Amaranth Advisors lost roughly $5 billion in a week, and this is from a hedge fund that boasted of world-class risk management systems. The result is a loss of 50% of the company’s asset base best summarized by this USAToday headline Faced with billions lost, Amaranth Advisors will shut down.
Amaranth Advisors was described as increasingly brash in their investments due to their confidence in their quantitative approach to risk management. According to this article in Business News, “The risk models employed by hedge funds use historic data, but the natural-gas markets have been more volatile this year than any year since 2001, making models less useful. They also might not predict how much selling of one’s stakes to get out of a position can cause prices to fall.” The Amaranth Advisors risk culture also had its roots in convertible-bond trading, a less-volatile market.
Enterprise Risk Management (ERM) best practices add a forward looking and scenario based approach for a more balanced and comprehensive view of risk. ERM is a process comprised of a series of iterative and sequential steps to enable continuous improvement in decision-making and performance with regards to the reduction of uncertainty within an organization. ERM helps a management team examine the markets in which it operates and formalize the acceptable risk tolerance for each segment. This process-driven approach helps a company set more appropriate controls to bring the business in alignment with the established risk appetite statement. This approach addresses the root cause of potential future problems rather than monitor transactions for historic symptoms.
The Amaranth Advisors outcome is a classic case that demonstrates the pitfall of an overly quantitative approach to risk management. Companies that have an over reliance on the traditional quantitative approach to risk management, namely the use of automated triggers based on data analysis to control risk, is much like the Emperor in the fabled children’s story who believed too heavily in just one approach for the source of his information.