Tuesday, September 19, 2006

How 'Bout That Incentive Pay?

by Tom Bozzo

Both the New York Times and Wall Street Journal have extensive coverage of energy trading woes at the hedge fund Amaranth Advisors. The W$J's headline is more dramatic than the Times's. As the natural gas market turned against the fund's bets (and gambling terminology seems the only appropriate way to describe their strategies), the fund lost $5 billion. Out of not-quite-$10 billion. In a week.

Dan Gross says:
Something tells me the gigantic losses at gigantic hedge fund, documented in the Wall Street Journal and New York Times today aren't going to show up in the various hedge fund indices that purport to track the performance of the sector.
Good question. Another is whether Amaranth will try to climb its way out of the chasm of its recent losses the old-fashioned way, or shut up shop on the grounds that it'll take too long for it to get back on the incentive fee gravy train. (*)

Yet another good question is whether top traders' pay packages appropriately reflect the risks they take. Their chief energy trader was lavishly compensated during the fund's high-flying days. Per the NYT:
Its energy portfolio has been overseen by Brian Hunter, a trader who joined the fund from Deutsche Bank in 2004 and conducts trades from his hometown of Calgary, Alberta. Mr. Hunter made enough money at Amaranth in 2005, an estimated $75 million to $100 million, to place him among the 30 most highly paid traders in Trader Monthly magazine.
Conceivably, Hunter will not do so well over the nearer term, but does his downside reflect that of his investors?


(*) Under usual arrangements, hedge funds that charge performance incentive fees (a percentage of the fund's returns) must clear the fund's previous 'high-water mark' to collect additional fees. Accordingly, a tactic used by some managers is to close the funds and start over if the high-water mark is too high.

We also remind interested readers that the lack of variation in hedge fund incentive fees, typically 20%, in the face of massive entry is an interesting economics-of-competitive-entry problem.
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