Hedge fund losses? Greedy investors? What else is new?

Date: Wednesday, September 20, 2006
Author: Derek DeCloet, Globeandmail.com

A month ago, Brian Hunter was one of the hottest energy traders in Calgary. Today he's a walking cliché. When an investor blows up in spectacular fashion, the scrutiny gets personal. So on Bay Street yesterday, people enjoyed a moment of schadenfreude at Mr. Hunter's expense.

They gossiped about his trades and cackled about his lavish paycheque and the Ferrari (naturally) he uses to navigate the Cowtown traffic. (Is there a single successful trader, anywhere, who drives a sensible car?) Yes, hedge fund guys like their money and most of them, Mr. Hunter included, like to show it off. That's not necessarily a bad thing. But it's a big part of the reason why the industry is beset with periodic blowups like the one that's hit Amaranth Advisors, his employer.

Amaranth isn't the first hedge fund to get crunched by steep losses and won't be the last. If anything, you're going to see more of these meltdowns, not fewer. And guess what? That's not a scandal. It's certainly not a case for bringing the regulators in to watch hedge funds the way they watch mutual funds.

No one, outside of Amaranth and its brokers, can precisely describe all of the trades that caused Mr. Hunter to lose billions of dollars in a week. But a picture has emerged of a trading strategy that bet natural gas prices this winter would rise more, or decline less, than prices for gas to be delivered next spring.

Any number of things -- a hurricane, an Indian summer in the U.S. Northeast -- could hurt gas inventories, cause a price spike for the winter season, and give Mr. Hunter the money for, say, a second Ferrari. The weather hasn't co-operated: There have been no repeats of Katrina and in much of North America, it's been a lovely, temperate fall.

Yet Mr. Hunter's bet was quite logical, and may even turn out to be right. The price of a barrel of oil today is about 12 times the price of 1,000 cubic feet of gas. The usual relationship is about six to one. At today's prices -- around $5 per mcf -- a lot of natural gas producers will make little profit and some are already cutting back on new wells, which will reduce supplies. It's easy to make a bullish case for natural gas over the next year.

The problem is that when you're doing it with borrowed money, as Amaranth was, you can't wait that long. Bay Street sources suggest that Mr. Hunter's was leveraged at least five-to-one -- that is, he had borrowed at least $5 for at least $1 of equity in the fund -- although some believe it was higher. "Even a good trader makes money only 55 per cent of the time," says a risk manager at one Toronto brokerage. "The obvious problem here is uncontrolled leverage."

Why would a hedge fund take a trade that's already risky -- a bet on the weather -- and add risk by using so much debt? We'd suggest three reasons: because they have a financial incentive to, because they have to, and because that's what their customers want.

Mr. Hunter's pay package last year was reported to be $75-million to $100-million (U.S.), based on his earning $800-million for the firm. If true, that means he got at least a 9.3-per-cent cut of the profits. What are the odds that his employment contract also requires him to share in the losses? Zero. But then, that's the model the entire hedge fund business works on. The manager gets a share of the upside (usually 20 per cent) but not the downside.

But "upside" is getting harder to find, with about 8,000 funds chasing the same pool of investment ideas. Even in Canada, where the hedge industry is smaller, it's tough. Globefund.com lists nearly 300 "alternative strategies" funds. Their average return over the past year (to Aug. 31) is 8.2 per cent -- barely half of the S&P/TSX total return index.

No wonder hedge managers turn to leverage as a way to juice the numbers. Their investors are a demanding bunch and as focused on short-term results as the managers are. Barton Biggs, the former Morgan Stanley strategist who wrote a book about his experience starting a hedge fund, tells of being paralyzed with fear that if he doesn't perform well in the first few months, clients will pull their money and the fund will be toast. That's what a 30-year reputation on Wall Street gets you in the hedge fund business: a few months' grace.

Amaranth's investors must have understood that their huge returns came with large risks. They surely knew that Mr. Hunter and his colleagues had all the incentive in the world to make monster trades, and that sometimes trades go sour. (If they didn't, they're remarkably naive.) But if investors want hedge funds to take less risk so they don't blow up, they should realize that will come at a price, too.