Avoiding Amaranth

Several South African investors lost money in the Amaranth hedge fund debacle. (Amaranth Advisors announced that losses in September amounted to $6bn, or 65% of assets under management.) Their exposures were typically held through Funds of Hedge Funds (FoHF's), to whom they had entrusted the job of conducting thorough due diligences designed to avoid such calamities. Yet, even revered fund of funds, including those of Goldman Sachs and Ivy, suffered setbacks from exposure to Amaranth.

No doubt the founders of Amaranth chose the name because it means (a flower)that never fades. Investors hoping for amaranthine returns must find this tragically ironic. Incidentally, amaranth also means a short-lived herb!

Amaranth's losses were primarily due to a large bet on natural gas futures. The answerable trader, 32-year-old Brian Hunter, incorrectly bet that these would go up further. Was this just bad luck and by extension, were the invested FoHF's just unlucky? We think not. In spite of our own fund of hedge funds 100% track record of avoiding hedge fund disasters, to our regret we do not own a secret recipe for avoiding fraud or catastrophe. Yet, we believe there were some strong indicators of impending disaster:

* The trader worked in Calgary, 2,000 miles away from the risk officer in Connecticut. Some of his previous positions in gas futures had paid off. Our interpretation is that his roll of the dice had been lucky a few times. This led, as it often does, to a misplaced sense of invincibility that evidently ingressed itself into his geographically remote colleagues. So, bigger bets were allowed for the next role of the dice.

* The fund was grotesquely under-diversified.

*  Nearly all CTA's and managed futures hedge funds use trading systems opaque to investors. Consequently, they elude sensible asset allocation by FoHFs and we think they should be avoided irrespective of past performance.

*  Most FoHF analysts are as susceptible as any investor to backing yesterdays winner. But even for those given to herd mentality, in this case the quantum of yesterdays win, seen against the purported management style, should have raised the alarm.

It seems that greed once again triumphed over prudence.

On a brighter note, the doomsayers (most audibly, purveyors of long-only funds) who perennially predict systemic disasters caused by hedge funds must have been disappointed that global financial systems so easily absorbed the fallout. Also, this episode is NOT a strike against FoHF's - on the contrary, investors who lost money through a FoHF's exposure to Amaranth fared dramatically better than those who chose the single manager route and invested in a fund designed not to fade.

By Rowan Williams-Short, Chief Investment Officer, Nedgroup Investment Advisors (UK)