Amaranth Advisors LLC was an American investment advisor, managing multi-strategy hedge funds with approximately $9 billion in assets. Throughout much of the firm's history, convertible arbitrage was the firm's primary profit center. As more and more capital began flowing into the convertible arbitrage strategy during the early 2000s, trading opportunities became more difficult to find. By 2004-2005, the firm had shifted much of its capital to energy trading. In September 2006, Amaranth collapsed after losing roughly $6billion on natural gas futures (Amaranth Advisor).
Amaranth's energy desk leader, Brain Hunter, who was a Canadian trader helped run the firm into the ground. Hunter grew up near Calgary and earned a master's degree in mathematics from the University of Alberta. Hunter gained experience at Calgary based TransCanada Corp. before moving to New York to join Deutsche Bank in May 2001. There, he made $69 million for the bank in his first two years. By 2003, Hunter was promoted to head of the bank's natural gas desk. In December 2003 Hunter's trading group lost $51 million in a single week in an excessively risky trade. In a New York state court lawsuit, Hunter ascribed the loss to "an unprecedented and unforeseeable run-up in gas prices," meaning Hunter's failure to foresee the risk of his own trade rendered him blameless for its consequences. Hunter also blamed Deutsche's trading software for allowing him to take large gambles. Finally, Hunter said he had earned $40 million for the bank during 2003, and therefore not only was he not responsible for the loss, he actually deserved a bonus. Deutsche Bank denied the allegations and he subsequently was let go from the firm. In April 2005, Hunter was reportedly offered a $1 million bonus to join SAC Capital Partners. Nicholas Maounis, founder of Amaranth Advisors, refused to let Hunter go. Maounis named Hunter co-head of the firm's energy desk and gave him control of his own trades.
In 2006 his analysis led him to believe that 2006-07 winters' gas prices will rise relative to the summer and winter prices. Accordingly, Hunter went long on the winter delivery contracts, simultaneously shorting the near the summer and fall contracts. When the market took a sharp turn against this view, the fund was hard pressed for margin money to maintain the positions. Once the margin requirements crossed USD 3 billion, around September 2006, the fund offloaded some of these positions, ultimately selling them entirely to JP Morgan and Citadel for USD 2.5 billion. The fund ultimately took a $6.6 billion dollar loss and, had to be dissolved entirely (Hunter).
Amaranth and Hunter were subsequently accused by the Commodity Futures Trading Commission of conspiring to manipulate natural gas prices. When a 2-day congressional hearing found Hunter not guilty of pushing up prices, and thus adversely affecting end consumers of the gas, CFTC framed accusations against Hunter for trying to push the prices too low and FERC framed similar ones, but going one step further, accused Hunter of being able to successfully do so. In 2007, Hunter attempted to organize a new hedge fund, Solengo Capital Partners. However, his efforts were thwarted by regulatory agencies due to his previous questionable trading practices. Shortly after finding his new fund wrapped up in regulatory red tape, Hunter sold Solengo's assets to Peak Ridge Capital Group and was hired by the firm as an adviser to its Commodity Volatility Fund. In 1Q 2008, the fund was up nearly 49% while many other hedge funds suffered losses (Hunter).
Hunter is currently the target of a $30 million fine to be levied by the Federal Energy Regulatory Commission in connection with the alleged manipulation of natural gas prices in 2006. In December 2007, Hunter sought to prevent the FERC from taking any action against him for his participation in trading in the natural gas futures market. A federal judge denied his request (Hunter). In 2006 Amaranth Advisors agreed to pay $7.5 million to settle accusations from regulators that it tried to manipulate natural gas futures. The agreement ends cases brought by the Commodity Futures Trading Commission and the Federal Energy Regulatory Commission involving the fund's trading on the New York Mercantile Exchange. The energy commission initially proposed a fine of $291 million. Amaranth's assets have been substantially diminished since the agency first proposed the fine, the commission said in its order approving the deal (Sender).
Why this happened?
Money management, position sizing, and risk of ruin are three main factors that contributed to Amaranth's collapse (Amaranth Advisors).
Amaranth controlled more than half the United States natural gas market before its collapse, according to a Senate report released in June 2007. The hedge fund, which is based in Greenwich, Conn., lost about $6.6 billion in energy markets. At that time, Mr. Hunter had more than $3 billion of bets outstanding. So he had somewhere around 50% of the funds in play on natural gas. Most sensible traders won't risk more than 2% of their account in any one sector or 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.
While Amaranth had traded energy for several years, its roots were in convertible-bond trading, a different, less-volatile market (McCall).
Mr. Hunter repeatedly used borrowed money to double-down on his bets. Buying more futures contracts of the kind his fund already owned supported their price by increasing demand, propping up paper gains, these traders say. But that support only lasted as long as Amaranth and its lenders were willing to spend cash to buy more contracts. Such trades may also have masked growing weaknesses in market fundamentals, his trading peers say.
Amaranth's systems didn't appear to measure correctly how much risk it faced and what steps would limit losses effectively. The risk models employed by hedge funds use historic data, but the natural-gas markets have been more volatile this year than any year since 2001, making models less useful. They also might not predict how much selling of one's stakes to get out of a position can cause prices to fall (Sender).
"It was a total failure of risk control to put your entire business at risk and not seem to know it," says Marc Freed, a managing director at Lyster Watson & Co., an advisory firm that invests in hedge funds for clients but not with Amaranth. "They were more leveraged than they realized."( Sender)
Funds like Amaranth are able to borrow three to eight times their initial capital to make bets thousands of times over. Mr. Hunter sometimes held 100,000 positions in a single contract, say traders familiar with his bets (Sender).
Still, the fund's high returns from energy before were popular with its investors. When Amaranth reported returns of roughly 12 percent in April, 2006, it told investors most of that profit was from energy trades. After Amaranth lost about 10 percent in May, or roughly $1 billion, mainly on energy trades, it told some investors that it was cutting back on leverage in the energy market (Sender).
Mr. Hunter's bets ultimately went bad because he misjudged the movement of the difference between prices for different month contracts, known as the spread. People familiar with the trades say he bet prices for nearby-month contracts months would fall and winter contracts would rise. These people say he also presumed gas might be scarce in March if use was heavy this winter and prices would then fall off in April (Sender).
Who was responsible?
Amaranth Advisors lost roughly $5 billion in one week because of joining the natural gas trades. The main reason for the huge loss was that the chief trader, Brian Hunter, ignored the simple rules of proper risk management and position sizing (Minsky). Therefore, the main person who was responsible for Amaranth Advisors' loss should be Brian Hunter, the hedge fund's chief energy trader.
Hunter was buying options to buy or sell natural gas at the specific prices in the future which others in the market thought never would happen. Although the strategy was supposed to be less risky than simply betting the prices would move up or down, and it would provide big payoffs if the prices came to pass, Hunter had to pay large premiums for the options, and declined the liquidity of the company at that moment (Sender).
By early September that year, the prices fell unexpectedly because of a storage glut, Hunter held bets that would pay off exponentially only if natural-gas prices rebounded, either on the prospect of a cold winter or a hurricane that destroy natural-gas facilities. But as evidence indicated a meek hurricane season and mild winter, prices fell more. Therefore the company lost more (Sender).
Amaranth's risk-management systems aggravated Hunter's failure of investment in natural gas trades. Hunter's main mistake was that he depended mostly on his own bets, without the rules of proper risk management, or with the incorrect risk management system. He bet the winter would be cold and the nasty hurricane would come when the prices of natural gas fell, but it turned out to be a meek hurricane and mild winter. He bet the price would increase to a specific high point or would decrease to a specific low point, ignoring the other traders' points, so he purchased a lot of options and paid large quantities of premiums, but the price turned out to move in opposite direction to his estimates. Therefore, Hunter should be the most important person who was responsible for Amaranth Advisors' large loss.
The Ripple Effect on the Market and Economy:
Amaranth Advisors lost approximately $6 billion on natural gas futures in 2006. This lost did not have a large impact on the economy as a whole though it did have a major shock to the market of hedge funds. Among other markets in the economy the energy market saw the biggest ripple effect after the Amaranth and Brian Hunter collapse. Though the hedge fund market saw the biggest change in how operations took place.
Hedge Fund Investor -
The biggest lost from the Amaranth Advisors and Brian Hunter natural gas scandal was carried by the investors. Hedge fund investors do not always know what is happening with their money on a day to day basis. The hedge fund makes the decisions for the investor as to where their money will be invested and how much risk will be taken. This was a major problem when investors found out that Amaranth Advisors had lost close to 65% of their funds. The investors had no idea how risk the hedge fund was being and were shocked to learn that no securities were in place to prevent such a large lost.
As a result of the Amaranth Advisors lost in 2006, investors will no longer take large risk in hedge funds without first calculating their own risk. Investors have started extensively analyzing their trading practices and risk management options before entering into a hedge fund. Furthermore, investors no long go on past performance of the fund because it is now very well know that a hedge fund could do good for several years before making one high risk investment that could cause the fund to lose everything.
In addition to investors taking a more hand on approach when it comes to hedge funds, the SEC and the Federal Reserve had also become involved in the process of hedge funds.
Amaranth Advisors and Brian Hunter -
Amaranth Advisors did not continue to operate after Brian Hunter lost over 65% of the company's assets. The company was charged with attempted manipulation of the natural gas futures in 2007 by the commodity commission. In 2010 the Federal Energy Regulatory Commission judge ruled that Brian Hunter violated the Commission's Anti-Manipulation Rule (Amaranth Advisors).
Risk Management Errors:
The Management -
Amaranth Advisors was made of several seasoned professionals. Mr. Brian Hunter was related to the gas futures disaster. Hunter joined Amaranth in 2004, and was a former Enron trader. He created Amaranth's energy trading desk. Hunter had to report to Arora who was his supervisor; but he didn't want to report to Arora and therefore threatened to leave the company in 2005. Hunter also complained about the compensation structure. Maounis the director of the company allowed Hunter to trade separately from Arora, this led to an increase in his operating profits from 7.5 to 15% and he helped Amaranth make $1 billion in profits in 2005. He was also allowed to return to Calgary his hometown to trade there. In the end his other natural gas traders had to migrate from Greenwich to Calgary. Since there were no solid rules for Amaranth employers to follow, they ended up setting their own terms of working which is not a good form of management.
The Strategies and Fund Structure -
Amaranth started out as a multi-hedge fund, and by end of 2006 they were mainly subjugated by the energy portfolio. The multi-strategy portfolio was made of trades in Energy Arbitrage, Convertible Bond Arbitrage, Merger Arbitrage, Credit Arbitrage, Volatility Arbitrage, Long/Short Equity and Statistical Arbitrage. Their contact with these various strategies changed dramatically over the year. For example, "when Amaranth was created, 60% was allocated to Convertible arbitrage and at the end of 2006 only 2% was allocated to this strategy" says Ludwig author of management risks. Amaranth didn't have no stop limit and no concentration limits, which allowed the firm to focus more towards energy trading by the end of August 2006. There were no leverage restrictions with the firm.
Amaranth's capital came from a variety of investors;
60% came from funds-of-funds
7% from insurance companies
6% from retirement and benefit programs
6% from high net worth individuals
5% from financial institutions
2% from endowments and 3% from insider capital.
Minimum investments in Amaranth were $5million, with a management fee of 1.5% and an incentive fee of 20%, employing a high water mark.
Risk Management and Liquidity Management -
"Amaranth was extraordinary in terms of risk management that it had a risk manager for each trading book that would sit with the risk takers on the trading desk," says Ludwig author of Risk Management. Therefore whoever had a chance to trade had their own reporting book. It was assumed to be a more successful way of understanding managing risk. Each strategy was stressed separately, however they had intentions to build a better form of reporting that would consolidate all strategies.
Was it Preventable?
When a financial institution is managing portfolios for other companies, its goal is to make as much profit as possible for their clients. The only way a company can receive a large reward when trading funds is taking on a portfolio with great risks. The greater the risk is the greater the return will be. However, how much risk is too much risk? When the collapse of Amaranth Advisors occurred did take on too much risk? Was it preventable? Brian Hunter was known to be very upfront when it came to trading future contracts, he was known to be a person to take on a large amount of risks and able to profit from them. However, when Hunter betted on natural gas prices, his estimations of making a profit were way off which cost the company $6.6 billion dollars.
The collapse of Amaranth Advisors could have been prevented by that the founder and head of Amaranth Advisors, Nicholas Maounis, could have put a tighter leash on Brian Hunter when it came to how much of the company's assets he could trade. When he hired Hunter to work for Amaranth he allowed him to be responsible for his own trades. If Maounis had some input in Hunter's trading strategies, he might have prevented the company from losing so much money. He should have had a say in how much money was allowed to be invested in a portfolio at a time (Burton).
Another way the Amaranth Advisor collapse could have been prevented is if Brian Hunter had not invested half of Amaranth's assets into the same portfolio. It is not in the best interest for a company to invest half the company's assets into one market such as Hunter did with Amaranth's funds trading them in the energy market. In 2006, when Hunter bid that the energy market and oil market stocks were going to increase in the future, he expected to make a hefty profit. Instead of making money, Hunter lost his company around 70% of their assets. He risked too much of the assets at the wrong time when the economy was beginning to go through a down turn. If Hunter did not risk so much of Amaranth's assets in one market Amaranth would have not experience such a great collapse (Burton).
To prevent the company from losing more money, Amaranth made deals with other financial institutions to take over the energy bets such as Merrill Lynch, JP Morgan, and Citadel. Amaranth had to pay Merrill Lynch $250 million to take over positions, paid JP Morgan and Citadel $2.15 billion to take over the rest of the positions in their energy bets (Davis).
Not only did Amaranth have to pay financial institutions to take over their positions in the energy market, they were also facing a lawsuit against the Federal Energy Regulatory Commission (FERC). The FERC was accusing Amaranth Advisors of manipulating the energy market by selling large amounts of contracts at the last minute before the expiration which led to the settle prices to plummet that worked to Amaranth's benefit. The result of the case ended up in a settlement where Amaranth agreed to pay $7.5 million to the FERC (O'Driscoll).
