Smart Hedge Fund

The Real Reason Amaranth Failed

The Slate article hit the right point: it is the compensation system for hedge fund operators that drives reckless behaviors in hedge fund managers and causes the catastrophic failures like Amaranth.

The real risk facing hedge-fund employees is that they won't make a killing. The average base salary (pre-bonus) for a hedge-fund peon is about $150,000—a lot of money in the real world, but chicken feed in this one. If hedge-fund peons don't help their bosses make a killing, they don't get big bonuses, and they often get fired. If the bosses don't make a killing, meanwhile, they don't get big bonuses and they often get fired by clients, who aren't paying massive hedge-fund fees to earn bank interest.

The way to keep your job and get rich in the hedge-fund business is to generate gains—on which you collect "success" fees that usually range from 20 percent to 50 percent. It doesn't matter whether the gains result from luck or skill, and it doesn't matter how much risk you take to get them. From the perspective of a hedge-fund employee, therefore, the risk/reward proposition looks like this:

Be conservative = medium risk, low payoff

Swing for fences = medium risk (get fired), enormous payoff (get massive bonus)

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." It's no wonder, therefore, that Hunter threw billions at chancy bets. He had a fortune to gain and little to lose. For Amaranth's bosses, meanwhile, the risks were greater—bad press, reputation damage, and, maybe, a pang of guilt about risking the jobs, bonuses, and deferred compensation of 400 people who didn't make $100 million last year—but, still, the risks weren't career-threatening.