The tale of two hedge funds caught out in the natural gas market.
The first company, MotherRock, a fund set up by former Nymex president Robert ‘Bo’ Collins, went belly up in August after basically speculating that the natural gas market had reached its peak. This was followed by more spectacular losses at Amaranth Advisers. The Connecticut-based company told investors that its two main funds had lost close to about 50% of their values after the gas market peaked and started to come off rapidly. Amaranth then found itself holding a massive spread position, which moved rapidly against it.
But besides trading in the same market, there is another connection between the two funds. Amaranth bought MotherRock’s portfolio from ABN Amro after the Dutch bank found itself responsible for the failed fund’s positions because of its role as its clearer on Nymex. As a result of MotherRock’s losses, the sale of ABN Amro’s futures arm to UBS has been delayed, although it is expected to go through around the end of this month.
Even though MotherRock’s losses are relatively modest, especially compared with Amaranth’s, they have highlighted something many investors, especially those in commodities, will do well to take on board.
After the fund imploded, its portfolio was accurately marked to market, an obvious requirement before it could be sold. When this was done, it was discovered that the revaluation rates for many of its positions, specifically a raft of long-dated, out-of-the-money options, were hopelessly inaccurate. Apparently MotherRock’s investors were shocked to find that there was no value left in the company. MotherRock’s positions had been revalued using Nymex settlement rates. For long-dated, out-of-the-money options, the reval rates are set by a committee.
This might just be one of the unfortunate events that materialize from time to time in financial markets, especially those which, despite their veneer of modernity, are actually relatively backward. But it has highlighted once again the need for accurate and independent revaluations. Sticking your finger in the air and coming up with some vague approximation is simply not acceptable – it leaves all market participants vulnerable.
As for Amaranth, its losses seem more like a case of a trader getting too big for his boots. Risk is not relative. It is a fallacy to believe that if you get it right by being long of 10, you might as well be long of a 1,000 and make 100 times as much money. Most traders’ decisions are influenced by the size of their positions; this acts for most as an in-built human risk management system. There is a simple reason why this makes sense, and that is liquidity.
Liquidity is perhaps the one variable in financial markets that it is almost impossible to model. Having an open position that is equal to or greater than the combined exposure of everyone else involved in a particular market is fine, as long as you are right. But when things go wrong, liquidity has a nasty habit of disappearing, as Amaranth and its investors found out. Still, the trader responsible for its huge losses will almost certainly resurface. There’s an old saying: “Lose enough money and make enough noise, and you’ll always get a job.”
