Lessons from Amaranth's $6-billion mistake

Sometimes the market zigs when an investor expects it to zag. It happens to most of us at one time or another. We buy a stock or fund units a day before they drop. Or we sell or redeem just before they jump a couple of notches.

Most of us don't suffer any permanent damage, our egos quickly recover, and we may even learn a lesson or two. Of course there are exceptions. A case in point is Amaranth Advisors LLC and its wager on the direction of the price of natural gas.

As widely reported, the Connecticut-based hedge fund operator bet incorrectly that the price of natural gas would rise higher. The end result is that $6 billion of wealth under its management evaporated in September when gas prices fell. It was left with only $2 billion, down from $8 billion. (All dollar amounts are in U.S. currency.)

It will take Amaranth managers only about 14.5 years of 10% per annum compound returns to get back to $8 billion from $2 billion. And that assumes investors won't redeem whatever is left.

Amaranth Advisors has been in Canadian news for other reasons lately because of its 15.3% stake in Cinram International Income Fund (CRW.UN/TSX) through its Canadian operations Amaranth Advisors (Canada) ULC and Amaranth Canada Trust. It wants Cinram's trustees to look at selling the company to maximize shareholder value.

However, it's the $6-billion loss that will be remembered, not Amaranth's efforts to maximize shareholder value at Cinram. A company news release says Amaranth's investors include sophisticated institutions and high-net-worth individuals. It invests "on a global basis, with a view to identifying and capturing disparities between value and price in financial markets worldwide."

Those of us who are not sophisticated institutions and who don't have millions to invest can learn a few lessons from Amaranth's debacle:

• Remember to diversify. No matter how much analysis you do, or how smart you are, or how sophisticated are the managers you choose, something can go wrong. You were told in grade school not to put all your eggs in one basket. You didn't know it at the time but you were being given your first lesson in investing.
  
  
• Investing with borrowed money can be risky. Sure, if you invest borrowed money and the investment goes up you will do much better than if you invested only your own money. But if the investment falls, or takes longer to go up than you anticipated, your equity will be eroded or worse.
  
  
• Lack of diversification and leverage are a dangerous combination. You must understand the potential impact on your net worth if you put most of your money and whatever you can borrow into a risky investment that goes down. You could end up losing most of your capital permanently. Of course, an even worse scenario is putting borrowed funds in some hedge fund whose manager levers the money you put in and bets a major portion of it on something that goes wrong.

I realize that many fortunes have been made by investing borrowed funds in a single investment. But even investors whose risk tolerance includes speculation are unlikely to have the risk capacity to absorb a loss of a major portion of their capital. The decision on whether to invest should weigh the risk against its potential return.

It's also important to understand that a hedge fund is not a mutual fund with different bells and whistles. The regulations that govern mutual funds prevent the use of leverage within a fund and require a minimum level of diversification. There are no such rules governing hedge funds, which is one of the reasons they are speculative. In fact, it is normal for hedge funds to use borrowed funds as part of their investment strategies and in some cases (but not all) to concentrate positions in the hope of making a killing on the market.

It comes down to knowing what it is that you are contemplating buying. For instance, if in fact you want a fund that takes large risks, then by all means seek out those that have concentrated positions. Just make sure that your leave yourself enough to get by on if things turn sour.

Hedge funds don't have to be all-or-nothing situations. Investors buy hedge funds because they expect they will do well when traditional stock-market investments produce negative returns. If that happens, the overall portfolios of those investors will be less volatile than portfolios that invest only in stocks.

If this suits your objectives, then generally the funds you should consider are ones that are funds of funds and use a number of hedge fund managers that have different management styles and mandates. That way, the theory goes, if one or even several use much of the money they manage, the profits of the others will offset the losses.

That's the way it should work. Read the offering documents thoroughly. You want to make sure that if one sub-advisor loses all the money under its management, the creditors can't lay claim to any other assets in the fund. Ask your advisor to review all the risk factors with you so you will fully understand your exposure in the event the fund you choose zigs when you expected it to zag.