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Another One Bites the Dust!

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Amaranth Advisors, LLC’s Chairman recently told investors that “highly unusual market behavior” and “a series of unusual events” caused the loss of over $6 billion dollars to a fund that started the month with $9.2 billion. That’s the hedge fund equivalent of “Stuff Happens!”

Not to worry though, investors can remain confident that all will be OK. The chairman went on to say that “the firm had full-time, well credentialed, experienced risk professionals to monitor and model our energy-portfolio risks”. The firm will continue to operate. “We are fully prepared to do what it takes to restore your confidence”, and recent events should not obscure “the quality of the platform that Amaranth has built” *1. What can this guy be smoking?

Apparently, the bet that went wrong centered on the spread of natural gas futures prices between contracts maturing in March and April of next year. Lots and lots of leverage was employed. But, when it hit the fan, there was no liquidity in the market to allow them to unwind their positions. Just how many investors do you think understood that? It certainly seems Amaranth didn’t. But, what about all the professional advisors that recommended them? Just what level of diligence did they exercise?

Meanwhile, the firm’s investors must be patient because most of them are subject to a two year lockup. There were reports that some investors offered their shares on Ebay! I wonder how the SEC and NASD feel about that? Having failed in the courts at a recent attempt to regulate hedge funds, perhaps the SEC should turn their attention to regulating Ebay?

Regulation and oversight is in order, and the SEC seems ready to attack the problem from another direction. Bravo! As you might expect, strong political opposition has emerged. Right now no one even has the foggiest idea how much capital the hedge fund industry has in play, or what the risk to the financial system might be. But, the 1998 failure of Long Term Capital Management should have given us all a wake up call. Absent some inspired intervention by the Federal Reserve, the cumulative losses of this one single fund threatened to bring down the world’s financial system. Yet today we still have no idea how much threat these gunslinger funds might pose.

Victims of Amaranth included some institutions that should supposedly know better such as a pension fund of 3M, funds of funds run by Goldman Sachs, Morgan Stanley and the long suffering people of San Diego County that suffered an $87 million loss out of $175 million invested last year for their retiree pension plan.*2 If those institutions failed so miserably to do due diligence on Amaranth, who might be qualified? In my opinion, there is not one institution on this planet that can properly evaluate many of these funds.

Here is something that should give you a hint that this is the toxic waste of the securities Industry. If I were to recommend even one penny of this to a single client, my insurance company would cancel my Errors and Omissions (Malpractice) Policy. At least they seem to understand the risks.

Each new generation must learn some lessons the hard way. Is there any parent out there that thinks he has been able to prevent his/her children from making many of the same mistakes that they made when they were younger?

As I survey the hedge fund industry I’m overtaken be a strong case of déjà vu. In the 80′s we had limited partnerships in real estate, equipment leasing, oil drilling, wine storage, movies, and cable TV. They all charged obscene fees, provided no liquidity, flew under the radar of most regulators, provided opaque disclosure, and offered seductive diversification from the traditional stock and bond markets. Much of the marketing stressed low level risk, alluded to “smart money” investors, and created an aura of exclusivity. Becoming a member of this sophisticated club of knowledgeable investors distinguished you from the chumps who were not offered admission. Does any of this sound familiar?

The sheep lined up to be fleeced. Gullible investors sank billions into these swamps. Most received pennies on the dollar or nothing at all in return.

And now, fast forward to today. Nothing has changed. The chumps are still lined up at the door. Like any bemused parent of teenaged children I can only shake my head and wonder how to get through to them. The “Just Say No!” message doesn’t appear to be working. They are going to have to learn their own lessons. It may get ugly!

*1 Accountants World 9/25/06

*2 Institutional Investor 9/27/06