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Hedge fund math: Big paydays = big temptation

Date: Thursday, September 28, 2006
Author: Eric Reguly, Globeandmail.com

The $1.2-trillion (U.S.) hedge fund industry must be sighing with relief. What ailed Amaranth doesn't appear to be ailing everyone else. It is obvious, surely, that Amaranth was utterly reckless in placing roulette-style bets -- black or red --on one asset class. The wrong colour came up and the firm is finished. Rival hedge funds would never put all the chips on a 50/50 outcome.

Forget it. The hedgies are virtually programmed to make the same mistake. What is astounding is that Amaranth and Long Term Capital Management were the only multibillion-dollar blowups of the past decade. There will be more -- there has to be -- for the simple reason that the funds' compensation schemes encourage unusually risky bets.

When you buy a mutual fund, the fund company typically pockets an annual fee of 2 per cent (or 200 basis points) of the value of the assets. Hedge funds also charge a 2-per-cent asset fee, but that's barely enough to get the lads out of bed in the morning. The kicker is the incentive fee -- usually 20 per cent of the fund's return (in a few brazen cases, 30 per cent is charged). In hedgie argot, this is the "2 and 20" plan and it's not negotiable.

Let's look at Amaranth's fatal bet. In its glory days, Amaranth was a $9.5-billion fund. The fund bet, and lost, about $4-billion when its Calgary trader, Brian Hunter, took an exceedingly bullish and exceedingly wrong view on natural gas futures (the fund's total losses climbed to $6-billion when post-blowup trading positions were unloaded at deep discount prices).

Mr. Hunter was swinging for the fences. At one point, Amaranth had devoted an astounding 56 per cent of its $9.5-billion in capital, or $5.3-billion, to energy trades. Now assume 4-to-1 leverage, that is, $4 was borrowed for every $1 in capital (Amaranth admits to having used 4.3-to-1 leverage in June). That would raise the total bet size to about $21-billion.

Now assume the bet went Mr. Hunter's way and the fund made 50 per cent on the monster position, or a bit more than $10-billion. Mr. Hunter and Amaranth's founder, Nick Maounis, would have been on the cover of every capitalist-shill magazine on the planet. George Soros and Paul Tudor Jones? Never heard of them.

Even better, 20 per cent of the profit -- $2-billion -- would have stuck to Amaranth and its partners. Each of them could have bought a used aircraft carrier for a yacht and moored it at an Amaranth-owned archipelago. A potential profit figure that large is not out of the question, given the size of the fund's energy exposure. Yesterday, the fund revealed that energy book profit was almost $2.2-billion in the year to the end of August, the month before Vesuvius buried the Amaranth Pompeians. The standard 20-per-cent skim would have earned the partners $440-million.

In principle, there is nothing wrong with performance-based compensation. But when it's this rich, you create an often irresistible urge to keep feeding the slot machine. There are 7,000 hedge funds. They go out of business all the time, just as companies hit the wall and fall into bankruptcy protection. You just don't hear about the smaller ones. MotherRock, an energy hedge fund, collapsed in early August following a reported loss of $200-million or more on natural gas trades. We don't know whether MotherRock had a Brian Hunter mini-me.

The Amaranth disaster has sent ripples of fear through the industry. The hedgies will examine their portfolios closely to make sure the bulk of their capital isn't in the hands of some kid who thinks he's a whiz at egg or camel-leather futures. The risk management book will get rewritten.

But how long before the hedgies start taking crazy risks again? The "2 and 20" incentive remains in place. What's more, hedge funds' returns are mediocre at best. The widely followed Credit Suisse/Tremont hedge fund index reports a year-to-date return for multistrategy funds (as opposed to narrowly focused funds such as convertible arbitrage or emerging market funds) of 7.9 per cent. That's nothing to cheer about when you consider the S&P 500 went up 5.8 per cent over the same period.

As returns wane, hedge fund investors will wonder why they're risking their loot, and giving away 20 per cent of any profits, to managers who don't beat the index by much, if at all. This will put pressure on the hedgies to seek higher returns to justify their Ferraris and Greenwich mansions. Higher returns require higher risks. Before you know it, bet-the-ranch-style strategies return and funds hit the jackpot. Or, like Amaranth, they blow up.

Unlike the Long Term Capital collapse, the Amaranth fiasco caused no panic among the other hedgies. Amaranth was the author of its own misfortune (they would say). It was an isolated case. We'll see.

The 20-per-cent profit motive says it will happen again.