Just a few weeks ago, the Amaranth hedge fund flew investors in to gloat about its incredible year to date performance. Their 30% gain since January had beaten the stock market hands down and energy trader Brian Hunter was being hailed as a market guru.
With natural gas prices reaching two year lows, Mr. Hunter then made a calculated bet to go long natural gas and quickly leveraged this bet as far as he could. As the market continued to tank, Amaranth’s fortunes declined, and seemingly overnight, one of the giants of the hedge fund industry revealed it had no choice but to unwind its positions and shut its doors. While certainly not the first hedge fund to go under, Amaranth’s fall could be the catalyst for a severe chain reaction as more and more hedge funds reveal their financial positions are deteriorating quickly.
The fall of Amaranth underscores important points about both the hedge fund industry and commodity investing in general. Since futures contracts are nothing but an agreement to buy a product in the future, very little money is needed to initially purchase such a contract. This quality of the futures market means that the majority of traders are leveraged. If the value of the contract goes up, no one may ever realize that a trader bought $30,000 worth of natural gas for only $2000 bucks. But as with all leveraged bets, if the price goes against the trader, their losses are multiplied. Hedge funds, in search of high returns, have utilized leverage for years, especially in the commodities market. This has played out handsomely for them as commodities have performed fantastically over the past 6 years. It is little coincidence that the emergence of hedge funds has occurred at the same time that the commodities markets have taken off.
But with a slowing economy, the price of oil, gold, silver, natural gas, and many other products have started to taper off, sending shock waves through the financial system. As the value of all of these products slip, many hedge funds, in a desperate effort to regain their losses, increase their leverage, hoping for a rebound. Amaranth tried this technique with little success. Their vulnerability on the downside became too great and the losses multiplied. And while Amaranth may be the first hedge fund to go down in a commodity bear market, there is no question that it will not be the last. If the price of oil, gold, sugar, and metals continue its recent decline (as we believe it may), the number of hedge funds going under will multiply exponentially.
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