Numerous articles over the past year-and-a-half have discussed oil market fundamentals, recognizing they were bearish, but looking forward to higher prices. "I'm a long-term investor," the writer says in defense of maintaining long positions in the face of collapsing prices.
The consequences of suffering a large loss are grave. The odds against recovering from large losses become staggering: it takes a 100% gain to recover from a 50% loss, a 200% gain to recover from a 67% drawdown, and a 300% gain to recover from a 75% loss.
Excessive losses erode investor confidence, compounding the problem. When losses exceed tolerances, investors abandon ship, locking in their losses.
Before that happens, the investor may be forced into reducing the exposure to prevent further large losses. If that happens at the wrong time, their capacity for recovery is reduced even further.
One might expect novice investors to get behind the eight ball like that, but not a billionaire hedge fund manager with decades of experience, right?
Confirmation Bias and Excessive Drawdown
According to articles in the press, crude oil trading legend Andy Hall started his firm, Astenbeck Management, with about $5 billion in assets under management (AUM) in March 2012, shortly after it registered with the SEC. Mr. Hall had amassed a fortune trading oil when prices were rising in the 1990s until the financial crisis. Then he shorted the market and famously earned a reported bonus of $100 million, when his firm was owned by Citicorp.
Most recently in his Letter of Investors reviewed by Reuters, it had $2.1 billion at the end of March 2016, a $3 billion loss, about 60% over a 4-year trading period (see graph for annual returns).
Mr. Hall's performance over the past four years is clearly a major departure from his reputation. His German castle that exhibits part of his art collection is pictured below.
Hall Art Foundation | Schloss Derneburg (Germany)
From a distance, my objective opinion is that Mr. Hall has been blinded by "confirmation bias," the tendency to search for, interpret, favor, and recall information in a way that confirms one's beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities."When you believe something, facts become inconvenient obstacles," Hall wrote in April (2014) according to Bloomberg's Bradley Olsen.
Two years ago, he formulated an investment thesis that crude oil prices would rise to $150 per barrel. His reasons shifted over time but he maintained his long position for much of the two-year period.
In his March 2016 letter, Mr. Hall wrote that U.S. crude production was almost 863,000 b/d lower than being reported by the Energy Information Administration. Based on production reported for January, output would have to have suddenly dropped by 900,000 b/d in February for Mr. Hall to be correct. According to Astenbeck's most recent Form ADV filing on March 30, 2016, the firm has just 4 employees who perform investment advisory functions, including research.
When crude prices bottomed in the first quarter of 2016, I deduced that he had reduced his long exposures on his remaining equity. Consequently, he was only able to capture about one-quarter of the rebound.
Although his hedge fund made money for the first time in five months during March 2016, he greatly underperformed the rise in crude prices. WTI spot prices rose by 24%, but his Astenbeck Commodities Fund ll gained just 5.9%, about 25% of the rise. Ironically, he had throttled back his exposure by 75% took that step just as crude prices bottomed after suffering huge losses from the long side.
It seems obvious and simplistic, but the lack of risk management can bring down even the those who have been at the top. A risk management plan and execution strategy is essential for all financial advisors and investors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.