Schaeffer on Hedge Funds

10/06/2006 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

The light of the recent losses posted by hedge fund group Amaranth technical expert Bernie Schaeffer takes high-flying speculators to task and issues a wake-up call to investors who may be too far out on the ledge.

"Hedge fund group Amaranth blamed its spectacular $6 billion loss this month on "highly remote" moves in the natural gas market. Amaranth founder Nick Maounis said the fund would no longer engage in energy trading, but he defended its risk management policies, saying that "Amaranth felt confident it did not have unreasonable exposure in the natural gas market. Sometimes even the highly improbable happens and that's what happened in September".

"It's amazing to me that Amaranth seems to have relied on the same "principle" as did the disgraced managers of Long-Term Capital, "stewards" of what was (until Amaranth) the biggest blow-up in hedge-fund history. This "principle" holds that various historical relationships between various markets will "mean revert" once they begin to diverge significantly from the norm and has become an article of faith among many of the major hedge funds. Given the alleged sophistication of these supposedly risk-savvy players, it is shocking that a principle that thumbs its nose at these events that are far, far more common than any modeling ever suggests continues to have holy-grail status.

"According to traditional probabilistic stock market models (one of which a founder of Long-Term Capital had been instrumental in building), the odds of a stock market crash of the magnitude of October 1987 ever occurring would be considered to have been minuscule even if the market had been in operation since the day the Universe was formed. But unlike what the Amaranths of the world would have you believe, it is not that the 1987 crash was so incredibly "improbable." Rather, it is that these models that are so avidly followed by those who should know better and who continue to be dead wrong about the odds of so-called rare events.

"The equity markets have been in a derivatives-induced coma for several years now, and the upcoming fourth quarter is about as ripe a period as I can imagine for it to come to an abrupt end. Regardless of which way the break goes, we will likely have derivatives pain, which almost certainly means more hedge fund pain. An upside breakout can blow away those who've been heavily overwriting calls; a downside break creates potentially huge liability for those who have sold a massive quantity of very low delta puts that have thus far been "free money," month after month. Market moves may begin to feed on themselves rather than mean revert, and some players will pay-big time-for this."

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