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I imagine you saw this one too about MotherRock:
http://www.thestreet.com/newsanalysis/wallstreet/10309030.html
Posted by: Niel Robertson | September 22, 2006 at 08:51 PM