Increasingly surprising is the non-story of Amaranth. I say non-story because, media hand wringing aside, the impact of a "spectacular" (New York Times) "breathtaking" (Wall Street Journal) and "devastating" fall of a $8 billion dollar fund has, in fact, hardly made a splash in the financial system.
So minor was the impact that the Wall Street Journal struggled early on to find any collateral damage at all. So much so, that the best Margot Patrick could drum up was the fund of funds "Man Group, PLC." And even there, the Journal only managed to solidly identify a (gasp) $10 million investment in Amaranth. I am sure more lurks under the opaque surface of firms like Man Group, but what seems clear is that where risk management "failed" at Amaranth (and I'm not so sure it really did, more on this later) the major holders seem to have diversified very well and, at least so far, no major collateral damage seems apparent.
The Journal eventually dug more victims out. The San Diego pension fund, for example, (not exactly the poster child for excellent management lately) had $175 million at stake with Amaranth, but that's out of $7.7 billion in assets. Could it be that the financial system is just better able to handle catastrophic failures within single firms like Amaranth today? And if so, isn't this how financial systems are supposed to be designed? Doesn't this show us the system is working? The rational allocation of risk and reward is proceeding apace?
We desire, nay, we demand that firms like Amaranth exist. We encourage it. Insist on it. There is always an appetite for risk, a huge one, even on the level Amaranth was taking it. I haven't heard it put better than by Barry Ritholtz at The Big Picture (who Abnormal Returns pointed me to) when he describes what talking to potential investors on a hedge fund road show is like for a GP:
Now comes THE QUESTION. This is the one that gets people into trouble:
"We are looking for a number. What should we expect from you in the first 2 years?"
What they want to hear is "I am going to do 30-40% annually, fully hedged."
I don't say that, because it isn't true. (God bless Jim Simons, who actually can honestly say that). That's what too many investors are looking for; its nothing more than the greed factor at work. They don't say it explicitly, but its true: We want you to outperform the long term S&P500 benchmark by 300-400% annually (and we don't care about mean reversion). We really don't care how you do it. We want outsized profits. WE WANT THE LATE 1990S AGAIN.
Money raisers and some GPs have long ago figured this out. You have a few choices: you can answer the investors' questions honestly -- or to quote Ray Davies, you can give the people what they want (or think they want):
"We expect gains of 35-45%, with minimal risk or leverage. Our black box algorithms have been backtested, and generate better numbers than that, but we would rather under-promise and outperform."
So what are we really worried about? That Amaranth took on a lot of risk? That was their job. That's what we wanted Amaranth to do. Required of them. What surprises me is the ease with which Amaranth swallowed their downside. So far as I am aware Amaranth didn't even fail to meet a margin call on the way down, which is quite a tall order given the size of the position that blew them up and the extraordinary leverage (up to 8:1) on it.
Within less than 10 days most of the offending business has been wound up and pawned off. So orderly, in fact, was the disposal that there is at least an "even money" case to be made that Amaranth might still be able to carry on (as some former shadow of itself) with operations. In short, it sounds a little to me like Amaranth's risk management was working not too badly. They imploded, rather than exploded.
There is nothing wrong with pure risk plays as long as we don't pretend that the returns therefrom are anything but risky, and we don't bet more than we can afford to lose. At least today it looks like Amaranth calculated that amount quite exactly. I wonder if their huge bets on natural gas were, actually, a calculated risk from the start.