Big or best fund
Hedge fund due diligence? Many people confuse BIG with BEST. Investors are urged to put more in big companies than small companies! Why? They are even expected to lend the most money to biggest sovereign debt addicts? With hedge funds, there is almost no overlap on a list of the best firms versus the biggest. Media and consultants focus on big firms. Instead I focus on managers that will make me the most money in the future. Isn't that the point?
The AUM sweet spot for risk adjusted returns for most hedge fund managers is in the tens to hundreds of millions NOT billions. Over 90% of the world's BEST hedge funds manage TOTAL firm assets of less than USD 1 billion. In fact I typically advise institutional clients to redeem if a fund gets above that. Apart from the importance of proper due diligence that's the biggest and best lesson to learn from Amaranth and other blow ups/performance disappointments.
Hedge funds are dead. Long live hedge funds. Maybe I consult in the wrong circles but the pensions, sovereign wealth funds and other fiduciary institutions I deal with want a reliable +10% over the long term not ± 30% maybe. There was none of the widely predicted contagion as proper hedge funds either were unaffected or benefited. As in 1998 with LTCM, the demise of an incompetent firm created massive alpha capture opportunities for the rare skilled.
Due diligence issues: - Amaranth
We could all make a massive leveraged bet on one idea but is this what investors want given the possibility of massive capital destruction? The best meteorologists with the fastest supercomputers haven't a clue on next winter's severity so why did Brian Hunter think he had an edge? His energy trading strategy may have been dressed up with spreads, options and "sophisticated" theories but it just amounted to a long natural gas beta bet with scant knowledge of how energy futures actually trade.
1. What it said on the packet versus real contents. Amaranth was clearly not what it marketed itself as. Multistrategy is inconsistent with having 55% of the fund in what was, effectively, one trade. Hedge fund regulation would NOT have prevented this. Soon Nick Maounis and Brian Hunter will be on the road trying to raise money for their new "hedge funds". Securities markets have perfect memory but most investors themselves forget very quickly. No competent manager could EVER lose such a high percentage of client capital. And losing leopards rarely change their speculation spots. Myron Scholes, John Meriweather, Victor Niederhoffer...
2. Risk adjusted returns. Even when Amaranth appeared to be doing well on topline "performance", adjusting for the risk and leverage to generate those returns, real performance was lousy. Amaranth's returns, since inception, were due to luck NOT skill. I remember when Long-Term Capital Management knocked out +40% in 1995/96 and "experts" considered them geniuses. They should have been making at least +200% each year for the risks they were taking. LTCM's risk-adjusted returns even in the so-called "good" times were abysmal. Incompetent hedge fund blowups are just the manifestation of what occurs every day. The capture of alpha out of the unskilled by the skilled.
3. Inexperience. In the conference call Nick Maounis cited "unusual" market behavior, not expecting the market to go against us and no viable way to exit our positions in the market. This is the level of "expertise" clients were paying 5.20% and 20% for? There was nothing unusual about it and a trader's job is to expect the unexpected, diversify and manage risk. Any security that goes up a lot can go down a lot as any COMPETENT trader knows. If your exposures are too big for the market to absorb then the positions are WRONG. Before you get in any trade you have to know where the exit is. A world class front-office and technology infrastructure does not help if you give a box of matches to a moron.
4. Red flags. The signs were there IF you did your homework. Many independent fund of funds and advisors either took a look and said no or redeemed a while back. Donald Sussman founder of Paloma and former boss and seed investor for Nick Maounis, withdrew three years ago. Why did this not concern others? Businessweek magazine pointed out that Amaranth was basically charging a management fee of 5.2%! There are very few hedge funds that can justify fees that high and Amaranth was NEVER one of them. The end of the article includes a fatuous comment from consultants Rocaton who loved Amaranth incidentally. Perhaps they should have looked at the thousands of better hedge funds they routinely disdain. There's vast hedge fund capacity out there if you bother to look AND have the skills to find it which clearly Rocaton does not.
5. Style drift and uncontrolled asset growth. While I believe in funds evolving, innovating and diversifying into new strategies, Amaranth basically had a convertible arbitrage guy failing to supervise an energy guy and clearly neither understood the commodities markets or had the necessary trading acumen. Good hedge funds managing multiple billions across several strategies took 10-15 years to get there. Amaranth tried to short circuit the learning process required to grow into and manage such size. They never had the experience or risk management discipline to profitably trade in the energy markets. CB arb is basically a long gamma strategy while being long a natural gas spread is effectively short gamma; that's why I suspect Nick Maounis had no idea a big move would affect them so badly. In CB arb a large fluctuation in the equity, in EITHER direction, usually benefits you, assuming you've hedged the credit risk.
6. Drexel Burnham Lambert disease! "I am so good I want to trade from my hometown!". Out of sight, out of mind? Is Greenwich such a bad a place to live and work? The houses and winters are a lot nicer than in Calgary. Talent should be nurtured but "stars" usually end up compromising a firm's stability. Intermediaries always tell investors about onsite due diligence visits in their presentations but how many went to Calgary to kick the tires? Not many but that is what the second layer of fees is supposed to pay for.
An investor doing due diligence should interview ALL traders with significant P/L responsibility WHEREVER they are. If they encounter ANYONE who in their subjective opinion appears brash, they should under no circumstances invest no matter how otherwise attractive the fund looks. I know many good traders and I have hired and fired several brash traders, but I have never met a good, brash trader. NEVER.
7. OTC derivatives. When you can, ALWAYS trade on an exchange where you have many counterparties and some anonymity. If you try to keep things "quiet" by transacting big OTC trades, you lose liquidity and increase your risk. Investment banks crave hedge fund business but prime broking and commissions are NOT the main profit driver. The BIG money comes from the flow of information. Amaranth concentrated its large natural gas position with counterparties who were, in effect, competitors. The information provided was of great use to their proprietary energy trading desks. Hedge fund traders need to know that deals they do with counterparties CAN AND WILL BE USED AGAINST THEM. The NYMEX speculative limits are not just to maintain orderly markets but to SAVE traders from themselves.
8. Chief Risk Officer. In the conference call Nick Maounis reiterated the strength of his risk management team. I don't see how this can be reconciled to events; with a proper risk management process for a real hedge fund this could never have happened. How experienced is the CRO? How much independence does she have? Does she have mandatory position override if "star traders" exceed limits? Are there any limits? Is she compensated well no matter how the hedge fund performs? Is her compensation of the same magnitude (same number of digits!) as the senior portfolio managers? Brian Hunter was not a rogue trader; "management" knew his positions. Natural gas is infamously volatile and his inexperience jeopardised the entire franchise. VaR is pretty useless but even VaR would have flagged this risk as would a realistic Monte Carlo simulation.
9. Industry skill varies. Fund of funds and advisors, as with hedge funds, range from extremely good to extremely bad. The extra layer of fees is worth it IF AND ONLY IF that fee is earned. Ongoing monitoring and due diligence is MUCH more important than initial. Interesting how many independent fund of funds operators avoided the Amaranth debacle while several broker/dealer asset management arms were invested. Could the difference be when hedge fund selection and monitoring is your CORE business and you eat your own cooking?
10. Questions to ask intermediaries and advisors: Do you just sit back and channel money to the usual names instead of earning your fee by sourcing and discovering real investment talent? Is some spreadsheet junky doing the due diligence or is the fund being assessed by someone with years of experience in ACTUALLY trading that strategy? Does your management structure ensure the selection of mediocre, "can't be fired for hiring IBM", type funds? Are you verifying that a "multistrategy" fund actually is multistrategy? Can you differentiate alpha from beta? Are your recommended funds lucky or skilled and how do you know?
The AUM sweet spot for risk adjusted returns for most hedge fund managers is in the tens to hundreds of millions NOT billions. Over 90% of the world's BEST hedge funds manage TOTAL firm assets of less than USD 1 billion. In fact I typically advise institutional clients to redeem if a fund gets above that. Apart from the importance of proper due diligence that's the biggest and best lesson to learn from Amaranth and other blow ups/performance disappointments.
Hedge funds are dead. Long live hedge funds. Maybe I consult in the wrong circles but the pensions, sovereign wealth funds and other fiduciary institutions I deal with want a reliable +10% over the long term not ± 30% maybe. There was none of the widely predicted contagion as proper hedge funds either were unaffected or benefited. As in 1998 with LTCM, the demise of an incompetent firm created massive alpha capture opportunities for the rare skilled.
Due diligence issues: - Amaranth
We could all make a massive leveraged bet on one idea but is this what investors want given the possibility of massive capital destruction? The best meteorologists with the fastest supercomputers haven't a clue on next winter's severity so why did Brian Hunter think he had an edge? His energy trading strategy may have been dressed up with spreads, options and "sophisticated" theories but it just amounted to a long natural gas beta bet with scant knowledge of how energy futures actually trade.
1. What it said on the packet versus real contents. Amaranth was clearly not what it marketed itself as. Multistrategy is inconsistent with having 55% of the fund in what was, effectively, one trade. Hedge fund regulation would NOT have prevented this. Soon Nick Maounis and Brian Hunter will be on the road trying to raise money for their new "hedge funds". Securities markets have perfect memory but most investors themselves forget very quickly. No competent manager could EVER lose such a high percentage of client capital. And losing leopards rarely change their speculation spots. Myron Scholes, John Meriweather, Victor Niederhoffer...
2. Risk adjusted returns. Even when Amaranth appeared to be doing well on topline "performance", adjusting for the risk and leverage to generate those returns, real performance was lousy. Amaranth's returns, since inception, were due to luck NOT skill. I remember when Long-Term Capital Management knocked out +40% in 1995/96 and "experts" considered them geniuses. They should have been making at least +200% each year for the risks they were taking. LTCM's risk-adjusted returns even in the so-called "good" times were abysmal. Incompetent hedge fund blowups are just the manifestation of what occurs every day. The capture of alpha out of the unskilled by the skilled.
3. Inexperience. In the conference call Nick Maounis cited "unusual" market behavior, not expecting the market to go against us and no viable way to exit our positions in the market. This is the level of "expertise" clients were paying 5.20% and 20% for? There was nothing unusual about it and a trader's job is to expect the unexpected, diversify and manage risk. Any security that goes up a lot can go down a lot as any COMPETENT trader knows. If your exposures are too big for the market to absorb then the positions are WRONG. Before you get in any trade you have to know where the exit is. A world class front-office and technology infrastructure does not help if you give a box of matches to a moron.
4. Red flags. The signs were there IF you did your homework. Many independent fund of funds and advisors either took a look and said no or redeemed a while back. Donald Sussman founder of Paloma and former boss and seed investor for Nick Maounis, withdrew three years ago. Why did this not concern others? Businessweek magazine pointed out that Amaranth was basically charging a management fee of 5.2%! There are very few hedge funds that can justify fees that high and Amaranth was NEVER one of them. The end of the article includes a fatuous comment from consultants Rocaton who loved Amaranth incidentally. Perhaps they should have looked at the thousands of better hedge funds they routinely disdain. There's vast hedge fund capacity out there if you bother to look AND have the skills to find it which clearly Rocaton does not.
5. Style drift and uncontrolled asset growth. While I believe in funds evolving, innovating and diversifying into new strategies, Amaranth basically had a convertible arbitrage guy failing to supervise an energy guy and clearly neither understood the commodities markets or had the necessary trading acumen. Good hedge funds managing multiple billions across several strategies took 10-15 years to get there. Amaranth tried to short circuit the learning process required to grow into and manage such size. They never had the experience or risk management discipline to profitably trade in the energy markets. CB arb is basically a long gamma strategy while being long a natural gas spread is effectively short gamma; that's why I suspect Nick Maounis had no idea a big move would affect them so badly. In CB arb a large fluctuation in the equity, in EITHER direction, usually benefits you, assuming you've hedged the credit risk.
6. Drexel Burnham Lambert disease! "I am so good I want to trade from my hometown!". Out of sight, out of mind? Is Greenwich such a bad a place to live and work? The houses and winters are a lot nicer than in Calgary. Talent should be nurtured but "stars" usually end up compromising a firm's stability. Intermediaries always tell investors about onsite due diligence visits in their presentations but how many went to Calgary to kick the tires? Not many but that is what the second layer of fees is supposed to pay for.
An investor doing due diligence should interview ALL traders with significant P/L responsibility WHEREVER they are. If they encounter ANYONE who in their subjective opinion appears brash, they should under no circumstances invest no matter how otherwise attractive the fund looks. I know many good traders and I have hired and fired several brash traders, but I have never met a good, brash trader. NEVER.
7. OTC derivatives. When you can, ALWAYS trade on an exchange where you have many counterparties and some anonymity. If you try to keep things "quiet" by transacting big OTC trades, you lose liquidity and increase your risk. Investment banks crave hedge fund business but prime broking and commissions are NOT the main profit driver. The BIG money comes from the flow of information. Amaranth concentrated its large natural gas position with counterparties who were, in effect, competitors. The information provided was of great use to their proprietary energy trading desks. Hedge fund traders need to know that deals they do with counterparties CAN AND WILL BE USED AGAINST THEM. The NYMEX speculative limits are not just to maintain orderly markets but to SAVE traders from themselves.
8. Chief Risk Officer. In the conference call Nick Maounis reiterated the strength of his risk management team. I don't see how this can be reconciled to events; with a proper risk management process for a real hedge fund this could never have happened. How experienced is the CRO? How much independence does she have? Does she have mandatory position override if "star traders" exceed limits? Are there any limits? Is she compensated well no matter how the hedge fund performs? Is her compensation of the same magnitude (same number of digits!) as the senior portfolio managers? Brian Hunter was not a rogue trader; "management" knew his positions. Natural gas is infamously volatile and his inexperience jeopardised the entire franchise. VaR is pretty useless but even VaR would have flagged this risk as would a realistic Monte Carlo simulation.
9. Industry skill varies. Fund of funds and advisors, as with hedge funds, range from extremely good to extremely bad. The extra layer of fees is worth it IF AND ONLY IF that fee is earned. Ongoing monitoring and due diligence is MUCH more important than initial. Interesting how many independent fund of funds operators avoided the Amaranth debacle while several broker/dealer asset management arms were invested. Could the difference be when hedge fund selection and monitoring is your CORE business and you eat your own cooking?
10. Questions to ask intermediaries and advisors: Do you just sit back and channel money to the usual names instead of earning your fee by sourcing and discovering real investment talent? Is some spreadsheet junky doing the due diligence or is the fund being assessed by someone with years of experience in ACTUALLY trading that strategy? Does your management structure ensure the selection of mediocre, "can't be fired for hiring IBM", type funds? Are you verifying that a "multistrategy" fund actually is multistrategy? Can you differentiate alpha from beta? Are your recommended funds lucky or skilled and how do you know?
© posted by Hedge Fund on 6:03 AM
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