The Rub: Part 1

“To sleep – perchance to dream: ay, there’s the rub!” -William Shakespeare (via Hamlet)

According to Grammarist, “The rub is a reference to the English game of bowls, where a rub is a flaw in the playing surface that interferes with the ball’s trajectory.” The more you know.

Having your own “stuff” can be nice. It’s a source of independence, of freedom. Eventually, we grow up, venture out from our parents’ protection, and make our own homes. Free at last. In some places, you can even dig a well and have your own water supply. And now Elon Musk can deliver you a solar roof, and you can generate your own electricity. Living off the grid: now that’s freedom! Or, to quote William Wallace ala Braveheart, “Freedooooooooooooommmm!” As long as your off-grid abode is far enough from your neighbors, you can yell this all day long between complimentary sips of well-water and on-the-house (literally) Tesla charges.

Off-the-grid living sounds excellent, but it’s also wise to build-in contingency plans, for instance: staying within a few miles of friends or family, just in case help is needed; having a friendly neighbor and a long hose for when the well-water isn’t flowing so good (see what I did there?); or, for those opting for solar power, maintaining a connection to the grid in case of emergency.

On a broader scale, most US states are tied together with other states to help react and assist with ebbs and flows of power generation and demand that occur naturally along with seasons or other weather changes. If you’ve followed any news in recent months, then you may have learned (like I did) that Texas is not one of those states. In fact, it’s the only state with its own power grid. That is fantastic when it works, but not so great (or disastrous) when it doesn’t – especially during an unexpected arctic vortex.

I’ve thoroughly enjoyed the time I’ve spent in Texas in recent years – the people, the music, and especially the brisket (which is the stuff dreams are made of, and a whole other conversation about “the rub”). And I completely took for granted the precarious infrastructure powering the glorious blues that screamed from Stratocasters up-and-down Austin’s 6th street. It took an unexpected winter storm to expose the weakness, but, in financial terms, the Texas power-plan was “short volatility,” which is to say that the strategy worked well until it didn’t. And therein lies the rub.

There are some classic examples of short volatility (aka “short vol”) gone wrong in the Alts world, and it’s a good idea to revisit them from time-to-time to learn from past mistakes. Some of these are even included within the CAIA® (Chartered Alternative Investment Analyst) program coursework for precisely that purpose: a greater understanding of what has gone wrong in the past should help us avoid similar future oversights. With the following four examples (in this post and an upcoming Part 2), we’ll span multiple decades, structures, and strategies, but what they have in common is too much leverage (implicit or explicit) that led to success, followed by an abrupt, painful demise. These are some real-life examples of hedge-fund blow-ups.

Amaranth Advisors, LLC

The Amaranth debacle earns the top spot in many hedge-fund-blow-up lists, so it’s a great place to start our discussion. Founded as a multi-strategy hedge fund in the year 2000, by mid-2006, Amaranth had raised over $9 billion in assets, and “energy trades accounted for about half of the fund’s capital and generated about 75% of its profits” (source: CAIA Level I, third edition). The concise version of the story is that the fund took outsized bets using natural gas futures, and suffered when the market moved against them; i.e., there was no contingency plan for things going wrong. While that strategy generated $1.26 billion in profits in 2005 (along with huge incentive fees for executives and traders), the fund ultimately lost about $6.6 billion into September of 2006, as positions were unwound and sold at a discount to other firms.

Now let’s consider why the underlying risk of the fund may have been overlooked by investors or even officers of the firm:

  1. Nicholas Maounis, the founder, came from another well-known multi-strategy fund, Paloma Partners, which was (and still is) known as a true “multi-strat,” in the sense of not being overly concentrated and focused on risk management. Also, Mauounis worked on Paloma’s debt side – nothing to do with energy – and originally founded Amaranth with a focus on convertible bonds. Given this backdrop, one might have expected a pretty “middle-of-the-road” experience from Amaranth.
  2. “Multi-strategy” can often imply a fair degree of diversification. While there were various other strategies included, such as convertible bonds, merger arbitrage, long/short equity, the fund became increasingly concentrated in the energy sector over the years. If earlier investors weren’t monitoring this trend closely, then they would have been surprised at the excessive natural gas exposure.
  3. The fund was doing very well….until it wasn’t. The positive performance could have caused more relaxed due-diligence by investors and less scrutiny from the fund’s internal risk officer. 

Long-Term Capital Management (LTCM)

LTCM was founded in 1994 and posted incredible net returns of 21%, 43%, and 41% in its first three years. To create those returns, the fund largely employed a strategy of fixed-income arbitrage combined with high leverage. The fixed-income arbitrage concept is innocent enough. Suppose there are similar securities (e.g., treasury bonds of different maturities) that are priced differently now but expected to be priced nearly the same in the future. In that case, one can place bets on the convergence of those prices.

As discussed briefly in Portfolio Longevity Part 4, convergence bets can be made by shorting (selling) the security expected to fall in price while simultaneously going long (buying) the one expected to rise in price. In normal times, these trades can produce a very steady and predictable source of returns. Then just add leverage, and – violà! – those returns can be multiplied to show incredible performance! By the end, however, even equities were incorporated into LTCM’s strategy to some degree.

The firm was able to grow to a size of about $5 billion before collapsing to about $400 million in September of 1998, as the 1997 Asian financial crisis and 1998 Russian financial crisis shifted the expectations of their trading strategy and led to losses. Even if the trades may have ultimately worked if held longer-term, leverage does not allow for staying power through periods of volatility. It does the opposite. The leverage employed by LTCM mind-blowingly included not only a 50-to-1 ratio on cash positions but – taking into account futures, swaps, and other derivatives – a total implied leverage ratio of 300-to-1! (source: CAIA Level I, 3rd Edition).

LTCM’s fundamental flaw was that their modeling of the trades and associated risk expectations (VaR, or value-at-risk – a topic for another day) didn’t allow for outlier events that occur in the real world. Instead, they were based on historical data that simply did not include such risks. The instant their trades moved against them, the assets could no longer support the leverage, and the collapse was inevitable. Ultimately, 14 financial firms came together as part of a bailout of LTCM’s balance sheet, and partners of the firm lost about $1.9 billion of their own money. Total losses were $4.6 billion. 

On to Part 2

We’ll cover more examples in part two, including the tale of a daily-liquid mutual fund gone wrong. We’ll also consider what investors can do to help avoid or at least mitigate these types of risks in their portfolios.

Until next time, this is the end of alt.Blend.

Thanks for reading,



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About the Author

Steven Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S. – and volunteers as the Treasurer for Campus Fun & Learn, a child development center on the campus of Rockland Community College in New York.