When Genius Fails Again

It’s Monday evening at 7 p.m. and I’m writing this because my plans have been cancelled. I was supposed to listen to Karl, from the hedge fund Amaranth, who was to tell me “everything I always wanted to know about hedge funds but was afraid to ask.”

Unfortunately, Karl had to cancel. You see, Karl had a bad day.

Earlier today, Karl’s company sent its investors a little note informing them that Amaranth had “experienced significant losses following a dramatic move in natural gas prices.”

How big a loss? When you consider that Amaranth was managing about $9.5 billion and its fund was up between 25 percent and 35 percent this year, the losses add up to around $5 billion in a single week. That’s a lot of money.

So I understand why Karl cancelled, and I don’t blame him. But in the interest of my fellow classmates, I thought I would provide a hypothetical Q-and-A for the cancelled session.

Q: Amaranth sounds so exciting. But I don’t get it. What do you do?

A: Foundations, rich people, and pension funds—both public and private— give us money to trade just about anything because we create ingenious models that eliminate much of the risks from trading.

Q: Nice. Can I make a lot of money at Amaranth?

A: Oh yeah. The beauty of Amaranth is that we make money regardless of what happens. Things go well and we get our carry— usually about 20 percent of the profits. If things don’t go well, we still get the fees. In a big fund like ours, the industry average of 3 percent goes a long way. If we screw up, we liquidate the fund, return the diminished capital, and start the whole thing all over again. It’s a win-win-win.

Q: So to get more fees, you always want to get bigger?

A: Exactly.

Q: But doesn’t getting bigger require riskier positions to generate the big returns your investors want?

A: Yeah, but our models can handle that.

Q: Then how’d you lose 5 billion in a week?

A: Oops.

Q: Seriously?

A: At the end of the day, it’s just betting. Buying and selling natural gas the way we do is a trade on the weather. I bet hurricane, you bet calm seas. You win some, you lose some.

Q: And what about the firefighter whose pension plan put money into Amaranth.

A: Oops.

Alas, this Q-and-A was clearly fictional. I’m not a lefty (or even a Democrat). I don’t intend this to be a screed about the evils of capitalism. What Amaranth can teach us, rather, is the need for a little humility.

The people at Amaranth were the best and the brightest. They were graduates of the best colleges. They took fairly rigorous math and economics courses, where they probably learned Portfolio Theory and Black-Scholes option pricing models.

And to be fair, most of what was taught worked most of the time. But then a kind of lethal hubris began to settle in. They began to believe that the right models and right formulas would allow them to master the markets. It all became play money in a great game.

Had the Amaranth-kids ventured beyond this bubble, they might have seen that an infinite faith in reason was not only delusional, but in time, would also prove destructive.

Markets are, at their core, exchanges between human beings. And individuals don’t always act rationally. Sometimes when the computer says natural gas should go up, it goes down. That happens.

What shouldn’t happen is that we put so much faith in models and systems and forget that there are risks to these trades, bets that can fail, and individuals that can get hurt.