Last week, Amaranth became the highest-profile hedge fund to collapse since the Long-Term Capital Management (LTCM) fiasco in 1998. With all the hand-wringing going on, and with barely a week's perspective on the events, I thought I'd offer up a few observations.

First, our financial system is probably more robust than it was in 1998. At one point during this summer, Amaranth's assets totaled $9 billion, more than LTCM ever managed. When the latter threatened to fail, the Fed organized a privately funded bailout to prevent any disruption in global financial markets. While undoubtedly painful for its investors, Amaranth's woes don't jeopardize the integrity of the financial markets; I've seen no report that the firm has failed to meet any of its obligations with its counterparties or creditors.

You might object that LTCM employed much higher leverage than Amaranth (40 to 100 times vs. 3 to 8 times, according to estimates). You'd be absolutely right, but that's partly my point: Investment banks that provide prime brokerage services have become smarter about managing their lending to hedge-fund clients. As it happens, the Financial Times reported that UBS (NYSE:UBS), which had the largest exposure of any major bank to LTCM, refused to act as prime broker for Amaranth's energy trading unit over concerns about its risk-management procedures.

While banks may have a better handle on credit risk, operational risk remains a concern. Although they have recently made great progress on this front, the banks' back offices are still working through a backlog of credit and equity derivative transactions (according to a recent report by Greenwich Associates, hedge funds now account for more than 55% of the trading volume in credit derivatives).

Regardless of advances in risk management, many individual funds will continue to fail or close voluntarily, and most of them we'll never even hear about. According to one paper co-authored by MIT professor Andrew Lo, the annual attrition rate for hedge funds actually increased between 1998 and 2003, to 10.7% from 9.5%. Other studies estimate a mortality rate as high as 20%. Either way, this starts to add up in a fund universe now numbering 8,000.

Fund assets are particularly vulnerable when managers behave as if risks that are difficult to quantify simply don't exist. In this case, it seems that Amaranth's head natural gas trader, Brian Hunter, and the fund's risk managers badly misjudged the liquidity risk associated with large derivatives positions in the natural gas market. (Specifically, it's the risk that unwinding a position will contribute to adverse price changes.) Where leverage is involved, the market is the only reality that counts -- or, in John Maynard Keynes' well-worn words, "The market can stay irrational longer than you can stay solvent." At a certain level of losses, Amaranth's brokers simply informed the fund that they would begin closing out its positions.

All this might seem academic for many individual investors who do not qualify as accredited investors for direct investment in hedge funds. However, many pension funds (both public and private) now allocate part of their assets to hedge funds, and various public companies also have exposure to the hedge-fund industry. The UK's MAN Group (LSE:EMG.L) is the largest hedge-fund provider in the world, while Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) are the 800-pound gorillas in prime brokerage. (Goldman is also one of the world's largest hedge-fund mangers.) All three firms manage hedge funds of funds (funds that are portfolios of different hedge-fund interests) that were invested in Amaranth.

Finally, Amaranth's failure may have nipped a nascent industry trend in the bud, at least temporarily: that of hedge-fund IPOs. Earlier this month, TheNew York Times reported that hedge fund and private equity manager Fortress Investment Group was considering an IPO in the fall. Amaranth's stunning demonstration of the speed with which a hedge fund can come undone will certainly have cooled investor enthusiasm for any such offering. The market can't be ignored, whether it be in natural gas or initial public offerings.

Earnings Growth (Est. 5 years)

P/ BV*

Forward P/ E*

Goldman Sachs

15.0%

2.5

9.9

Morgan Stanley

12.8%

2.4

10.9

MAN Group

N/ A

0.4

12.0
* Based on closing prices on 09/26/2006.

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Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.