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Roger Nusbaum has an interesting look at the Amaranth story on his site. As usual, good commentary. With a $5 billion loss in a week, this will certainly become a case study to add to any FRM or PRM curriculum along with LTCM, Baring (Nick Leeson), and Metallgesellschaft. By they way, those interested in risk management (industry pro or not) should look at these sites: Global Association of Risk Professionals and Professional Risk Managers' International Association.

During the bull market of the 1990’s we certainly saw enough risk taking as tech buying was like taking daily vitamin supplements. Supposedly good for you, so just keep on doing it. The problem was not enough focus on the general balanced diet (asset allocation). After the bust, we saw some risk aversion. “Risk management” has been the big buzzword with Sarbanes-Oxley and other measures put in place to deal with problems, albeit in a rather reactive measure. We can only hope that ongoing risk management becomes ever more pro-active than reactive.

But what I wanted to comment on was Roger’s comment on materials being roughly 3% of the S&P 500. Americans don’t have the same issues as Canadians, Australians or other commodity heavy countries have. The S&P/TSX Composite (broad Canadian equity index) had 16.7% in materials as of June 30th, 2006. 30.4% was in energy. No surprise but a challenge for investors.

Perhaps Canadians have been a bit spoiled watching the main equity indices here double over the past 3 years with the commodity bull market. Furthermore, the Canadian dollar has meant that foreign investments have generally seen performance degraded due to the foreign exchange.

So with the strong gains, you would think that diversification would be the way to go, possibly with the Canadian dollar being strong and a possible reversion to the mean in order. The problem is that the benefits of international diversification have been reduced with the increased globalization of world economies and markets. You would think that EAFE exposure would provide good benefit but even emerging markets are in question for Canadian investors (and anyone else with heavy commodity exposure). Take a look at this chart that plots the Canadian broad market index and iShares Emerging Market Index (NYSEARCA:EEM).

The black line is the S&P/TSX Composite. EEM looks like a leveraged position in the Canadian index! Thus, for any investor with heavy broad Canadian equity exposure, implementing a broad emerging market position provides little in diversification (the correlation does not seem to be low), but in fact you get the opposite. For those that may have bought emerging markets earlier this year to diversify their risk, it would have been synonymous to doubling down your bet at the poker table.

Thus, adjusting cash allocations and/or implementing put options are an absolute requirement for those who have made nice gains in the nice bull market we’ve had in the past 3 years.

If we see down markets like we had in May and June, then it will be too late for proactive measures. Reactive measures in the form of shorting futures will be required. For those who do not require a specific percentage hedge but can apply the use of ProShares’s inverse ETFs.

For those who think I have too much of a focus on the issue of the Canadian equity investor, take a look at how the emerging markets compare with the Goldman Sachs Natural Resources Index (NYSEARCA:IGE):

There’s again a strong correlation between the two except for the past month. If they continue to deviate, then that would be nice. If they continue to track, then investors need to consider what diversification benefits they provide to the rest of their portfolio.

Roger’s right. You have to be aware of how much you have in the commodity space. But you also have to be aware of other positions in your portfolio that may behave similarly with commodities. Emerging markets is just one example. There may be more. Part of risk management is finding the weakest link.

Like Barings and Nick Leeson, it’s hard to say that Brian Hunter, the trader at the center of this latest blowup, was the weak link. Sure, he did it. But who was watching the trades in the back office? Was their a compliance department monitoring things? There had to be a risk management employee at this hedge fund shop whose job was to measure the risks. We hear that other participants in the natural gas market knew of what Amaranth was doing and suggested that this blowup was of no surprise to them. Someone at Amaranth higher up the chain also had to know what was going on. If they knew, they’re in trouble. If they didn’t know, I actually think that’s worse.

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Source: When Diversification Just Isn't Enough