Wednesday, July 31, 2013

Before Investing in Another Hedge Fund, There’s Required Reading

Before Investing in Another Hedge Fund, There’s Required Reading

Before anyone makes an investment in a hedge fund, they should be required to read one book: Barbara Dreyfuss’ Hedge Hogs: The Cowboy Traders Behind Wall Street's Largest Hedge Fund Disaster.  Whether you serve on an investment committee, a retirement board, or act as a sole fiduciary,        you should not make another investment in hedge funds until you’re done with this book.  Better yet, you ought to have your entire staff read it as well, and then schedule a meeting to discuss it.   While you are getting folks to read the book, add your consultant, actuary, and custodial bank to the list of required readers.

Ms. Dreyfuss chronicles the demise of Amaranth Advisers, a multi-strategy hedge fund that allowed its natural gas trader to build a series of investment positions that wiped out a majority of its investors’ capital.  The book contains some dramatic scenes, especially when Brian Hunter, Amaranth’s star energy trader, desperately tries to trade out of his untenable position.   However, the real value of this book comes in the details, and that is why Hedge Hogs is so important.  Ms. Dreyfuss shows how Mr. Hunter slowly amassed the means to destroy Amaranth, despite all the risk managers and risk management systems deployed by the firm.

Gatwick (2006)

There are times when you have to read this book slowly in order to grasp how Mr. Hunter and his competitors at other hedge funds are placing their bets on natural gas prices.  However, it is important to understand what is going on, because this small group of traders made speculative bets that were much bigger than the physical market for natural gas.  In other words, we get to see what happens when too much institutional capital swamps just one tiny niche of the investment marketplace.  We also find out that these speculative excesses have consequences for the real economy.  Ms. Dreyfuss details how Mr. Hunter’s trades distorted the natural gas market and made it nearly impossible for utilities, manufacturers, and other businesses to hedge their energy costs.

I am not recommending this book because it will help investors avoid making mistakes.  Rather, they need to read this book to help them prepare for dealing with the inevitable problems that will befall their hedge fund investments.  As more and more money flows into these types of speculative investments, there will be more implosions.  What happened to Amaranth isn’t the by-product of some cataclysmic event like the credit bubble.  Instead, Ms. Dreyfus reveals that an ordinary, well-diversified investment can turn toxic, when too much money meets someone who is willing to gamble with it.  For all of those investors who think that their investment checklists, scrupulous due diligence, and risk models will steer them clear of the next Amaranth, read the book and think again.  There’s probably another Amaranth already in your portfolio; you just don’t know it.

  

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