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It looked like a hedge fund

Amaranth Advisors promised modest returns with little risk. But then it made increasingly bigger bets on a single commodity, until it all blew up

GREENWICH, CONN. -- A week ago Friday, top officials at Amaranth Advisors LLC gathered their troops and confirmed what many in the financial markets had already begun to suspect: that the $9-billion (U.S.) hedge fund had made a series of disastrous bets on natural gas prices; that these bets could ultimately cost the firm a considerable amount of its value; and, most ominously, that it would require a grim struggle merely to survive.

The day before, Amaranth had lost a staggering $560-million on its energy trades, compounding what had lately been a miserable run of luck for the six-year-old fund. With creditors about to bang on the door, and limited means of unwinding their positions, senior partners huddled at the firm's headquarters on the second floor of a sprawling office building nestled amid exclusive boarding schools and country clubs on the leafy fringes of Greenwich, Conn.

Brian Hunter, the precocious trader who ran the energy group -- and who many blame for creating the mess -- flew in from his native Calgary, where he is now based. Manos Vourkoutiotis, an executive who lives in Toronto and heads the Canadian operations, quickly arrived on the scene, joining company co-founder Nicholas Maounis to help manage the crisis with investors and lenders.

Over the weekend, the group began trying to sell off its massive natural gas positions and liquidate other portfolios, some as large as a half-billion dollars. Since then, the team has been routinely logging 20 hours a day to help contain the fallout from an estimated $6-billion in losses -- and perhaps salvage their reputation with angry investors and regulators, who are once again raising concerns about the murky world of hedge funds.

Yet what Amaranth lacked, observers believe, was precisely the foundation on which hedge funds were created more than five decades ago: A sufficient hedging process designed to provide consistent returns to investors regardless of whether the markets were moving up or down.

Amaranth didn't fall apart because it was acting like a traditional hedge fund. It fell apart because it wasn't.

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Greenwich, population 62,000 and holding rock-steady, may be the richest town in North America. The average price of a home here is $2-million, although there are many that fetch five, six, sometimes even 10 times that amount. A small apartment, assuming you can find one, costs about $2,400 a month. Indeed, it is so expensive that many of the professionals who work here "reverse commute" from Manhattan, where -- get this -- it is actually more affordable.

"There is so much goddamned money here," confided one local, a clear outlier in his white Pontiac. For most people, "the Bentley is the second car."

This isn't a wild exaggeration. Greenwich is like New England's version of Levittown -- if everyone in Levittown drove a Lexus, made more than $1-million a year, and lived in a Victorian estate.

No one has contributed more to this influx of new money than the flourishing hedge fund industry. There are an estimated 200 hedge funds in the area, controlling a staggering $120-billion worth of assets, or roughly 10 per cent of the global hedge fund industry.

Commercial real estate is virtually non-existent, and the little space that is available commands $85 a square foot -- double what it went for 10 years ago, and more than similar space can cost in New York.

Every morning, the early train from Manhattan snakes its way into the town's station and disgorges hundreds of professionals in neatly pressed suits. They march in a column up Greenwich Avenue, past stores like EuroChasse (European hunting and country clothing) or Richard's (an expensive men's fashion stop whispered to do $75-million a year in sales) before dashing into the local Starbuck's for a coffee. From here they disperse, some climbing the hill to ESL Investments -- run by Sears owner and legendary hedge fund artist Edward Lampert -- and others doubling back to Greenwich Plaza, two large, smoked-glass buildings that are reputedly home to dozens of funds.

The funds themselves, in keeping with their private nature, generally inhabit a collection of unremarkable offices, bereft of any signage to indicate their presence.

"They keep under the radar screen," said Mary Ann Morrison, president of the Greenwich Chamber of Commerce. " They are spending all day long at their desks, and then they are leaving at night."

Unless they stop off at L'esacle, a favoured watering hole in the Delamar Hotel, which overlooks Indian Harbor just a two-minute stroll from the former offices of Long Term Capital. On this particular day, a hedge fund conference is in full swing, and patrons swill glasses of wine in front of a 130-foot yacht moored alongside the outdoor bar.

Amaranth, in geographical terms anyway, is an outsider. Its building is about a 20-minute drive from downtown Greenwich, just a few miles past the neo-classical façade and well-manicured grounds of Tudor Investment Corp., a legendary hedge fund operated by Paul Tudor Jones.

Amaranth was the brain child of Nick Maounis, a finance professional who had cut his teeth trading convertible bonds for a decade at Paloma Partners. In September, 2000, he decided to strike out on his own and left Paloma to start Amaranth. He hired 27 employees, attracted about $450-million and launched the first Amaranth hedge fund.

During the market meltdown of 2001 and 2002, Amaranth managed to post decent returns of more than 5 per cent, which raised its profile, particularly among rich investors looking for a safe haven. Mr. Maounis, 43, began marketing his fund as a safe alternative to other high-flying hedge funds. He promised modest returns, around 10-per-cent annually, but with low risk.

The pitch worked, and by the end of 2005, Amaranth had amassed more than $7-billion in assets from a variety of blue-chip institutions as well as some very wealthy individuals, who had to commit a minimum of $5-million apiece. By then, the physical operations had also swelled, and the fund boasted 360 employees in Toronto, Houston, London, Singapore and Greenwich.

Mr. Hunter arrived in early 2004, at the invitation of Harry Arora, a former Enron trader who had joined the company to help build an energy trading business. Mr. Hunter was a math whiz who was trading natural gas at Deutsche Bank AG in New York before a falling-out with the firm.

Former Amaranth colleagues say Mr. Hunter kept his head down at first, plugging away at a variety of complicated energy trades. Mr. Hunter's big break came a year ago when hurricane Katrina smashed into the Gulf Coast, wreaking havoc in New Orleans and disrupting dozens of natural gas refineries. Prior to that, Mr. Hunter had made a series of trades based on the presumption that natural gas prices would soar, which they did immediately after the hurricane struck.

The strategy worked so well that Amaranth pocketed $1.3-billion in profit from energy trading in 2005 and $2.2-billion in the first eight months of 2006: stellar results, to be sure, but not the sort that typically point to a risk-averse hedging strategy. Amaranth billed itself a "multi-strategy fund," meaning that risk would essentially be minimized by diverting capital to various sectors and investments. But by this time, it was committing more than half its capital to the energy business alone.

Inside the firm, a former colleague says Mr. Hunter was treated like a god. He earned close to $100-million last year, and was allowed to run the company's energy trading from Calgary.

"There's a hubris which comes about people when they make money," said one former Amaranth employee who worked with Mr. Hunter. "At some point he thought he was infallible."

In July, Amaranth's funds posted slight monthly losses, but Mr. Maounis stood by his energy trader, telling investors that the company planned to start a $5-billion energy fund in December. By August, the firm's assets had climbed to more than $9-billion.

Then, inexplicably to investors, the wheels came off. There had been rumours in the marketplace for weeks that Mr. Hunter had backed himself into a corner with massive bets on natural gas prices -- bets that were highly levered through borrowing.

The idea was that the difference in price for natural gas between March and April of 2007, and also for 2008 and 2009, would increase heading into the winter. If it worked, Mr. Hunter could possibly have made another fortune, but if the spreads collapsed, then Amaranth could find itself in grave trouble. Of course, this is precisely what happened: The heavy borrowing left the firm scrambling, and investment banks threatened to pull their lines of credit, forcing Amaranth to dump its natural gas portfolio at a discount. The questions, in the aftermath, were simple ones.

"Where were the hedges?" was the blunt assessment of one veteran fund manager in Greenwich.

Amaranth certainly looked like a hedge fund: It dabbled in the requisite exotic derivatives, placed complex trades in the energy market, reportedly took both long and short positions in the stock market, and charged clients expensive commission fees. Yet it was undone by a risky gamble that gas prices would move in only one direction.

In a conference call with investors yesterday, Mr. Maounis blamed his troubles on an unexpected shift in the price of natural gas, and also on other players on the market, who ganged up on the fund without offering it any chance to liquidate its energy stakes "economically."

"We had not expected that we would be faced with a market that would move so aggressively against our positions," he said. "We viewed the probability of market movements such as those that took place in September as highly remote . . . but sometimes even the highly improbable happens."

The secretive nature of these loosely regulated investment vehicles has always prompted concern, and the worries about blowups have only intensified amid the hedge fund industry's breakneck growth: Total assets have almost tripled to $1.2-trillion since 2000, and are forecast to hit $2-trillion in a few years, as more and more money managers are lured by lucrative compensation.

Some industry observers believe this will be the impetus for regulators to finally crack down on the industry and demand better transparency. Indeed, the U.S. Securities and Exchange Commission has launched a probe of Amaranth, following the lead of Justice officials in Connecticut, one source confirmed yesterday. But given the myriad, and sometimes convoluted strategies employed, tighter regulation might not solve much.

The problem with the proliferation of hedge funds is that the term itself has become a cipher. Some self-described hedge funds are essentially value investors, taking long-term positions in a handful of stocks, and resorting to a minimal amount of short-selling for risk protection. Some dabble in esoteric commodities markets, or speculate on currency. Others have become activist investors, blurring the lines with private equity. In all, said one veteran hedge fund manager, there are probably a few dozen different styles.

All of this speaks to the same point: There is a glut of money chasing too few opportunities, and it is inciting some funds to take ever-larger risks.

The Amaranth Energy & Commodities Fund, for instance, gained 30 per cent in 2004, 72 per cent in 2005, and 52 per cent in the first six months of 2006, according to a June statement sent to investors. The total return since this group's inception in mid 2002 was a whopping 407 per cent, the documents stated.

"The disbelief for me is that all these fund of funds that populate the hedge fund business, that so many of them would turn a blind eye to a low-volatility fund like Amaranth posting such great results until they blew up," said one hedge fund operator. "That should have been a warning bell."

Six red flagsLightly regulated hedge funds are the fastest-growing segment of the Canadian financial market. With experts saying more flameouts are bound to happen in the sector, here are a few warning signs that investors should consider.

1. Higher-than-average returns

If you believe you're investing in a low-risk hedge fund, look at your returns. A double-digit return in a single month may indicate you're not in a low-risk fund, according to Tim Mungovan, a partner at Nixon Peabody LLP in Boston and head of the firm's investment partnership litigation practice.

2. Prevalence of credit derivatives

In the U.S., there's a mounting concern among experts about the sudden prevalence of credit derivatives, or contracts that are designed to allow hedging of credit risk.

3. 'Style drift'

Unlike other investments, hedge fund trading positions can fluctuate wildly from month to month. That's why it's vital to keep close track of any changes in the fund.

4. Overegging one basket

Beware of funds that aren't well diversified, both in terms of where they invest and who does the investing. 5. Legal structure

Pay attention to the legal structure of your fund. Many, at least in the U.S., are limited partnerships, which may make it more difficult for investors to take legal action in the event of any losses. 6. Complexity

Hedge fund strategies are becoming ever more complicated, and risk management systems may be failing to keep up. As numerous case studies of hedge fund blowups have shown, investing in complex trades is risky business.

© 2007 The Globe and Mail. All rights reserved.

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