In his 2006 memo titled ‘Pigweed’ Howard Marks provided investors with six classic investment mistakes that every investor should avoid using the real-life case study of hedge fund – Amaranth Advisors.
Amaranth Advisors was an American multi-strategy hedge fund founded by Nicholas Maounis and headquartered in Greenwich, Connecticut. During its peak, the firm had up to $9 billion in assets under management before collapsing in September 2006, after losing in excess of $5 billion on natural gas futures.The firm’s failure was one of the largest known trading losses and hedge fund collapses in history.
Here’s an excerpt from that memo:
Investors love things as long as they’re riding high but lose all respect when they’re brought low. It doesn’t take long to become discredited in the investment world. And so it is for Amaranth Advisors, which now might be relabeled “pigweed” – another word for the plant that gave the fund its name.
For those who’ve been incommunicado over the last few months, Amaranth is a hedge fund that was formed in 2000. In the beginning it stressed relatively safe strategies like convertible arbitrage. But more recently it ventured into other things and in 2004 hired a young man named Brian Hunter to engage in energy trading, leading to the recent events.
On September 18, it announced that it had lost 40% of its $9.5 billion of total capital on natural gas trading, a percentage that was revised upward to 65% over the next few days. The fund sold off its energy trading book, Brian Hunter departed, and Amaranth threw in the towel and is liquidating.
Now that Amaranth’s collapse has earned it a place on the list of investment disasters, we should consider the lessons that can be learned from it. I’ll try to provide some useful insights regarding Amaranth, as usual without claiming to be an expert on the subject.
Classic Investment Mistakes
Hemlines go up and down. Ties go from wide to narrow and back again. There are only so many ways in which things can vary. Likewise, there are only a few mistakes one can make in investing, and people repeat them over and over. It seems Amaranth made several.
1. Borrowing short to buy long (and illiquid). This cardinal sin is at the root of most great investment debacles. A fund’s capital should be as long-lived as its commitments. And no fund should promise more liquidity than is provided by its underlying assets. You can successfully invest in volatile assets if you’re sure of being able to ride out a storm. But if you lack that certainty and face the possibility of withdrawals or margin calls, a little volatility can mean the end. In the case of Amaranth, just as had been true of Long-Term Capital Management and the big junk bond holders that were forced to sell out at the 1990 lows, many of the losses would have turned back into profits if they had just been able to hold on through the crisis. That’s why I always caution, “Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.” It’s not enough to be able to get through on average; you have to be able to survive life’s low points.
2. Confusing paper profits with real gains. The Wall Street Journal of September 20 points out that Hunter was encouraged by the positive marks to market showing up in his statements, so much so that he added further to his positions. But he seems not to have asked whether the gains were real and realizable. The Journal also points out that Hunter was such a big buyer in thin markets that his buying often supported prices and created the very profits he found so encouraging. But if the profits were the product of his buying, and thus dependent on it for their continued existence, he clearly had no way to realize them. My father used to tell a joke about the guy who insisted that his hamster was worth thousands more than he had paid for it. “Then you should sell it,” his friend urged. “Yeah,” he responded, “but to whom?”
3. Being seduced by loss limitation. Hunter is said to have liked buying deep-out-of-the-money options, and everyone knows that one great thing about buying options is that in exchange for a small option premium you receive the right to benefit from price movements on lots of assets. You can only lose 100% of the amount you put up . . . and in deep-out-of-the-money options people do just that all the time.
4. Misjudging liquidity. People often ask me whether a given market is liquid or not. My answer is usually, “that depends on which side you’re on.” Markets are usually liquid in one direction or the other but not necessarily both. When everyone is selling, a buyer’s liquidity is great, but a seller will find the going difficult. When sellers’ urgency increases, they’re likely to have to give on price in order to achieve the “immediacy” they crave (see my memo “Investment Miscellany,” November 16, 2000). If their desire for immediacy is extreme, the bids they see might be absurdly low. Thus markets can’t be counted on to accommodate a seller’s need to realize fair value.
5. Ignoring the impact of others. In small markets, everyone may know about your trades. That means they can copy them (making buying tough and adding to the crowd that will eventually jam the exits), and they can deny you fair prices if they know you have to sell. Aggressive traders, especially at hedge funds, don’t wear kid gloves.
6. Underestimating correlation. There’s another old saying: “In times of crisis, all correlations go to one.” It means that assets with no fundamental or economic connection can be caused by market conditions to move in lockstep. If a hedge fund experiences heavy withdrawals during a period of illiquidity, assets of various types may have to be dumped at once, and thus they can all decline together. Further, hidden fault lines in portfolios can produce unexpected co-movement. Let’s say you’re long sugar and gas, two unrelated commodities. Unusually warm weather can reduce the demand for gas for heating and also cause a record sugar crop (as happened this year). Thus the prices of seemingly unrelated goods can decline together. Intelligent diversification doesn’t mean just owning different things; it means owning things that will respond differently to a given set of environmental factors. Thus it requires a thorough understanding of potential connections.
The case of Amaranth is highly and painfully instructive, and it bears out another of my favorite expressions: Experience is what you got when you didn’t get what you wanted.
You can read the memo here – 2006 Howard Marks Memo – Pigweed.
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