Amaranth Advisors Hedge Fund Ruined by Ignoring ‘Risk of Ruin’

I finally got around to reading about the blowup of Amaranth Advisors hedge fund. I’m astounded that some of these supposedly sophisticated hedge funds apparently have no clue about such basic concepts like money management, position sizing and ‘risk of ruin‘. The disaster at this fund is a great illustration of why I’ve always said that and understanding of money management and risk management are the most important aspects of trading. Here are some excerpts from the article (emphasis is mine):

Of all the traders gambling big sums on energy, a 32-year-old Canadian named Brian Hunter made some of the brashest bets and the fastest money.

Brash, eh? Let’s look at the definition of brash, just to be clear — impulsive, brazen, Heedless of consequences, presumptuously daring . Enough said!

At the end of August, trading natural gas, he was up approximately $2 billion for the year. Then Mr. Hunter lost roughly $5 billion, in about a week.

His losses savaged returns for Amaranth, dragging its assets under management down to $4.5 billion from $9 billion at the start of September.

Those are some incredible swings for a fund that I guess was around $7 billion to start. That can’t be safe. 

“The cycles that play out in the oil market can take several years, whereas in natural gas, cycles take several months,” Mr. Hunter said in an interview late in July, when his returns were looking rosy. “Every time you think you know what these markets can do, something else happens.“

Hmm, if things are so unpredictable maybe you should be trading smaller.  I guess Brian and Amaranth never heard of Black Swans.

At that time, Mr. Hunter had more than $3 billion of bets outstanding, investors familiar with the funds’ holdings say.

So he had somewhere around 50% of the fund in play on natural gas. Most sensible traderswon’t risk more than 2% of their account in any one sector / instrument. There’s no telling how much of Anaren’s capital was actually at risk because apparently Brian didn’t use stops or have a point where he’d know he was wrong and exit.

continued taking positions some other traders had abandoned as too risky.

Remember, he’s brash!

Backed by borrowed money and a deep-pocketed fund, Mr. Hunter took on more exposure to certain futures contracts than do some big investment banks employing more than 100 energy traders, say several traders and ex-colleagues. He sometimes held open positions to buy or sell tens of billions of dollars of commodities.

Apparently the fund’s pockets weren’t that deep. I hope those positions were hedged since they were using a lot of margin and apparently holding for long periods of time.

He was up for the year roughly $2 billion by April, scoring a return of 11% to 13% that month alone, say investors in the Amaranth fund. Then he had a loss of nearly $1 billion in May when prices of gas for delivery far in the future suddenly collapsed, investors add. He won back the $1 billion over the summer, only to lose that and much more last week.

His swift reversal calls into question how well some hedge funds grasp the risk they are taking in the now-popular energy markets. Vince Kaminski, a risk-management expert who protested chancy trades while at Enron Corp. and until recently was at Citigroup Inc.’s commodities desk, said yesterday that it is dangerous to take giant positions in relatively shallow markets, which certain months are in gas futures. “This is a typical mistake of inexperienced and aggressive traders,” he said. Mr. Hunter “appeared to have a position that the entire market knew about. The markets are very cruel.” Citing a well-known epigram, Mr. Kaminski added, “‘The market can stay irrational longer than you can stay solvent.‘”

Obviously this fund had no clue about their risk!

Nick Maounis, Amaranth’s founder and chief executive, said in August that more than a dozen members of his risk-management team served as a check on his star gas trader. “What Brian is really, really good at is taking controlled and measured risk,” Mr. Maounis said.

Damn, they actually had a risk-management team? Scary.

As for Brian being “really good at taking controlled and measured risk”, look what happened at his previous employer, Deutsche Bank:

In December 2003, just as his group was close to ending the year up $76 million, he claimed in the suit, things went awry. In a single week, they had losses of $51.2 million, he said in the suit. He blamed “an unprecedented and unforeseeable run-up in gas prices”

There he goes blaming his troubles on that darn unpredictable market. Hmm, maybe that’s why people take measures to control their risk!

Mr. Hunter wanted to make bigger bets in his main market, gas. He had an ability to keep calm with huge bets on the line and markets were going berserk.

I bet he was calm since it wasn’t his own money on the line!

Although Mr. Hunter had fared well, many traders say he was acquiring positions that were too large to get out of if the market turned — including a bullish bet on winter gas.

Another aspect of position sizing… why would you ever take such large positions? That makes no sense. Good thing that risk-management team was on the job. 

The sad thing is that all of this drama could have been avoided if these guys simply had an understanding of the concept of “risk of ruin“:

The risk of ruin is the chance that standard deviation will destroy your bankroll before you have a chance to win at the levels you expect. Remember, the edge that you have is just like the edge the casino has – anything could happen in the short term.

[SNIP]

To avoid risk of ruin, make sure that your bet size is a small (very small) percentage of your overall bankroll. If you have a $10,000 bankroll, and you’re betting $1000 per hand at blackjack, then you probably won’t be playing long, no matter how well you count cards or how well you’ve mastered basic strategy.

On the other hand, if you have a $10,000 bankroll, and you’re making $10 bets on hands of blackjack, you’re going to have a lot better chance of finishing your trip to the casino a winner instead of a loser. The bigger your bankroll in comparison to your average bet, the lower your risk of ruin.

Here are some other useful articles on money management and risk of ruin:

• Money Management by Bennett McDowell — “Money management in trading involves specialized techniques combined with your own personal judgment. Failure to adhere to a sound money management program can leave you subject to a deadly “Risk-Of-Ruin” exposure and most probable equity bust.”
• Risk of Ruin — “Again this should be obvious: The smaller the amount you risk for any one trade relative to your capital base the lower the risk of ruin.”
To Trade or Not to Trade? The Real Question Is How Much? by Teresa Lo — ” Risk management. Money management. Trade size. Position size. Optimal f. Kelly Criterion. Collectively, these phrases determine a trader’s ultimate fate.” and ” In trading, there is a well-defined line between aggressive and insane risk-taking.”

If it isn’t already obvious, the primary goal is to stay in the game & live to trade another day. If you can do that and have a decent strategy (with a positive expectancy) the profits should take care of themselves.