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NYT on Amaranth as a Familiar Story, Youthful Bent Included

Ahead of Amaranth Advisors’ much awaited investors conference call, The New York Times has published an article A Familiar Story, Youthful Bent Included written by Heather Timmons. The article details the familiar story of a young, high-flying trader who does extremely well, before flaming out in spectacular fashion. The article starts with:

A high-flying trader takes big risks and produces spectacular returns before imploding — and possibly taking the firm down with him. It is not an unfamiliar story line in the markets, and it may be one that is playing out at Amaranth Advisors, the Connecticut hedge fund that said this week that it lost billions of dollars as a 32-year-old trader, Brian Hunter, made a bad bet on natural gas prices. Yet the huge money that has poured into the commodities markets in recent years means that more such blowups may be coming, fund managers say. Nearly $60 billion has been invested in often volatile energy markets by hedge funds, the Energy Hedge Fund center estimates.

“We’ve had a big buildup of a lot of risk, without a big blowup,” said Nassim Nicholas Taleb, the author of “Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets,’’ which contends that luck has as much to do with success in the markets as skill.

The whole article is worthy of reading for those that are interested in energy investments or the Amaranth story. Toomre Capital Markets LLC (“TCM”) is a capital markets consultancy specializing in Enterprise Risk Management (“ERM”). What TCM finds fascinating with the Amaranth story is that the senior managers at Amaranth seemed to be oblivious to the extreme risks that they were taking by concentrating more than half their investors capital in one investment strategy. We frankly do not understand how they could have invested more than half their investors’ funds in the energy sector and specifically on a bet on the price of natural gas. As this NYT article explains,

But trading commodities like energy may be particularly susceptible to such wild spins of the roulette wheel. “Trading commodities has always been a youthful game, because it takes a certain youthful aggression” to make the bold decisions necessary, said Jay Levine, principal of Enerjay, a broker and consultant in Portland, Me. “In general, these young bucks have a certain knack of getting in and out of the market.” Commodities also appeal to younger traders because of their use of leverage: only a limited amount of money is required upfront to trade. And because prices are very volatile, there is an element of instant gratification that also appeals. “Why sit in a stock for years waiting for it to appreciate when you can buy and sell something in hours,” Mr. Levine noted.

This NYT article also gives a clue as to what went wrong for Mr. Brian Hunter: his success led to his becoming a dominant market participant. As Mr. Hunter’s success continued, he was allowed to take on increasing larger positions, so much so that:

Traders in the natural gas market referred to Mr. Hunter of Amaranth as a “bully,’’ not in reference to his personality but to his ability to move the price of natural gas artificially, because of the huge positions he was taking. “It is very hard to play poker against a guy that has hundreds of millions at his disposal,” one trader said.

However, a dominant market participant is particularly vulnerable to hubris and unforeseen negative events. Often, young traders have only predominantly experienced the positive side of trading strategies. They rarely have experienced losses of the same or greater magnitude than their supposed “expertise” gains. Hence, they infrequently have gone the process of “lessons learned” when unexpectedly everything seems to go wrong at once. The NYT article elaborates:

What younger traders often lack is a strategy to unwind their trades if the market goes against them. “Anyone that tells you they don’t make a bad trade is a bold-faced liar,” Mr. Levine said. What separates good managers [and traders] from the bad ones is “how you recover from it, financially,” [and live to play the trading game again another day] he said.

The risk management of energy risk is quite different from fixed-income, equities and foreign-exchange instruments. Toomre Capital Markets LLC has prepared a marketing brochure for Advanced Micro Devices that goes into greater depth about energy risk management. This brochure should be available shortly. In the interim, as this NYT article explains,

“Energy trades a bit differently from most other commodities, in that the volatilities are quite high and liquidity can be varied and or poor,’’ said Michael Denton, an energy risk expert at Towers Perrin Risk Capital. Both issues present “risk control challenges,’’ Mr. Denton added, which can be managed by limiting concentration and providing adequate capital to support trading. Still, energy trading will always entail “significant risk,’’ he said, “because storage and transportation are limited and demand is stochastic and highly inelastic.’’ In addition, data used to build quantitative models to control risk are also more difficult to obtain or of poorer quality in the energy markets, Mr. Denton said.

This NYT article concludes with what happens when a trending market turns, particularly for young traders who never have experienced the downside of their supposed “expert” trading decisions. The conclusion of the article is as follows:

Most people investing in commodities are “investing on the sustainability of the cycle, on things going higher,” said Louis Gargour a former RAB Capital fund manager who recently founded his own fund, LNG Capital. Because so many people are buying and not selling, the short-term volatility has increased, which can particularly hurt people who are highly leveraged, as commodity traders are. “When the market retreats, it is vicious,” Mr. Gargour said.

He added, “No one listens to the risk managers until it is too late.” Especially the younger traders, said fund managers and longtime traders. They say the commodity markets are full of Brian Hunters, traders in their late 20’s or early 30’s, who have never traded through severe conditions like the plummet in crude oil prices in the 1980’s. Instead, they have watched as natural gas prices, as well as those of many other commodities, rose — unevenly, but with clear annual gains — since 2001. (The trading desk Mr. Hunter ran at Deutsche Bank suffered losses in 2003, but he contended in a lawsuit that he personally made money for the firm that year.)

Where more experienced traders in commodities have pulled out of the market in recent months, or made long-term bets that these historically cyclical investments would fall, younger traders may have been convinced the market could keep going up, say their peers. Emerging-market demand for commodities and fears about petroleum supplies has created what traders refer to as a supercycle, one that has driven prices higher, for longer, than ever.

“The young guys just keep on buying and buying, and say, ‘Who are you, grandpa, to say what value is?,’ ’’ said Mr. Gargour of RAB Capital, who is 42.
When a big risk taker is producing huge gains, the temptation to allow such star traders a lot of latitude is intense — especially at hedge funds under pressure to keep up strong annual returns. “When you’re a hot trader, people are afraid of not laughing at your jokes,” said Mr. Taleb, the author of “Fooled by Randomness.’’ “When you make a lot of money at a firm, you can start owning the firm. That’s the biggest risk when you hire someone who is very successful — you end up working for him.”

Toomre Capital Markets LLC wonders if the multiple sophisticated investors in Amaranth Advisors’ funds realized that they were entrusting their millions to a young hot-shot trader. One suspects that Amaranth’s offering documents did not highlight that the firm’s risks would be concentrated in the “expertise” of such a commodity trader. Today’s conference call with Amaranth’s investors certainly should prove to be interesting…