2006 12 07 Pigweed

© Oaktree Capital Management, L.P. All Rights ReservedMemo to: Oaktree Clients From: Howard Marks Re: Pigweed At Citibank back in the ’70s, Chief Investment Officer Peter Vermilye placed a lot of emphasis on building team spirit. His tools included sk its at our annual staff outings, and he never hesitated to participate in costume. My favor ite was his portrayal of Johnny Carson’s savant, “Carnac the Magnificent.” He would hold a seal ed envelope to his forehead and intone “Schlum-bair-zhjay,” as the French pronounce th e oil service company’s name. Upon opening the envelope, he would read, “Wha t they call it at $75.” Holding up the next envelope, he’d say “Slum-burger.” The explanation in side: “What they call it at $15.” In other words, 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 strate gies like convertible arbitrage. But more recently it ventured in to other things and in 2004 hired a young man named Brian Hunter to engage in energy trading, lead ing to the recent events. On September 18, it announced that it had lost 40% of its $9.5 billi on of total capital on na tural gas trading, a percentage that was revised upward to 65% over th e next few days. The fund sold off its energy trading book, Brian Hunter depa rted, 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 le arned from it. I’ll try to provide some useful insights regarding Amaranth, as usual without claiming to be an expert on the subject. UYou Bet! As I read about Amaranth, one thing stood out: the repeated use of the words “trade” and, especially, “bet.” Nothing about “invest” or “own.” And certainly no reference to “value.” The pattern really is striking. Of course, part of this change in attitude could be attributable to the de frocking described above. Six months ago, the articles might have described Amaranth as an astute energy investor, rather than the reckless gambler it’s considered today. But certainly the new nomenclature is everywhere, and I find it appropriate. What’s the distinction? Investors want to ow n things for the long run, under the belief they’ll grow and strengthen over time (or that today’s va lues will come to be better appreciated). © Oaktree Capital Management, L.P. All Rights ReservedTraders buy and sell, usually in short order, to take advantage of mom entary phenomena. I usually think of them as betti ng on the direction of the next pr ice move. Certainly we can say their timeframe is hours or days, or maybe w eeks, but rarely months and never years. And what is a “bet”? That’s one of those word s we all know the meaning of but would be hard- pressed to define without using the synonym “wager” or the word “bet” itself. I consulted The Random House Dictionary of the English Language and found a very useful definition: a bet is “a pledge of a forfeit risked on some uncertain outcome.” In other words, you attempt to profit from an uncertain event, and if it doesn’t go as you hope, you forf eit something of value. Well then, Amaranth certainly was a bettor. One question: If it’s so obvious today that Am aranth was “betting,” were people equally aware of that fact a few months ago? I don’t think so. Gains are often presumed to be the result of carefully considered investments, while it’s us ually losing ventures that are described as having been bets. UWhat Was Their Game? Amaranth’s energy trading operation was in bus iness to bet (there I go!) on short-term movements in energy prices. But it didn’t base its activities on saying “w e want to own natural gas” or “we want to be s hort.” That would be risky. Instead, it said things like this: “The price of natura l gas is always higher in the winter than in the summer, as is proper, because cold weather caus es the demand for gas to increase. But right now, we think the price discrepanc y is wider than it should be: Janua ry gas is too high relative to July gas. So we’ll short January gas and buy an equal amount of July gas.” Under this approach, there’s no net exposure to the overall direction of gas prices, just a bet (if you will) on the wideness of the spread. The fund wo n’t gain if the price of gas rises or lose if it falls. Instead, it’ll gain if the spread narrows in a reversion to the mean, or it’ll lose if the spread anomalously widens further. This is a true hedged position: an arbitrage. I define arbitrage as taking largely offsetting positions in the same or closely related assets exhibiting a price discrepancy, with the goal of profiting, with very little ri sk, when the mispricing corrects . Its aim is to profit from the movement of asset prices relativ e to each other (the relationship between which usually can be counted on to stay within a normal range), not fro m the movement of the price of a single asset (which can behave any way at all in the short run). This is a very valid approach for a hedge fund to take. It epitomizes hedging, something th at most hedge funds now seem to engage in infrequently or not at all. So where did Amaranth’s risk – and the possibility of catastrophic loss – co me in? The answer’s simple: Positions that are low in risk can be rend ered quite risky with the help of leverage. Back in ancient history (1998), a fixed in come hedge fund called Long-Term Capital Management pursued arbitrage transactions like Amaranth’s (on a much more diversified basis but with more leverage) and experienced a similar meltdown. I noted that earlier, when things © Oaktree Capital Management, L.P. All Rights Reservedwere going well, one of Long-Te rm’s principals had said, “We’re going around the world scooping up nickels and dimes.” There’s great appeal to his notion of profiting from a large number of small mispricings that others aren’t smart enough to seize upon. But he had left off a few key words from the end of his sentence: “. . . in front of a steamroller.” The steamroller enters the picture when so much leverage is employed that a fund can’t survive a moment of aberrant market behavior. TIn a memo on hedge funds in October 2004, I menti oned that when there’s a big increase in the number of little fish attempting to live off each big fish’s leavings (or in the number of hedge funds relative to mainstream investors), the pickings become slimmer. Given the increased efforts to exploit inefficiencies today and the fact that str ong cash inflows and resultant high prices have depressed prospective returns in many markets, managers are often resorting to increased leverage in order to reach their return targets. But it’s essential to remember that leverage is the ultimate two-edged sword: it doesn’t alter the probability of being right or wrong; it just magnifies the consequences of both. TUThe Perils of Diversification TThe Amaranth saga demonstrates that the riskines s of a portfolio is not just a function of the fundamental nature of its holdings, but also of th ings like concentration a nd leverage. I often say there is no investment so good that it can’t be ruined by too-high an entry price. There’s also no investment so safe that can’t be rendered risky by buying too much of it with borrowed money . TDiversification has long been considered a pillar of conservati ve investing. It’s a simple concept: “Don’t put all your eggs in one basket .” Spreading your capital among a number of assets or strategies reduces the likelihood of a disaster. TIn the 1960s, Bill Sharpe pointed out that adding in a risky but uncorrelated asset can reduce a portfolio’s overall riskiness. It has become accepted wisdom that overall risk can be reduced (and return increased) by adding alternative investments to a por tfolio of stocks and bonds. TBut people don’t always take note of a dangerous outgrowth of these dicta: that diversifying into uncorrelated assets with borrowed money can increase, not reduce, the risk of the portfolio. TLet’s say you have $100 invested in U.S. stocks . You realize how undiversified your portfolio is, and that a market crash can bring a substantial loss. So yo u sell off $75 worth of stocks and put $25 each into emerging market stocks, high yield bonds and natural gas futures. Now your portfolio is invested equally in four asset cl asses rather than one a nd thus probably safer. TBut what if, instead, you hold onto your $100 wo rth of U.S. stocks and borrow another $300, investing $100 in each of those three new asset classes. You’re again invested equally in four asset classes. Equally diversified but much less safe . That’s because leverage has magnified the sensitivity of your portfolio to market movements. © Oaktree Capital Management, L.P. All Rights ReservedTA crash that wipes out one of the four asset classes in the diversified $100 portfolio will reduce your net worth by 25%. But that same crash, wh en experienced in the leveraged and equally diversified $400 portfolio, will eliminate your entire net worth. So investors should always consider the combined effect of diversification and leverage. Amaranth was much safer when it was all in convertible arbitrage than after it increased its leverage in order to diversify into energy trading. Diversification is a good thing, but a lot depends on how you finance it. T“Multi-strategy” is one of today’s hot buzz words. But as Orin Kramer puts it (see page 12 for who he is), “Amaranth is a reminder that a multi-strategy structure is not a proxy for risk diversification.” That is, I th ink, multi-strategy + risk control = protective diversification, while multi-strategy + leverage = more ways to lose. UGenerating Alpha I want to say up front that I have absolutely no idea how one dependabl y achieves above average profits from trading or investing in commodities, pr ecious metals or currencies. That’s not to say it can’t be done. There are pe ople who’ve gotten very rich that way, managing both their own money and that of others. Of course, the efficient market crowd would say someone will get rich doing everything – even playing the lottery or flipping coins – simply because the tails of a probability distribution usually aren’t en tirely unpopulated. But who it is that gets rich that way may be purely random. If that’s the case, the mere existence of a few winners doesn’t in itself prove that something is an “alpha” activity in which ha rd work and skill will produce consistent performance, or that large numbers of people can pull it off. I believe firmly that the markets for commodities and currencies are generally efficient. That means a lot of highly motivated people participate; many are intelligent and computer-literate; they all have access to similar in formation; and they’re willing to take either side of most propositions. These people cause all of the availa ble information to instantly be incorporated in the market price of each asset, such that the mark et price always reflects the consensus view of the significance of the available information. As a further consequence, few people if any can dependably identify and profit from instances when the market price is wrong. That, in turn, makes it difficult to consistently achieve hi gh absolute returns or perform better than others. That difficulty constitutes the ultimate proof that a market’s efficient. Take currencies for example. Exchange rates exist so that currencies will be valued fairly relative to each other in view of countries’ differing growth rates, interest rates, inflation prospects and fiscal and trade de ficits, etc. Further, exchange rates change as the outlook for these things changes. Their cu rrent status is widely known, and predicting changes is something few people can do right more often than others. Thus it seems unlikely that some people will be able to regularly generate higher returns than others. If it’s so hard to value currencies, commodities and precious metals, why do I think we can invest intelligently in equities, corporate debt and whole companies? It’s because these things generate income, and an expected stream of future income can be translated into a current value. © Oaktree Capital Management, L.P. All Rights ReservedBut how do you determine the intrinsi c value of a Euro, a bar of gold or a barrel of oil? You can talk about the positives and th e negatives associated with th ese goods. But how do you convert those things into a price? For example, the factors that argue for high oil prices are obvious. “The supply is finite.” “We’re using it up at an accelerating rate.” “Envi ronmental issues in the U.S. will constrain the domestic supply.” “Much of the foreign suppl y is in the hands of hostile or unpredictable governments: Iran’s a worry, Venezuela is turning anti-American, and Saudi Arabia is subject to instability.” Sure they make oil a valuab le good, but how valuable? How do we know the current price doesn’t adequately reflect these things already? What’s the Uright U price for it? We had a particularly instructive lesson in Ju ly. The price of oil had been strong, and the outlook was for more of the same . With the price at $77 per ba rrel, it was reported that the Alaskan pipeline had to be shut down to repair damage. With domestic shipments restricted, the price had to rise; oil Uhad U to be a buy. But the $77 price at which oil traded on the day of the announcement hasn’t been seen since. Within just four months, the price of oil fell to $55 (down 28%) – and the factors listed above were just as true at $55 as they were at $77. Without the ability to reliably convert funda mentals into prices, I don’t see how one can achieve consistently superior risk-adjusted gains. Above average investment performance (in an y market) has to be the result of either unusual insight into values or the intersection of risk taking and luck. It’s hard to tell the difference between the two in the short run, but the truth always becomes clear in time, because luck rarely holds up for long . UThe Short-Term Performance Trap That leads me to Amaranth’s experience in natura l gas, and to the key lesson to be learned from it. Is anyone capable of regularly generating sk illed-based (as opposed to luck-based) returns at an ultra-high level by trading natural gas? I don’t know for sure, but I would think not. I’m not saying no money can be made that way. But while the capital markets might permit one to steadily earn 5-8% a year (or maybe even 8-10%) by committing capital to this activity, returns in the teens shou ld be infrequent, and returns above 20% probably should be considered the result of extreme good fortune (and thus as having been just as likely to go the other way). There are exceptions, but a good statis tician can live with a few exceptions without feeling they disprove the main point. I think it’s essential to realiz e that Amaranth’s troubles in natural gas didn’t start this year, with the positions that didn’t work. They started with the $1 billion in profits that Hunter generated in 2005, which permitted Amar anth to report a return roughly double that of the average hedge fund. TIn the investment business, clients love high retu rns and hate low returns. That makes sense. And when the market’s up 10% and their manager is up 20%, clients are real ly happy. But that’s my pet peeve. Rarely does anyone say, “Whoa. That return’s too high. How did it happen? © Oaktree Capital Management, L.P. All Rights ReservedHow much ri sk did my manager take in order to generate that?” No, in the investment world few people find high returns worrisome. TEveryone talks about beta, (which I’m tempted to pronounce “bee-tah” now that I’ve spent six weeks in London), but few people dwell on it when returns are soaring. Credulous investors think the manager who generated 20% in an up- 10% market contributed alpha of 10%. But maybe he had zero alpha and a beta of 2 instead . . . or maybe negative alpha of 20% and a beta of 4. Regardless, I almost never h ear people talk about returns being so high that they’re suspect. According to Hillary Till of Pr emia Capital Management (in her report on Amaranth published by France’s EDHEC Business Sc hool), “Since May, investor s knew [Amaranth’s] energy portfolio had typical up or down mo nths of about 11%. . . . Ther efore, it would not have been unusual for the fund’s energy trades to lose 24% in a single month. . . .” But nobody seemed to care, since the energy book gained $2 billion in just the first four months of 2006. In other words, Amaranth had enjoyed the up months. That certainly didn’t im ply that down months weren’t lurking. In f act, just the opposite. THere’s the most important thing: My wife Nancy often quotes a few lines from Rudyard Kipling’s poem, “If”: TIf you can meet with Triumph and Disaster TAnd treat those two Impostor s just the same; . . . TYours is the Earth and everything that's in it, TAnd – which is more – you’ll be a Man, my son! TLikewise, short-term gains and short-term losses are potential impostors, as neither is necessarily indicative of real invest ment ability (or the lack thereof). TSurprisingly good returns are often just the flip side of surprisingly bad retu rns. One year with a great return can overstate the manager’s skill and obscure the risk he took. Yet people are surprised when that great year is followed by a terrible year. Investors in variably lose track of the fact that they both can be impostors, and of the importance of digging deep to understand what underlies them. TOne gets the impression that no one at Am aranth asked the right question when Brian Hunter shot the lights out in 2005: “How’d you do that?” Or if they asked, they were satisfied with what turned out to be the wrong answer: skill, rather than leveraged aggression combined with luck. They let him move to Calgary, and they gave him a large enough capital and/or risk budget to enable him to bring down the firm. TBut The Wall Street Journal of Sept ember 19 laid out how this came about. “. . . late last year, the double-whammy of Hurricanes Katrina and Rita made Mr. Hunter a hero at Amaranth and a minor legend on Wall Street, as he made $1 billio n for Amaranth.” Hunter liked to buy deep- out-of-the-money options. While these things ex pire worthless most of the time, a major, unexpected price move in the underl ying asset can produce huge profits. © Oaktree Capital Management, L.P. All Rights ReservedTBut does betting on a long shot and prof iting from a freak o ccurrence make someone a skilled investor, or just the “l ucky idiot” that Nassim Nichol as Taleb describes in “Fooled by Randomness”? Should that kind of performance insp ire reverence or concern? Well, Amaranth’s 2005 gas profits produced awe, but anyone looking behind them should have been worried. What would have happened, investors might have asked, if events had unfolded differently? Taleb’s “alternative histories” are always worthy of consideration (see below). TThe events in the gas market that decimated Am aranth in 2006 may have been unforeseeable and unprecedented. But those adjectives might apply just as well to the elements that made it successful in 2005, and no one – especially not th e fund’s managers – seems to have mentioned that fact at the time. When pe ople profit from such things, it’s considered all right and good, but then when they reverse into losses, it comes as a shock. They’re two sides of the same coin, but investors have a really tough time keeping that in mind. UWhat’s Real? To be able to attach the proper significance to short-run performance, it’s essential that one understand the idea of “alte rnative histories.” I came across it in Taleb’s book, which I consider the bible on such topics. This concept is related to Orin Kramer’s description of Tpast performance as “the interaction of particular historical and market conditions and the judgments and beliefs of managers during that period.” In other words, investment performance is what happens to a portfolio when events unfold. People pay great heed to the resulting perf ormance, but the questions they should ask are, “Were the events that unfolded (and th e other possibilities that didn’t unfold) truly within the ken of the portfolio manager? And what would the performance have been if other events had occurred instead?” Those other events are Taleb’s “alternative histories.” How about an example of the right way to view outcomes? TWell, with the college football bowl season upon us, I’d like to discuss last year’s championship game, something I’ve been musing about for almost a year. The University of Southern California football team was undefeated in the 2005 regular season. It boasted two successive years’ Heisman Trophy wi nners and many other grea t players. It won its games in spectacular fashion and was widely touted as one of the best college football teams of all time. In fact, in the week leading up to the championship game against the University of Texas, ESPN ran daily segments that compared USC against a top team from the past, each time stating that USC was better, and why. When it came down to game time, however, Texas played very well and USC couldn’t contain their talented quarterback, Vin ce Young. With two minutes to go in the game, holding a slim five-point lead, USC’s coach, Pete Carroll, chose to “go for it” on fourth down, rather than punt the ball downfield – undoubtedly out of concern th at if Texas got the ball with two minutes left on the clock, his team would be unable to keep them from scoring. USC failed to make a first down, and Texas got the ball with good field pos ition, scored a touchdown and won the game. © Oaktree Capital Management, L.P. All Rights ReservedIf USC had made the two yards they needed on that fourth down play, it’s extremely likely they would have won the game. And if they’d w on the game, they doubtless would be described today as the best college football team in history. But it didn’t happen that way, and no one talks anymore about their being the best, or even the s econd best. Now they’re considered just another great team. What this shows is how tenuous the connection can be between outcomes (which most people take for reality ) and the real, underlying reality. What do I mean by that distinction? Consider this: What’s the probability that if USC had made the needed two yards – and today was considered the best team ever – they really would be the best team ever? Certainly not 100%. And just as interestingly (or to me maybe more so), what ’s the probability that, even though they didn’t make the two yards, they actually are the best team that ever played? Certainly not zero. But since USC lost that game, most people would find nonsensical a suggestion that they’re the best t eam in history. To contemplate th at possibility, they would have to consider an alternative history in which USC made those two yards. Can the result of one play really decide the issue? That’s the one thing we all can probably agree shouldn’t be the case. “Everyone knows” that the score of a game doesn’t necessarily tell you which is the better team. So then outcomes aren’t necessarily indicative of reality, meaning that alternative histories should be given significant weight. (I guess the ultimate step would be to suggest that USC actually won the game, the scor e notwithstanding. That would be going too far . . . although we often hear a losing team’s fans say, “We won that game.”) While we’re looking deeply into things, let’s spe nd a minute on Pete Carroll’s decision to go for it on fourth down. Was he right or wrong? He has gone for it on fourth down many times in his coaching career, and most of the time it worke d. In fact, USC twice had run on fourth down earlier in the championship game, making the needed yardage once and scoring a touchdown. But on that final attempt they were unsuccessful. Does that mean Pete made a wrong decision? Or was it a right decision that ju st happened not to work on that o ccasion? One of the first things I learned at Whart on in 1963 was that you can’t judge the correctness of a decision from the outcome. This is another concept that many peopl e find nonsensical. But good decisions fail to work all the time – just as bad ones lead to succe ss – simply because it’s so hard to predict which history will materialize. It seems ridiculous for something as momentous as the label “best team ever” – and the measure of a team’s real wort h over an entire season – to hi nge on the outcome of one play that took four seconds. Clearly that’s a dist ortion, but no less of a distortion than many people’s response to short-term inves tment performance, both good and bad. UKing for a Day TIn the current environment, there can be little ability to restrain a hot manager. According to Amaranth’s head of Human Resources until 2004, the CEO of the fund “. . . sought to centralize oversight of traders and keep bi g discretionary trading authority on the fund’s Greenwich trading floor. After big gains in 2005, Mr . Hunter was allowed to trade from Calgary. ‘To have a © Oaktree Capital Management, L.P. All Rights Reservedrelative newcom er . . . receive so much discretion is just shocking to me.’ ” (The Wall Street Journal, September 20) TBut today, if a hedge fund CEO tells a trader wh o’s been generating great performance that he can’t have more capital, or take risky positio ns, or pursue the maximum imaginable incentive fee, or move to Calgary, he’ll lose him. Th ere’s always another employer who’ll meet a hot trader’s demands. No, this isn’t a time when discipline and risk control come easy. TIn this climate, even an earlier dust-up at De utsche Bank regarding Bria n Hunter’s gas trading and bonus wasn’t enough to keep him from becoming the linchpin of a $9.5 billion fund, managing half its capital. And it wouldn’t have deterred others from hiring him if he quit because Amaranth had tried to restrain him. TA decade ago, if an employee who’d run up big profits in his first year asked for a huge bonus, we’d say, “Come back after you’ve put together a few good years.” But in today’s climate, if a hedge fund doesn’t come up with an out-sized bonus after one good year, it’s unlikely the employee will stick around to give it a second. Thus Brian Hunter was paid $75 to $100 million in 2005, his first full year at Amaranth , arguably for betting right on the weather. TIt doesn’t take much to be venerated today. One or two good year s make somebody a “top trader.” Three years can enable someone to rais e a billion-dollar hedge f und. In fact, even after the fall, The Wall Street Journal described Brian Hunter as an “experienced manager” . . . at 32. Doesn’t anyone think that before someone is elevated to the invest ment peerage, he or she should have a record spanning more than a few years, a nd have been tested in down markets? I knew the world had been turned on its head when I read on “dailyii.com” about Hedge Funds Investment Management, a London fund of funds that will invest only with people who’ve been in the business for 3½ years or less. TUUnlikely Things Happen TThe EDHEC report mentioned above makes a numb er of interesting observations concerning Amaranth’s portfolio: TAs of June 2006, energy trades accounted for about half of Amaranth’s capital and generated 75% of its profits.  TAmaranth had 6,700 energy positions, leveraged 4.5 to one, including open positions to buy or sell tens of billions of dollars of commodities.  TAmaranth was responsible for a substantial portion of all of the gas trades that took place.  TIn the far-out months, in which fewer traders participate, “the fund’s positions were indeed massive.”  TMany of Amaranth’s trades probably had “phys ical-market participan ts” on the other side, people who had taken positions to hedge risks intr insic to their business. Because they would be unlikely to unwind their trades at Amaranth’s convenience, ex its were problematic.  TIn view of all of the above, “the magnit ude of Amaranth’s energy position-taking was inappropriate relative to its capital base.” © Oaktree Capital Management, L.P. All Rights ReservedTHillary Till describes Amaranth’s loss as a 9-st andard-deviation event (Long-Term Capital’s is estimated at “8-sigma”). By way of referen ce, 5 standard deviations include the central 99.99994% of a Tnormal probability distribution. A 5-sigma event below that range should happen about three times in every ten million trials (thus a given daily occurrence should happen once every 10,000 years). But it’s amazing how often this kind of event seems to occur when derivatives are combined with leverage. TEveryone speaks about preparing for “worst-case” outcomes, but invariably things can get even worse. Statistical reassurance should be relied on only to a reasonable extent. Common sense has to come into play as well. TURisk Management and Risk Managers TYou know from my memo of February entitled “Risk” that I’m not a big fan of quantitative risk management. It’s often said of a man that “h e knows the price of ever ything but the value of nothing” – and it’s not meant as a compliment. Likewise, I feel effective assessment of portfolio risk is less likely to come from Ph.D. statisticians who lack intimate knowledge of the assets in the portfolio than through wise judgments made subjectively by investors possessing “alpha.” TIn the memo on risk, I enumerated several criteria that should be present if modeling is to prove effective. I also observed that most of them are lacking in the investment world. In an article in the Financial Times of October 10, John Kay wrote of the risk that arises because of “uncertainty about whether the model you have developed describes the world accurately.” He concluded that “mathematical modeling of risk can be an aid to sound judgment but never a complete substitute.” My first boss, George Egbert, Jr., Citib ank’s Director of Research in the 1960s, used to say of economists, “They should be on tap but not on top.” Reliance on risk modeling should be similarly limited. T“What Brian is really good at is ta king controlled and measured risk.” Thus spoke Nick Maounis, the CEO of Amaranth, less than a month be fore its collapse. He cited the more than a dozen members of his risk management team who se rved as a check on his star gas trader, and he said “spreads and options are of their very natu re instruments for positions which are designed to allow the user to capture upside with a much clearer understanding with respect to downside exposure” (The Wall Street Jour nal of September 19 and 20). But in the end, outsized profit potential without risk turned out to be a pipe dream as usual. TAmaranth’s systems didn’t appear to meas ure correctly how much risk it faced and what steps would limit losses effectively. The risk models employed by hedge funds employ historic data, but th e 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. T“It was a total failure of risk control to put your entire business at risk and not seem to know it,” says Marc Freed [of Lyst er Watson & Co., an advisory firm that 10 © Oaktree Capital Management, L.P. All Rights Reservedinvests in hedge funds]. “They were more leveraged than they realized.” (The Wall Street Journal, September 20) TAfter the fall, the Journal quotes Mr. Maounis as saying Amaranth’s traders “were surprised not only by adverse market moves that triggered the lo sses but also by the lack of ability to exit the losing positions.” That’s it, right there: the word “surprise.” It’s one thing to make an investment you know is risky and have it come out wrong. It’s something entirely different to make an investment that entails risk of which you’re unaware. TMr. Maounis and Amaranth’s risk managers shoul dn’t have been surprised. They should have been alerted by the volatility of the fund’s energy results. According to Till, its LPs should have been as well. “Investors would not have need ed position-level transparency to realize that Amaranth’s energy trading was quite risky.” But the evidence of that potential risk came primarily in the form of outsized gains, and these are rarely recognized as the red flag they are. TAmaranth’s investors relied heavily on its va unted risk management capability and on the assurance that risk was under control. But the fund failed to survive its seventh year. Quantitative risk managers can only opine on whether a disaster is likely or not. Even if they’re right about that, it’s up to you to decide whether you’re willing to bear the risk of an improbable disaster. They do happen! TUClassic Investment Mistakes THemlines 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 ove r. It seems Amaranth made several. TBorrowing 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 a ssets if you’re sure of being able to ride out a storm. But if you lack that certainty and face the possibility of withdrawal s 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 fo rced 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. TConfusing paper profits with real gains. The Wall Street Journal of September 20 points out that Hunter was encouraged by the posit ive 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. Th e Journal also points out that Hunter was such a big buyer in thin markets that his buying ofte n supported prices and cr eated the very profits he found so encouraging. But if the prof its were the product of his buying, and thus 11 © Oaktree Capital Management, L.P. All Rights Reserved 12 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 sh ould sell it,” his friend urged. “Yeah,” he responded, “but to whom?”  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.  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, b ut 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.  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.  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 commoditi es. Unusually warm weather can reduce the demand for gas for heating and also cause a record sugar crop (as happened this year). Thus th e prices of seemingly unrelated goods can decline together. Intelligent d iversification 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. * * * Orin Kramer manages the Kramer-Spellman hedge fund and, more famously, chairs the State of New Jersey Investment Council, which oversees the state’s $80 billion pension fund. He is © Oaktree Capital Management, L.P. All Rights Reservedextremely knowledgeable concerning risk and re turn, herd behavior and the vicissitudes of investing in an institu tional setting. In a speech a few w eeks ago, he made som e excellent points: TMy own view is that we exaggerate the ut ility of standard performance measures. In general, past performance reflects the interaction of partic ular historical and market conditions and the judgments and be liefs of managers during that period. In particular, managers may consciously or unconsciously pursue strategies which assume the risk of low-frequency, high-severity outcomes. Strategies which can only be torpedoed by low-frequency ev ents will mostly produce favorable outcomes; identifying the tail risk implicit in such strategies is an extraordinary challenge. The absence of the severe negativ e outcome is not, regrettably, proof that it cannot occur. (Emphasis added) TIn other words, (1) short-term investment perfor mance is not a helpful in dicator of ability, (2) good results can arise just because a manager c hose a high-risk course and was bailed out by events, and (3) that same course could just as eas ily have led to disaster . . . and certainly could do so next time. However, it’s rare for either managers or clients to r ecognize the unreliability implicit in short-term results, especially when they’re good. TOrin also notes that Amaranth “occurred when the skies were blue; the fund unraveled because a small and volatile commodity behaved in an unpredi cted fashion.” This collapse didn’t require an adverse economic environment or a market cras h. The combination of arrogance, failure to understand and allow for risk, and a small advers e development can be enough to wreak havoc. It can happen to anyone who doesn’t spend the time and effort required to understand the processes underlying his portfolio. December 7, 2006 13 © Oaktree Capital Management, L.P. All Rights Reserved 14Legal Information and Disclosures This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein. Further, Oaktree makes no representation, and it should not be assumed, that past investment performance is an indication of future results. More over, wherever there is th e potential for profit there is also the possibility of loss. This memorandum is being made av ailable for educational purposes only and should not be used for any other purpose. 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