Amaranth: What You Should Know About Multi Strategy Hedge Funds

Dear &C1_DEAR,

Most of our investors by now have seen press regarding the large Greenwich, CT based hedge fund, Amaranth Advisors LLC ("Amaranth"), and their reported losses of over 55% on a "natural gas spread trade."

First off, let me note that the managers of funds on the Altegris platform have reported to us that they had no exposure to Amaranth.  Although I have no first-hand details regarding Amaranth's current situation, I would like to share some thoughts on the fund, or more importantly, on the style of manager Amaranth represents, a "Multi-Strategy" hedge fund.

Multi-Strategy Hedge Funds: What Exactly Are They?

Multi-Strategy (or "Multi-Strat") hedge funds represent some of the largest hedge funds on the street. Some of the biggest and most successful names in the hedge fund industry are Multi-Strats, including names such as Citadel, Tudor, SAC and others.

By definition, a Multi-Strat hedge fund employs a wide variety of trading strategies across a vast number of markets in order to generate returns. Rather than being confined to a specific niche style or market, Multi-Strat hedge funds possess the ability to dynamically float capital to whatever segment or strategy they feel will be most profitable.

Think of a Multi-Strat like a hedge fund-of-funds, but where the managers are all directly employed by the hedge fund. While a typical fund-of-funds may employ 10 or more strategies and hire 20-30 funds externally to execute their game plan, a Multi-Strat hedge fund may similarly utilize 10 or more strategies, but employs all the traders internally all under the same roof. Typically the traders for a Multi-Strat operate as individual trading businesses, keeping their own profit/loss book. This approach has both potential advantages and disadvantages.

Potential Advantages of a Multi-Strat...

One of the main reasons why Multi-Strats have had success attracting investors is that they are perceived by some to offer the diversification of a fund-of-funds, without the extra layer of fees, and without constraints on reallocation. The argument goes something like this... "I am as smart as your average fund-of-funds. I can allocate to my traders internally, and I won't charge you an extra layer of fees. I can redeploy capital internally to my trade desks wherever there is opportunity. If I have reason to believe that my energy traders have more opportunity than my currency traders, for example, I can reallocate internal capital with a phone call or an email. In contrast, if a fund-of-funds wants to reallocate, it may take months as they hire and fire external managers, many of whom have 90-day or longer liquidity constraints."

...and Potential Disadvantages

This argument is, on the surface, a logical one and has merit. However, there are also potential disadvantages with investing with a Multi-Strat manager. One potential issue is that the Multi-Strat investor may not receive the true benefits of diversification. As a Multi-Strat investor, rather than placing your money with a fund-of-funds, which in turn typically invests your money across multiple diversified managers, you place all your money with a single manager, who allocates internally among various strategies. The Multi-Strat manager's choices of where to allocate are constrained by the strategies that he or she has in place and the individual managers that run those strategies. In the entrepreneurial world of hedge funds, it may be easier for a manager to invest externally in multiple "best-of-breed" managers than to convince these same managers to all come and work for you.

Transparency is another potential area of concern. In the case of a fund-of-funds, my Altegris team may be able to contact the independent custodian or administrator of a fund-of-funds and receive full (or limited) transparency by obtaining reports of underlying allocations. Although in some cases this kind of transparency is not available to us, often a phone call or email can mean that we get a pretty good handle on the fund-of-fund's allocations for a specific period in time. This type of transparency is not so easily obtained with most Multi-Strats. Allocations can change in minutes, and Multi-Strats typically don't depend on third-party administrators to identify underlying allocations. Most Multi-Strat hedge funds deal with so many different types of strategies, it can be hard to get a handle on what the internal allocations and exposures really are.

In the case of Amaranth, transparency may have helped investors understand what type of risk they were potentially taking. If the reports are true, the entire fund has apparently been halved by outsized bets to their energy trading, which historically led performance for the fund. The fund was up over 30% earlier in the year, but recently loaded up on natural gas exposure and voila!—a 55% loss. The founder of Amaranth, Nicholas Maounis, a former Paloma Partners hedge fund guru, is highly regarded for his trading acumen. The list of institutional investors who the media has reported as having exposure to the Amaranth losses is long, and includes Geneva-based Union Bancaire Privee, San Diego County's retirement fund, Bermuda-based insurer Max Re Capital Ltd., Arden Asset Management in New York, and the pension fund of 3M Co., the St. Paul, Minnesota-based maker of Post-it Notes and other products. Funds managed by Goldman, Morgan Stanley, Credit Suisse Group and Deutsche Bank AG also reportedly had money with Amaranth, and they all found out the hard way that getting good transparency on a Multi-Strat isn't necessarily easy.

Why Would a Multi-Strat Like Amaranth Place Big Bets on One Strategy?

Still, it is amazing to me that a $9 billion dollar Multi-Strat could risk so much on one manager...or on one strategy under its roof. Although the numbers vary, fund-of-funds that report to Altegris often tell us that they limit the amount that they will allocate to a single manager, typically in the neighborhood of 5%. The reason is fairly obvious: if the manager has a bad run, you have a better chance to limit your losses. You would think that a well-run Multi-Strat would employ similar risk management. The institutional investors I mentioned in the previous paragraph, all presumably very smart people, may have had the same assumption when faced with a lack of transparency.

The problem may very well lie in the natural evolution of Multi-Strats. Most of you know that at Altegris, we believe size can kill a manager's returns, depending on the strategy. Many Multi-Strategy managers started out as small, single strategy niche managers that outgrew their capacity. When this happens a manager has a choice. They can close to new money (indeed some funds we had open a year ago are closed). They can continue to accept capital, in which case returns may suffer, or they can "expand" their operation and become a Multi-Strat fund. THIS PATH IS FOR THE BOLD AND BRAVE.

Once a manager decides to become a Multi-Strat, his whole world changes. Rather than focusing solely on the strategy that made them a good hedge fund to begin with, the manager has to hire and groom managers from a variety of different disciplines and build a business with competing personalities, internal competition and a variety of complex trading systems. I like to use the restaurant analogy...imagine your local small fine dining restaurant with 50 seats, deciding to open a multi-national chain and triple the menu choices. Very hard to do. I'm not saying it can't be done—indeed there are a few Multi-Strats that I respect and have my own personal money with, and ones that Altegris has placed on its platform. But in general, a Multi-Strat hedge fund is simply very hard to build and build right. Running a single strategy fund with $400 million with a team of 6 that you grew and groomed is much different than running a fund 20 times that size with 100 employees, an HR director and bureaucracy. Case in point, Nicholas Maounis, the Amaranth founder, started out as a convertible arbitrage trader, and I believe a very good one. He then built out a Multi-Strat fund. Where did he suffer his over 50% losses? From one source: his team of energy traders who were pursuing a strategy that is a far cry from his original discipline of convertible arbitrage trading.

So what can we learn from Amaranth?

It is, of course, far too early to tell. The purpose of this short letter is primarily to reassure Altegris's clients and prospects that our platform of managers have reported to us they had no exposure to Amaranth's losses. But further, I wanted to make this simple point: if you want access to a Multi-strategy manager, you should be aware that investing in a Multi-Strat does not eliminate single-manager risks. We at Altegris strongly believe there are some great Multi-Strat funds available. But for the most part, if an investor desires diversification in hedge funds, we will more often than not recommend either a quality hedge fund-of-funds, or the creation of a strong portfolio of single manager, single discipline products.

If you have any questions about this letter or would like to discuss this or any other issue with me directly, please don't hesitate to call.

Best regards,

Jon Sundt
President
Altegris Investments, Inc.
(858) 459-7040