Hedge funds pass away all the time. Hedge Fund Research of Chicago estimates that 326 went out of business in the first half of this year. But Amaranth isn’t just one of almost 9,000 hedge funds, it was favored by the likes of Goldman Sachs, Morgan Stanley and Lehman Brothers, which steered billions of dollars of clients’ money into it. Lehman–which, like Amaranth and the other players here, declined to talk to me–has told its clients it got some of their money out. It’s not clear if any other advisers did.
Amaranth doesn’t seem to be corrupt in the way Enron or WorldCom were. It looks like typical financial excess: energy traders in Calgary, Canada, more than 2,000 miles from Amaranth’s home office in Greenwich, Conn., blew the fund. They’d made tons of money in previous years. Amaranth started 2006 with $7.5 billion and has probably lost more than 80 percent of it. Its investors and key personnel are going to bail. It’s done.
But rather than chew over Amaranth’s particulars, I’d like to show you the big picture: how hedge funds work and why the people running them can have different motivations than their investors do.
Most hedge funds don’t actually hedge their risks. They’re mutual funds on steroids–largely unregulated investment pools designed for big-money types who can afford losses. If a manager shoots for the moon and hits it, he can become enormously rich overnight. If he misses the moon the following year, his investors lose out–but he can often go down the street and start again, because some high-rolling richies seem perversely attracted to players who’ve hit the moon, subsequent disasters notwithstanding.
The key to this dynamic: fee structure. A hedge fund typically charges investors 2 percent a year of their investment (more than double a typical mutual-fund fee) to keep the lights on and the Bloomberg machines running. But the big money comes from collecting a share of investors’ profits. Twenty percent is typical, 50 percent isn’t unknown. This seems to align the managers’ interests with those of the investors. But often it doesn’t. Here’s why: let’s say your fund has $1 billion of assets, runs big risks and doubles its money in a year. The fund manager gets 20 percent of the gain: $200 million. Some of that goes to key traders, who would otherwise bolt for another shop. The following year, it misses the moon and shrinks to $1 billion. How much of the aforementioned $200 million does the manager have to give back? Zero. Heads, he wins. Tails, he loses investor money, not his.
To be sure, hedge-fund investors aren’t idiots. Hence funds have “high-water mark” provisions. In our case, the investors’ capital has to grow back to $2 billion before the managers can begin to collect profits: 20 percent of everything above $2 billion. But here’s the rub. If the high-water mark is very high, traders flee and managers may fold the fund and try to start a new one.
I’m not saying that all hedge-fund managers–or those at Amaranth–take idiotic risks or leave investors in the lurch (I do know Amaranth screwed up). I’m sure most hedgies are honorable and smart. But plenty will shoot for the moon with your money.
If there’s a good side to Amaranth’s implosion, it’s the embarrassment suffered by the state and city pension funds that put money into it. In recent years public pension funds seem to have become convinced they can magically cure their financial woes by winning big on hedge funds. That lets politicians avoid having to ask retirees to take less or taxpayers to pay more. But when you step into the world of hedge funds and other “alternative investments,” you’ve got to pick the right managers. Consider these numbers from Yale, whose endowment is legendarily successful. Yale says that the top quarter of “absolute return” hedge-fund managers made their investors 15.6 percent annually for the 10 years ended June 30, 2005. But managers ranked in the third quartile produced only 8.5 percent. In venture capital, the disparity’s worse: 28.7 percent a year versus a loss of 14.5 percent.
Finally, there’s Amaranth’s name. Its founder was invoking a mythical flower that never fades. But amaranth has a secondary meaning: a pigweed. I’ll say no more.
