The Ignorant Investor

Gretchen Morgenson of the New York Times writes:

Enormous losses at one of the nation’s largest hedge funds resurrected worries yesterday that major bets by these secretive, unregulated investment partnerships could create widespread financial disruptions.

The hedge fund, Amaranth Advisors, based in Greenwich, Conn., made an estimated $1 billion on rising energy prices last year. Yesterday, the fund told its investors that it had lost more than $3 billion in the recent downturn in natural gas and that it was working with its lenders and selling its holdings “to protect our investors.”

The clients of the firm include all kinds of "pension funds, endowments and large financial firms like banks, insurance companies and brokerage firms" who have basically been chasing outsized returns in a sideways market. What happens when people get desperate to promise high returns? They start taking more risks. They start betting. And while some people are going to win their big bets, some have got to lose, too. Charles H. Winkler, chief operating officer at Amaranth, recently noted to clients that the fund was up 25 percent for the year, according to a source cited by the Times. But days later rumors started cropping up that the fund was bleeding cash in a losing bet on movements in the price of natural gas (when markets are moving sideways, that's really the only way to make money).

Now rumors are that the funds losses are even bigger than they're letting on publicly. But the best is way down in the story:

Amaranth employs a so-called multistrategy approach to investing that allows nimble portfolio managers to seize opportunities in whatever markets seem to be most promising at the time.

Now that Amaranth has owned up to huge losses in a single sector, “multistrategy’’ seems to have been a misnomer at the fund.

. . . according to its Web site. The firm deploys capital “in a highly disciplined, risk-controlled manner,” it noted.

The advertising doesn't reflect the reality? What a surprise. The thing is, anyone who promises huge returns without high risk is usually a weasel. Yet behind every huge loss with pension funds and other big entities are sophisticated managers falling for the promises of huge returns. These guys aren't dumb. It's just they have to make big money even when the market is fully priced and stable.

The article goes on to note that the firm's energy portfolio is run by Brian Hunter, a trader who joined the fund from Deutsche Bank in 2004. Hunter made so much for the firm in 2005, the Times notes -- an estimated $75 million to $100 million-- that he was listed among the 30 most highly paid traders in Trader Monthly magazine.

Who wouldn't take huge risks with other people's money when they payoff is $75 million a year? You'd be insane not to. The worst that will happen to Hunter, absent any fraud, is that he goes looking for a new job in another profession. Or just retires to sit his ass on his big pile of money.

The article wraps up by implying that more regulation may be needed in hedge funds because of their increasing power in the markets. About 9,000 hedge funds now manage more than $1.2 trillion in assets (maybe a little under a tenth of the money in mutual funds). I'm not holding my breath. An SEC effort at rulemaking in the area recently got tossed out by a federal judge, and a Republican Congress isn't going to be rushing intoregulate the industry any time soon.