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September 25, 2006 9:54 pm

James Altucher: How to avoid blow-up blues

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I don’t like to bring up the memory but the events of this week remind me of my most embarrassing moment running other people’s money. It was late 2003 and a potential investor wanted me to stop by his house, meet his wife and family, and enjoy their cooking. I would stay overnight in the guest room and we would have our meeting in the morning the next day. He has eight kids and, inevitably, some of them were sick. Specifically, a stomach flu. The meal was pleasant, good conversation, a fine steak and wine, and all the trimmings.

A few hours later I thought I was going to die. I spent the whole night in the bathroom, which happened to border my hosts’ bedroom. And I was making a lot of noise. By morning I had to call a car service and just crawl into it to take me home. Ugh. I can’t bear to even think about it. We ended up good friends. But still. Pain.

I was reminded of that this week because it feels the exact same way to be an investor on the opposite side of a blow-up. I’m not invested in Amaranth so I can’t speak about that particular pain but I can imagine the stages the investors in Amaranth must have gone through.

Denial. “This is Amaranth. There’s no way those rumours are true. I’ll just call my guy there and we’ll work it all out.”

Paranoia. “My guy” never calls back. He is always out to lunch. Or in a meeting. Or, “he just left for the day. And his cell phone coverage is spotty where he is”. Because the suburbs of Greenwich, Connecticut are kind of like the Amazonian jungle. It’s true. Then it hits you. The worst thing is happening. Someone has either stolen your money or something else really horrible is happening.

You get a note on Friday afternoon, “Don’t worry. We’ll be sending a communication to investors on Monday.” A what? A “communication”! You don’t get that e-mail until Friday at 5.20pm. You try to call but voicemail picks up everywhere. You attempt to call people at home but they are all unlisted or not picking up. It’s a long weekend. You are lying in bed and the ceiling is spinning. Trips back and forth to the bathroom. Your wife and kids want to cheer you up but nothing can happen. You are on the phone for hours with your partners working through all the scenarios until finally you get the e-mail . . . 

Reality. Your investment was down 65 per cent for the month. You are almost relieved it was not more until you finally realise you are out of business. They were 8 per cent of your funds and you are going to have the largest drawdown in your fund of funds’ history. “How could you not have known this was probable?” all of your investors will say. Not only that, you have invested in a blow-up. You are officially in the penalty box now as far as new investment. Welcome to hedge fund hell.

My opinion is: kudos to Amaranth! Maybe the guy made a rogue trade. Or maybe not. Hedge funds are supposed to take risks. George Soros once bet a billion on the pound. What if it had gone against him? Would he then have been considered a rogue trader? Finally, someone stands up and takes a stance. Eighty per cent of hedge funds are in ExxonMobil, Microsoft, Wal-Mart and Procter & Gamble. Ugh. And then they charge their investors 2 per cent management fees and 20 per cent performance fees. Oh, and on top of that, you can’t get your money back for the next three years. And even then it is only 10 per cent a quarter you can redeem.

And, by the way, don’t call us, we’ll call you, and don’t expect to file your taxes on time because it ain’t going to happen.

If you’re really upset with the Amaranth situation, and want to avoid all the typical problems with hedge funds, here is one suggestion. I was speaking at a conference (“The Art of Indexing”) in Washington last week. On my panel was Gary Knapp who researches derivative products for the New York Board of Trade.

He showed me a strategy he had been working on: using futures, go long 80 per cent Russell 2000 futures and 20 per cent T-bills. Then do two market neutral-overlays: first, go long 100 per cent Russell 1000 Growth and short 100 per cent Russell 1000 Value (so you benefit if “growth” beats “value” for large stock).

Second, go long 100 per cent Russell 2000 Value and short 100 per cent Russell 2000 Growth . This way you win if value beats growth among smaller stocks. He tested it out from 1994-2006. During bull markets, bear markets, liquidity disasters, wars, recessions, rising interest rate periods and declining interest rate periods. Bubbles and busts. The result: 11.8 per cent a year with low volatility.

Then he overlaid a chart of the hedge fund index. It was almost identical. “Why bother paying 2 and 20,” he said, “and have your money locked up when you can just do this and probably get better returns and get your cash back the minute you need it? And you avoid an Amaranth.”

Hmm, but it’s not esoteric enough. I might not be invited to dinner any more.

james@formulacapital.com

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