The loss—an enormous one by any standard—is a useful reminder for fund investors. First, it suggests once again that there is reason to be concerned about retail and institutional investors’ increasing fascination with hedge funds. Only a few days ago, the manager of BT’s pension scheme said it was doubling the fund’s stake in hedge funds and other alternative investments from 7% to about 15% of assets. Big pension funds in the US have also been
stuffing money into hedge funds.
These investments aren’t necessarily a bad idea—if used well, hedge funds can help diversify a broader portfolio. However, their lack of transparency, ability to engage in high-risk tactics, and high costs make them considerably riskier than investors may be assuming. The fact that highly sophisticated institutional investors were invested in Amaranth suggests just how hard it can be to manage these risks, even for the most knowledgeable professionals. Various media accounts have noted that its roster of shareholders included Morgan Stanley, Goldman Sachs, Pension funds for the states of New Jersey and Pennsylvania and for the county of San Diego in California.
A Lesson in (non) Disclosure
The reporting issue is very real. Hedge funds do not have to report their performance publicly unless they choose to. This suggests a natural upward bias in reported performance, as firms have strong incentive to report returns for funds that have done well, but not for those that have fared poorly. Further, information about the evolution of a fund’s strategy may be slim to none. Amaranth, for example, was by most accounts a fairly cautious fund that was perceived to have sound risk controls. Then a single trader started making high returns for the fund with bets on natural gas futures. He was apparently given more leeway in light of his strong performance—sufficient leeway, as it happened, to cause the fund to lose more than half of its investor’s capital in an extremely short period of time.
Look Forwards, Not Backwards
Amaranth’s fall from grace also serves as a warning for those seeking to chase the strong performance of energy and other commodities in recent years. Only a few weeks ago, a firm announced the launch of a batch of exchange-traded securities that would track commodities futures. If you thought they were a good idea, the Amaranth example should give you pause. Here we have a strategy being run by a sophisticated energy trader, backed by quantitative risk controls, and the fund still lost half its asset base. The leverage employed by Amaranth made the problem much worse than it otherwise would have been, but it still shows the risks inherent in betting on the direction of commodity prices.
Too Much of a Good Thing?
Hedge fund managers may be being forced into riskier bets by the flood of new money into the sector. The industry has grown hugely over the past 15 years—one estimate is that total assets in hedge funds have grown from $39 billion US in 1990 to $1.3 trillion US in March 2006--and hedge funds and funds of hedge funds are now commonplace vehicles. With many offerings using the same or similar strategies, it follows that market inefficiencies that savvy managers could previously exploit to reap outsized gains might have become less profitable.
If that is so, hedge funds will have to rein in their costs to maintain appeal. Put bluntly, the industry’s fees are high, with a 2% annual charge plus 20% of profits not an uncommon structure. People will pay this when you can deliver meaningful outperformance net of fees on a regular basis, but hedge funds appear to be struggling to do this. Morningstar data show that returns in most categories of hedge funds have lagged global and UK equity indexes and open-end UK equity funds and unit trusts over the past three years. A 2005 study in the Financial Analyst’s Journal by Burton Malkiel and Atanu Saha also showed that—when corrected for reporting biases—hedge-fund returns had substantially lagged the S&P 500 index between 1995 and 2003. Although hedge funds in aggregate also displayed much lower standard deviation than the S&P 500, the authors concluded that the risk of selecting a poor performing or a failing hedge fund was substantial.
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