22 September 2006

Henry Blodgett: Risky Business (Slate)

Henry Blodgett has an article titled "Risky Business" on Slate that does a good job explaining why hedge funds sometimes make what seem to be stupid bets, but which are in fact perfectly rational from the perspective of the fund managers.

As an example, Blodgett cites Amaranth Investor's $6bn loss in natural gas:

In the immediate aftermath, such gigantic failures are usually attributed to the moronic mistakes. In Amaranth's case, for example, a 32-year-old named Brian Hunter was so sure he knew what natural gas prices would do that he bet the firm. Amaranth's bosses and risk-control people, meanwhile, concluded that the risks were worth taking because—well, for starters, because it was apparently inconceivable that gas prices could fall to levels not seen since … 2004.

Blodgett says that even though funds may be run and staffed by very bright people, their rewards and their risks are not aligned with investors:

For an aggressive trader betting other people's money, swinging for fences entails little risk: "Eighty percent chance I make another $100 million; 20 percent chance we bomb and I get another job."

The moral: before handing your money over to someone to manage, check that their interests are aligned with yours.

No comments: