It's become clear to me that my conception of what a hedge fund is (or should be) has little basis in reality. See, when I think of a hedge fund, I think of a fund that has identified some discernible arbitrage opportunity, arising from investor bias or regulatory incongruity. Either that, or the fund's strategy is the practical application of some obscure finance paper, perhaps embedded into some software that trades automatically. This view, however, is a little too idyllic it would seem, since a lot of funds are simply uni-directional bets on a certain asset or derivative. In the case of the recent Bear Stearns fiasco, some are actually claiming that the fund wasn't a hedge fund because there was no, you know, hedge. Or take last year's big blowup, Amaranth:
But what gets me is that Hunter's trade was so mind-numbingly dumb, an unsubtle bet, like betting a lot of capital that oil doesn't go below $50 next year. It doesn't suggest a strategy of any depth. Further, his position size was large enough (40% of the NYSE outstanding contracts for certain gas futures) that, like Long Term Capital Management's volatility trade in 1998, or Victor Niederhoffer's 1997 losses at the CME, market makers exaggerated the price movement when they sensed that a big position was going to have to cash out. Nothing moves prices more quickly than knowing a big player is going to have to buy back, or sell out, of his position. So Amaranth's strategy was doubly dumb.
That's what really surprised me when I first heard about Amaranth -- I assumed that there must've been something more than just a bet on the price of oil. I figured that there had to be, as Eric Falkenstein put it, more depth. After all, why lever up on a simple bet like this, if it just means that you're levering down at the same time?