What Does Hedge Fund Mean?An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.

Investopedia explains Hedge FundFor the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.   

It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

What is a Hedge Fund?

      A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously -- many hedge against downturns in the markets -- especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.

      There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return. A macro hedge fund, for example, invests in stock and bond markets and other investment opportunities, such as currencies, in hopes of profiting on significant shifts in such things as global interest rates and countries’ economic policies. A macro hedge fund is more volatile but potentially faster growing than a distressed-securities hedge fund that buys the equity or debt of companies about to enter or exit financial distress. An equity hedge fund may be global or country specific, hedging against downturns in equity markets by shorting overvalued stocks or stock indexes. A relative value hedge fund takes advantage of price or spread inefficiencies. Knowing and understanding the characteristics of the many different hedge fund strategies is essential to capitalizing on their variety of investment opportunities.

      It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same -- investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. A successful fund of funds recognizes these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds.

Hedge fund strategies vary enormously – many, but not all, hedge against market downturns – especially important today with volatility and anticipation of corrections in overheated stock markets.

The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive (absolute) returns under all market conditions.

The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities or gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

Key Characteristics of Hedge Funds

Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.).

Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.

Many hedge funds have the ability to deliver non-market correlated returns.

Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.

Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent.

Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns.

Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.

Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund.

Facts About the Hedge Fund Industry

Estimated to be a $1 trillion industry and growing at about 20% per year with approximately 8350 active hedge funds.

Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives.

Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.

Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.

Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.

Hedge fund managers are generally highly professional, disciplined and diligent. Their returns over a sustained period of time have outperformed standard equity

and bond indexes with less volatility and less risk of loss than equities. Beyond the averages, there are some truly outstanding performers. Investing in hedge funds tends to be favored by more sophisticated investors,

including many Swiss and other private banks, that have lived through, and understand the consequences of, major stock market corrections.

An increasing number of endowments and pension funds allocate assets to hedge funds.

Hedging Strategies

A wide range of hedging strategies are available to hedge funds. For example:

selling short - selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop.

using arbitrage - seeking to exploit pricing inefficiencies between related securities - for example, can be long convertible bonds and short the underlying issuers equity.

trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment.

investing in anticipation of a specific event - merger transaction, hostile takeover, spin-off, exiting of bankruptcy proceedings, etc.

investing in deeply discounted securities - of companies about to enter or exit financial distress or bankruptcy, often below liquidation value.

Many of the strategies used by hedge funds benefit from being non-correlated to the direction of equity markets

Popular Misconception

The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage.

Benefits of Hedge Funds

Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets.

Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns.

Huge variety of hedge fund investment styles – many uncorrelated with each other – provides investors with a wide choice of hedge fund strategies to meet their investment objectives.

Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds.

Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets.

Adding hedge funds to an investment portfolio provides diversification not otherwise available in traditional investing.

Hedge Fund Styles

The predictability of future results shows a strong correlation with the volatility of each strategy. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility.

Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth. Includes sector specialist funds such as technology, banking, or biotechnology. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. Tends to be "long-biased." Expected Volatility: High

Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market's lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. (This selling pressure creates the deep discount.) Results generally not dependent on the direction of the markets. Expected Volatility: Low - Moderate

Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available, although Brady debt can be partially hedged via U.S. Treasury futures and currency markets. Expected Volatility: Very High

Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed. Expected Volatility: Low - Moderate - High

Income: Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. Expected Volatility: Low

Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets -- equities, bonds, currencies and commodities -- though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves. Utilizes hedging, but the leveraged directional investments tend to make the largest impact on performance. Expected Volatility: Very High

Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. May also

use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage. Expected Volatility: Low

Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns. Usually low or no correlation to the market. Sometimes uses market index futures to hedge out systematic (market) risk. Relative benchmark index usually T-bills. Expected Volatility: Low

Market Timing: Allocates assets among different asset classes depending on the manager's view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy. Expected Volatility: High

Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class. Expected Volatility: Variable

Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: Variable

Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High

Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company. May also utilize derivatives to

leverage returns and to hedge out interest rate and/or market risk. Results generally not dependent on direction of market. Expected Volatility: Moderate

Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor or underfollowed by analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market. Expected Volatility: Low - Moderate

What is a Fund of Hedge Funds?

o A diversified portfolio of generally uncorrelated hedge funds. o May be widely diversified, or sector or geographically focused. o Seeks to deliver more consistent returns than stock portfolios, mutual

funds, unit trusts or individual hedge funds. o Preferred investment of choice for many pension funds, endowments,

insurance companies, private banks and high-net-worth families and individuals.

o Provides access to a broad range of investment styles, strategies and hedge fund managers for one easy-to-administer investment.

o Provides more predictable returns than traditional investment funds. o Provides effective diversification for investment portfolios.

Benefits of a Hedge Fund of Funds

o Provides an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market.

o Delivers more stable returns under most market conditions due to the fund-of-fund manager’s ability and understanding of the various hedge strategies.

o Significantly reduces individual fund and manager risk. o Eliminates the need for time-consuming due diligence otherwise required

for making hedge fund investment decisions. o Allows for easier administration of widely diversified investments across a

large variety of hedge funds. o Allows access to a broader spectrum of leading hedge funds that may

otherwise be unavailable due to high minimum investment requirements. o Is an ideal way to gain access to a wide variety of hedge fund strategies,

managed by many of the world’s premier investment professionals, for a relatively modest investment.

What are hedge funds?

B. Venkatesh

NEWSPAPER reports suggest that US-based hedge funds are investing in India. What are hedge funds? These funds, like mutual funds, collect money from investors, and use the proceeds to buy stocks and bonds.

Unlike mutual funds, however, hedge funds typically take long and short positions in assets to lower portfolio risk arising from broad market movements. How?

A hedge fund may take long positions in certain stocks, and short positions in certain other stocks such that their portfolio beta is close to zero. A beta close to zero means that the portfolio will remain relatively unchanged due to the broad market movement. Such a portfolio will primarily change if the stocks move more than the broad market.

Consider, for instance, Hero Honda and Bajaj Auto. The hedge fund may buy Bajaj Auto and short Hero Honda, such that the portfolio beta is close to zero. Suppose Bajaj Auto moves up by 10 per cent, and Hero Honda and the broad market move up by 7 per cent. The fund's net gain is 3 per cent. This is because Bajaj Auto outperformed the market, precisely what the hedge fund was betting on when it constructed the portfolio.

In short, hedge funds generate security-specific returns, and attempt to lower market risk. Notice that a mutual fund would have gained 10 per cent if it had invested in Reliance.

To improve their security-specific returns, hedge funds leverage their portfolio. The fund may collect, say, Rs 100 crore from investors, borrow Rs 50 crore, and invest Rs 150 crore.

In the above instance, an unleveraged fund may have gained only 3 per cent of Rs 100 crore. But a hedge fund that has borrowed Rs 50 crore will gain 3 per cent on Rs 150 crore less interest cost on Rs 50 crore.

Hedge funds are having their best year since 1998, yet most fund managers still are well below their peaks before the market's meltdown last year, industry analysts said.

Hedge fund assets rose 2.5 percent in July, contributing to a 9.9 percent climb over the first seven months of the year, and the best year-to-date results since 1998, Credit Suisse/Tremont Hedge Fund Index said.

The industry has a long way to go to recover from 2008, when funds on average suffered their worst year ever and investors redeemed record amounts of money.

Morningstar found that only 8 percent of the funds it follows fully recovered from drawdowns since the beginning of 2007. The group mostly includes funds that use "global trend" strategies -- global macro funds and managed futures funds.

These funds, which invest in commodities and currencies, suffered the lightest or no losses last year as stock and credit markets tanked.

By contrast, the strategy with the fewest funds recovering crisis losses were those funds focused on distressed securities, which were hit especially hard last year.

"It takes a long time to recover from drawdowns. There is a compound effect," Morningstar hedge fund analyst Nadia Papagiannis told Reuters. "Given where we are with the economy, we're still not out of hot water."

High-water marks are a critical measure for hedge fund managers. It represents the value they must exceed before they can start generating performance fees of 15 to 50 percent.

Since hedge fund drawdowns began in November 2007, fund assets fell more than 25 percent, Morningstar said. Hedge funds have begun to grow again, but have recovered 14 percent, or a little more than halfway.

Overall, a Morningstar index of 1,000 funds rose 2.2 percent in July, and 11.5 percent this year through July, the firm said on Tuesday.

Another data provider, HedgeFund.net said on Tuesday that total hedge fund assets rose 6 percent in the second quarter to $1.79 trillion, as rising asset values more than offset $25 billion of customer withdrawals. But net investments in May and June have turned that trend around.

Emerging markets-focused funds rank among the best performing funds this year, up 21 percent, and have seen some of the highest rates of investment, HedgeFund.net said.

Managed futures funds, which have lagged this year after leading the pack in 2008, are still attracting funds. By contrast, convertible arbitrage funds have soared this year, up 22 percent so far, yet new investment has been slow to follow, HedgeFund.net said.

 

Hedge funds: the good, the bad, and the ugly

By ULRICH KELLER

IT IS widely known that alternative assets - and hedge funds in particular - have been hit hard by the financial crisis. But one should not discard an asset

category because of misbehaviour by a certain group of managers.

Undoubtedly, overall results in the hedge fund sector were disappointing in 2008. But it is important to distinguish the good from the bad - and what is more important, to recognise the ugly.

At UBS Global Asset Management's Alternative Funds Advisory (AFA) we sought to identify the true cause of the underperformance. In fact, a review of the positioning of many of our hedge fund managers over the past year did not reveal a great deal to criticise. Indeed, in the main, our managers maintained well-constructed books.

The true source of risk was the meltdown of the interbank market and the resulting sudden drain of liquidity after the collapse of Lehman Brothers in September 2008. It is important to understand that the major part of the market was not just less liquid. In many asset classes, including structured products, OTC contracts and emerging market bonds, no trading was taking place at all.

A good indicator for illiquidity is the development of the so-called TED - the spread between US Treasury bonds and the Eurodollar interest rate futures - over time. In typical trading conditions the spread would be expected to be around 50 basis points, but as a result of the crisis, it moved to around 450 basis points - almost 10 times higher than normal (see chart).

The widening of the spread inflated the cost of short-term trading and exerted significant pressure on hedge fund trading positions across the board. Importantly, the widening spread was to some degree indiscriminate in its effect. Even well-constructed books suffered as a result of the market turbulence.

At the same time, the absence of liquidity made the scope for managing risk - that is, changing, hedging or exiting exposures - either extremely limited or impossible. In our view, this was the critical element driving event-driven and relative-value strategies, while extending also into equity-long/short.

On the other hand, global macro trading and systematic managed futures remained largely unaffected by the illiquidity, simply because they typically trade only the most liquid instrument classes, such as foreign exchange, futures and sovereign bonds.

We would suggest that the fact that these strategies were the exception from the rule underlines the case for the identification of market liquidity as the core driver of performance over the period.

Of course, not all hedge fund managers were running books sustainable for going into a crisis, and the ensuing shake-out will result in a number being discontinued. In our view, such a cleansing process is healthy and unavoidable, and we are encouraging certain managers to liquidate rather than continue with an inappropriate strategy.

Positive returns

Investor disappointment at underperformance in the hedge fund sector was compounded by the restriction of redemptions promoted by the illiquid market. This was done either by installing gates - that is, imposing limits on the amount to be withdrawn over a defined period - or by issuing an illiquid side pocket. In contrast, most professionally-managed funds-of-funds were, to some extent, insulated against illiquidity and fared better than the sector in general.

None of the UBS Alternative Funds Advisory core diversified portfolios, which include the UBS Alpha Select Fund, UBS AFA Trading Fund and UBS A&Q Alternative Solution, had to restrict liquidity. Typically, AFA allocates strongly to global macro trading and/or systematic managed futures. Indeed, managed futures was, by far, the best-performing hedge fund strategy in 2008 and allowed the UBS Alpha Select (A-shares) fund-of-funds product to out-perform the HFRI Fund-of-Funds Composite Index by 455 basis points.

With the TED spread falling below 100 basis points this year and currently trading safely below 50 basis points, financial markets have normalised to a great extent. At the same time, while pockets of illiquidity remain, they no longer constitute a systematic market factor, and redemption pressure for most hedge fund managers has been digested. Accordingly, most managers consistently produced positive returns so far in 2009.

Hedge funds were, on average, in positive territory in January and February, when the markets were strongly down, as well as in March and the following months, when the markets were up, demonstrating their unique potential to deliver positive returns in falling as well as in rising markets. In fact, given the normalisation in the market, well-diversified hedge fund portfolios have every chance of being among the better-performing asset categories in 2009.

The writer is chief investment officer of Alternative Funds Advisory (AFA), a business unit of UBS Global Asset Management providing investment services in hedge funds, private equity and infrastructure

This article was first published in The Business Times.

What Was the LTCM Hedge Fund Crisis and Could It Happen Again?Wednesday March 21, 2007

The recent subprime mortgage meltdown, and its potential impact on hedge funds, have caused many commentators to wonder if another shock such as the LTCM hedge fund crisis could occur.

Well, what exactly happened? In 1998, Long-Term Capital Management (LTCM) was a very large hedge fund that was heavily invested in foreign bonds. When Russia announced it was defaulting on its bonds, LTCM’s highly leveraged investments crumbled. Since so many banks and pension funds were invested in LTCM, its problems threatened to push most of them to near bankruptcy. Only the intervention of then-Chairman of the Federal Reserve Alan Greenspan convinced the banks to retain confidence. Nevertheless, the U.S. stock market declined 20% before it was all said and done.

Could it happen again? The recent demise of hedge fund Amaranth Advisors in September 2006 did not impact the stock market at all. However, since hedge funds' investments are unregulated, it is altogether possible that another crisis could occur.

CRONY CAPITALISM

LTCM, a hedge fund above suspicionby Ibrahim Warde

Crony capitalism used to be cited as the underlying cause of the 1997 crisis in Asia. Indonesia, South Korea and Thailand were model pupils of the IMF (1), they had got all their fundamentals right (inflation, unemployment, growth), so there had to be some other explanation. The blame was laid on the kind of capitalism practised in those countries, where a closed, secretive and incestuous elite held absolute sway over politics, the economy and finance, where banks lent to cronies and crooks, and the state miraculously came to the rescue when the time came to balance (or cook) the books. Japan, for example, has just nationalised some of the big banks, giving an immediate boost to ... the Nikkei index.

So for the past year, governments in Asia and elsewhere have been politely told to put their house in order, make their systems more transparent and subject to the laws of the market. Above all, they must stop propping up failing banks or enterprises on the pretext of some connection with a crony or his hangers-on.

This argument may have lost some of its edge since the rescue of the flagship hedge fund, Long Term Capital Management (LTCM), on 23 September. That was the day when William J. McDonough, president of the Federal Reserve Bank of New York, called on the cream of the international financial establishment to refloat the fund which was virtually bankrupt. And, in only a few hours, 15 or so American and European institutions (including three French banks) came up with $3.5 billion in return for a 90% share in the fund and a promise that a supervisory board would be established (2).

The banks have played a double game in their dealings with LTCM. Many financial establishments and even state bodies, including the Chinese and Italian central banks, put money into it. The banks offered LTCM credit facilities that gave it a degree of leverage (the difference between the expected profit on an operation and the cost of financing it) that promised spectacular returns. They also served to offset its financial transactions. And, better still, many leading figures such as the chairmen of Merrill Lynch and Paine Webber, David Komansky and Donald Marron, put their own money into it.

The banks’ staggering lack of curiosity about the fund’s activities is particularly disturbing in view of the astronomical sums involved. At the beginning of the year, LTCM had capital of $4.8 billion, a portfolio of $200 billion (borrowing capacity in terms of leverage) and derivatives with a notional value of $1,250 billion.

But the banks had put their faith in the fund’s pedigree and reputation. The founder, John Meriwether, was a legendary trader who, after a spectacular career, had left Salomon Brothers following a scandal over the purchase of US Treasury bonds. This had not tarnished his reputation or dented his confidence. Asked whether he believed in efficient markets, he replied: "I MAKE them efficient" (3). Moreover, the fund’s principal shareholders included two eminent experts in the "science" of risk, Myron Scholes and Robert Merton, who had been awarded the Nobel prize for economics in 1997 for their work on derivatives, and a dazzling array of professors of finance, young doctors of mathematics and physics and other "rocket scientists" capable of inventing extremely complex, daring and profitable financial schemes.

The fund’s operations were conducted in absolute secrecy. Investors who asked questions were told to take their money somewhere else. Nevertheless, despite the minimum initial payment of $10 million frozen for three years, there was a rush to invest and the results appeared to be well up to expectations. After taking 2% for "administrative expenses" and 25% of the profits, the fund was able to offer its shareholders returns of 42.8% in 1995, 40.8% in 1996, and "only" 17.1% in 1997 (the year of the Asian crisis). But in September, after mistakenly gambling on a convergence in interest rates, it found itself on the verge of bankruptcy.

The boys are very happy

Although he had no supervisory authority over the institution, Fed chief Mr McDonough considered the rescue justified because a sudden and disorderly retreat from LTCM’s positions would have posed unacceptable risks to the American economy. And in fact, in a climate of general panic, creditors would have had to get the best price they could for the $200 billion portfolio. The Fed stresses that it was not really a rescue because no public funds were involved. It swears it had no intention of helping wealthy speculators out of a hole and vows that the shareholders will not emerge unscathed. The LTCM spokesman, on the other hand, thanked the firms that had contributed funds and added "The boys are very happy today. They’re in better financial shape than ever over the long run (4)".

The supervisory board has assigned some of its best derivatives experts to monitor the management of the fund, but the latest news is that the patient is still bleeding despite the injection of new blood (5). Two weeks after the rescue, the fund is rumoured to have lost a further $200 million.

Summary of the Nature of LTCM:

Long Term Capital Management (LTCM) was a hedge fund located in Greenwich, Connecticut. The founders included two Nobel Prize-winning economists, Myron Scholes and Robert C. Merton. Scholes and Merton, among other things, developed along with the late Fischer Black, the Black-Scholes formula for option pricing. LTCM also included as guiding spirit John Meriwether, a former vice chairman of Salomon Brothers and famous bond trader. David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System was also part of the LTCM team. Also several important arbitrage analysts from Salomon Brothers joined LTCM. Eric Rosenfeld left Harvard University to join LTCM. It was a very elite group.

The idea behind LTCM was quite simple to articulate but not necessarily that easy to implement. LTCM was to look for arbitrage opportunities in markets using computers, massive databases and the insights of top level theorists. These opportunities arose when markets deviated from normal patterns and was likely to re-adjust to the normal patterns. By creating hedged portfolios the risks could be reduced to low levels. According to the model developed by Merton the risk could be reduced to zero, but in practice some of the crucial assumptions of Merton's model did not hold so the risk of the hedged portfolios was not really zero, as subsequent events proved.

Myron Scholes stated the objective of LTCM in a striking image. He said LTCM would function like a giant vacuum cleaner sucking up nickles that everyone else had overlooked.

The History

Long-Term Capital Management (LTCM) was the management arm of a hedge fund that operated from its founding in 1993 to its liquidation in early 2000. It went through a period of spectacular success from 1994 to early 1998. In August of 1998 Russia defaulted on its debt and the financial markets came unraveled. Historical regularities that had prevailed failed to hold and LTCM which had bet on those regularities nearly went bankrupt. It was saved only by the Federal Reserve Bank of New York sponsoring a bailout of LTCM by its creditor banks. The Fed justified its intervention on the basis of the potential of the failure of LTCM precipitating a financial crisis and the creditor banks were enticed into extending credit to LTCM because their financial losses in a general financial crisis could well be more than what they stood to lose if LTCM defaulted on its loans. As it happened LTCM survived long enough to pay off its indebtedness but by early 2000 it was liquidated.

LTCM had its origins in an Arbitrage Group put together by John Meriwether at Salomon Brothers of Wall Street. Meriwether was a successful bond market trader that parlayed his early successes into a position of prestige and influence within the firm. Although he was an astute trader he was even better at choosing and managing talented people.

Meriwether recruited Eric Rosenfeld and William Lasker from the faculty at Harvard. He also hired Victor Haghani, an Iranian American whose father was an international trader from a Sephardic Jewish family in Iran. Haghani trained in finance the London School of Economics. Haghani was one of Meriwether's star traders. Another was Lawrence Hilibrand who was trained in finance at M.I.T. Another Ph.D. in finance from M.I.T. secured by Meriwether for his group was Gregory Hawkins.

Meriwether's Arbitrage Group was so successful at earning profits for Salomon that they were able to demand a change in the way they were compensated. Meriwether negotiated a 15 percent share of the profit for his traders on their trades. This led to Hilibrand in 1989 receiving $23 million in pay. This arrangement created envy and resentment among the other groups at Salomon.

Meriwether's Arbitrage Group would probably have been content with their arrangement at Salomon indefinitely, but fate intervened. A trader under Meriwether's supervision revealed to him that he, the trader, had made a false bid on Treasury securities. Meriwether reported the confession to others in authority at Salomon but, because the trader had said that there had been only one instance, no action was taken. Later it was found that the trader had lied to the Government many times and the Government wanted someone punished for improper supervision of the trader. Meriwether was asked to resign, which he did although he, and the Arbitrage Group, felt he was being unfairly punished.

The members of the Arbitrage Group lobbied for Meriwether to be brought back but to no avail. In 1993 gave up on returning to Salomon and began to organize the recreation of the Arbitrage Group as a new enterprise. He sought $2.5 billion in financing to be raised from a limited group of investors. The minimum investment was to be $10 million. Merrill Lynch was to handle the financing. The actual legal structure involved the

creation of two partnerships, Long-Term Capital Portfolio in the Cayman Islands to be the owner of record for the securities and Long-Term Capital Management in Delaware. John Meriwether and his partners were the principals in the Delaware partnership of Long-Term Capital Management. The office and operations of LTCM would be in Greenwich, Connecticut.

In raising funds Meriwether created the category of Strategic Investors, who would invest at least $100 million. He was successful in bringing in some of the top financial organizations in the world into LTCM despite the fact that the fees charged were exceptionally high. The typical hedge funds charged 20 percent of profits earned plus a one percent of an investor's assets as fees. In contrast LTCM charged 25 percent of profits and levied a 2 percent fee on assets. In addition, investors in LTCM were required to commit their funds for at least three years. Despite the heavy fees and long term committment LTCM was able to raise $1.25 billion. It was not the $2.5 billion that Meriwether set as a target but it was by far the largest funding raised for a hedge fund.

Meriwether was able to lure away from Salomon most of the principal figures of the Arbitrage Group. David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System was also part of the LTCM team. The top people became partners of LTCM. In addition to the traders of the Arbitrage Group Meriwether was able to get two of the top economists, Myron Scholes and Robert C. Merton, to join LTCM. This was a major coup for Meriwether because Scholes and Merton added academic respectability to the hedge fund. Meriwether got Scholes and Merton before they received their joint award of the Nobel Prize in Economics. Fischer Black who would have shared the Nobel Prize with them had he lived a bit long was a respected figure on Wall Street.

Not only did Myron Scholes lend prestige to LTCM from his academic reputation but he was one of the most effective salesmen for LTCM in its quest for investors. Robert C. Merton is without question one of the most brilliant economists of all time but it is not clear that LTCM benefited from his analytical skills. It may, in fact, suffered from his presence in that his model of financial markets should not have been taken as the ultimate description of reality in an enterprise risking billions of dollars.

LTCM started off with abundant funding, a stable of brilliant, experienced traders and two stellar academics. The public had the impression that the firm would make extraordinary profits from arcane knowledge unavailable to anyone else. Myron Scholes summed up the strategy with a metaphor that will last forever. He said that LTCM would make money by being a vacuum sucking up nickels that no one else could see.

In practice LTCM strategy for making money was based up more mundane principles. One of these principles was the power of leverage. This principle can best be expressed by the equation:

requity = rassets + L(rassets - rdebt)

where requity is the rate of return on equity capital, rassets is the rate of return on overall capital, rdebt is the interest rate on debt and L, the leverage ratio, is the ratio of debt capital to equity capital. The equation shows that the rate of return on overall capital is augmented by an amplified difference between the rate of return on overall capital and the interest rate on debt. If the leverage is high and capital earns a rate of return greater than the interest rate on debt then all is well, but leverage is a two-edged sword. If the rate of return on overall capital falls below the interest rate on debt then high leverage can turn a mildly bad year into a catastrophe.

The dark side to the leverage equation is the equation that says what happens to risk as a result of leverage. Risk can be measured in various ways but the common result is that the equity risk of a leveraged firm is the risk of the unleverage firm multiplied by a factor of (L+1); i.e.,

riskequity = (L+1)riskassets

This formula works for risk as measured by the standard deviation of the rate of return as in portfolio analysis or risk as measured by the volatility coefficient β as in the Capital Asset Pricing Model. The formula assumes the debt is risk-free.

LTCM was operating with a leverage ratio in the neighborhood of thirty. At that leverage ratio LTCM needed a rate of return on capital that was only about one percent higher than its interest rate on debt to reach impressive levels of above thirty percent. Roger Lowenstein in his book When Genius Failed gives the rate of return on overall capital for LTCM as being 2.45 percent in 1995. This means that LTCM was probably making its high rate of return on equity by keeping its cost of capital extremely low. The people at LTCM drove very hard bargains on financing. They were able to get low rates and special deals because the banks did not want to get left out of LTCM business. LTCM was reputed to have a sure fire way to make fabulous profits and to be paying $100 million a year in finance fees. No banker wanted to be left out of that bonanza. It appears from Roger Lowenstein's figure that the secret to LTCM's success was bountiful loans at low rates. These bountiful loans enabled LTCM to achieve a thirty to one leverage ratio. The unusually low interest rates enabled it to achieve a positive differential between its overall rate of return on capital and the interest rate it was paying.

LTCM's speculative positions generally involved banking on market regularities such as the differences between interest rates. It is generally assumed that the markets establish some sort of equilibrium between rates. If differentials deviate from their past values there is the presumption that with time markets will re-establish those equilibrium differences. Sometimes the equilibrium difference between two rates is zero and then one speaks of the convergence of those rates. What happened when markets went into turmoil in 1998 is investors panicked about risk. They wanted certainty in that uncertain period. Investors fled the unpredictable markets for quality securities, ones with a high

degree of certainty. Thus higher differentials for the riskier securities did not stop the flight to quality securities. For LTCM which bet on the re-enstatement of equilibrium conditions it was a disasterous time. The firm began to lose hundreds of millions of dollars each day.

In addition to the losses caused by the turmoil in the financial markets there was also the problem that the top traders at LTCM with almost pathological overconfidence began to take unhedged positions in the market, effectively betting huge sums on the direction changes in financial variables would take. One form of this type of position was taking large positions in derivatives, such as options, whose market value depended upon the volatility of an underlying security. When the volatilities increased above historical averages LTCM took market positions that would be profitable only if the volatilities declined. Eventually the volatilities did decline but in the short term these positions threatened LTCM with collapse.

Even with hedged positions which the theory asserted insulated the value of a portfolio from changes in stock price there was risk associated with price jumps. For example, one way to create a perfectly hedged portfolio is to combine share holding with written calls on that stock. If the ratio of shares to the written call options, called the hedge ratio, is the right value the changes in the market price of the shares is exactly offset by the change in the financial obligation associated with the written calls. But this holds true only if the stock price changes by infinitesimal amounts. If the stock price gaps upward before the portfolio holder can re-adjust the hedge ratio the hold can experience considerable losses. Events such as earthquakes, defaults, political revolution and so forth do bring instantaneous changes in price and the models used by LTCM did not allow for this type of risk.

The above point is illustrated by the following graph.

In the graph, S represents the current price of the stock. For a curent stock price S a hedge ratio is determined which makes the curve flat at S so any very small change in the price of the stock will leave the value of of the portfolio unaffected. But if the price of the stock falls by a significant amount instanteously without the opportunity to adjust the hegge ratio the loss in the value of the stocks held is not fully compensated by the decline in the expense of the written calls held. The losses from a significant decline in the price of the stock are limited to the value of the stocks in the portfolio, but there is no such limit to the losses on written calls when the price of the stock increases significantly. In that situation the cost of fulfilling the obligation involved with the written calls is unlimited and is not offset by the increase in the value of the stocks held. Some firms have found to their chagrin that they lost large amounts of money on fully hedged portfolio that were constructed to protect them against infinitesimal price fluctuations. Fully hedged portfolios involving written calls are not truly risk free. Surprisingly the very smart people at LTCM overlooked a variant hedging strategy that would have made price jumps a boon. There were other conceptual short-comings of LTCM strategies.

It has been known since 1915 when it was pointed out by Wesley Claire Mitchell that the distribution of rates of return in the stock market is not a normal distribution. There are too many extremely large deviations from the average. Surprisingly there are also too many small deviations from the average. The following diagram illustrates how this happens.

Because the tails of the distribution have higher probability than a normal distribution such a distribution is called a fat-tailed distribution. But the probability of small deviations is also higher than for a normal distribution. What is under-occurring is the medium deviations from the mean. A period in which only small deviations occur may beguile the investor into thinking a stock has low volatility when, if fact, a fat-tailed distribution has infinite volatility.

Another chronic problem with LTCM's strategy is that although the traders took a large number of separate positions there was effectively no benefits for risk-reduction through diversification in a financial crisis because, in effect, most of the separate transactions were the same bet on the stabilization of the markets and a return to equilibrium.

With losses of capital by LTCM its bank lenders became worried about the security of their loans. In the fall of 1998 when LTCM was on the brink of failure the Federal Reserve Bank of New York brought the lenders together and brokered a bailout. Some

fourteen or so banks contributed about $300 million each to raise a $3.65 billion loan fund. That fund along with the equity still held by LTCM enabled it to withstand the turmoil in the markets. Another financial crisis occured in the form of unusually high spreads on swaps. LTCM was reorganized and continued to operate. By the next year it paid off its loans and was effectively liquidated by early 2000.

In 1994, John Meriwether, the famed Salomon Brothers bond trader, founded a hedge fund called Long-Term Capital Management. Meriwether assembled an all-star team of traders and academics in an attempt to create a fund that would profit from the combination of the academics' quantitative models and the traders' market judgement and execution capabilities. Sophisticated investors, including many large investment banks, flocked to the fund, investing $1.3 billion at inception. But four years later, at the end of September 1998, the fund had lost substantial amounts of the investors' equity capital and was teetering on the brink of default. To avoid the threat of a systemic crisis in the world financial system, the Federal Reserve orchestrated a $3.5 billion rescue package from leading U.S. investment and commercial banks. In exchange the participants received 90% of LTCM's equity.

The lessons to be learned from this crisis are:

  Market values matter for leveraged portfolios;

  Liquidity itself is a risk factor;

  Models must be stress-tested and combined with judgement; and

  Financial institutions should aggregate exposures to common risk factors.

LTCM seemed destined for success. After all, it had John Meriwether, the famed bond trader from Salomon Brothers, at its helm. Also on board were Nobel-prize winning economists Myron Scholes and Robert Merton, as well as David Mullins, a former vice-chairman of the Federal Reserve Board who had quit his job to become a partner at LTCM. These credentials convinced 80 founding investors to pony up the minimum investment of $10 million apiece, including Bear Sterns President James Cayne and his deputy. Merrill Lynch purchased a significant share to sell to its wealthy clients, including a number of its executives and its own CEO, David Komansky. A similar strategy was employed by the Union Bank of Switzerland (The Washington Post, 9/27/98).

LTCM's main strategy was to make convergence trades. These trades involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones. There were four

main types of trade:

  Convergence among U.S., Japan, and European sovereign bonds;

  Convergence among European sovereign bonds;

  Convergence between on-the-run and off-the-run U.S. government bonds;

  Long positions in emerging markets sovereigns, hedged back to dollars.

Because these differences in values were tiny, the fund needed to take large and highly-leveraged positions in order to make a significant profit. At the beginning of 1998, the fund had equity of $5 billion and had borrowed over $125 billion — a leverage factor of roughly thirty to one. LTCM's partners believed, on the basis of their complex computer models, that the long and short positions were highly correlated and so the net risk was small.

1994: Long-Term Capital Management is founded by John Meriwether and accepts investments from 80 investors who put up a minimum of $10 million each. The initial equity capitalisation of the firm is $1.3 billion. (The Washington Post, 27 September 1998)

End of 1997: After two years of returns running close to 40%, the fund has some $7 billion under management and is achieving only a 27% return — comparable with the return on US equities that year.

Meriwether returns about $2.7 billion of the fund's capital back to investors because "investment opportunities were not large and attractive enough" (The Washington Post, 27 September 1998).

Early 1998: The portfolio under LTCM's control amounts to well over $100 billion, while net asset value stands at some $4 billion; its swaps position is valued at some $1.25 trillion notional, equal to 5% of the entire global market. It had become a major supplier of index volatility to investment banks, was active in mortgage-backed securities and was dabbling in emerging markets such as Russia (Risk, October 1998)

17 August 1998: Russia devalues the rouble and declares a moratorium on 281 billion roubles ($13.5 billion) of its Treasury debt. The result is a massive "flight to quality", with investors flooding out of any remotely risky market and into the most secure instruments within the already "risk-free" government bond market. Ultimately, this results in a liquidity crisis of enormous proportions, dealing a

severe blow to LTCM's portfolio.

1 September 1998: LTCM's equity has dropped to $2.3 billion. John Meriwether circulates a letter which discloses the massive loss and offers the chance to invest in the fund "on special terms". Existing investors are told that they will not be allowed to withdraw more than 12% of their investment, and not until December.

22 September 1998: LTCM's equity has dropped to $600 million. The portfolio has not shrunk significantly, and so its leverage is even higher. Banks begin to doubt the fund's ability to meet its margin calls but cannot move to liquidate for fear that it will precipitate a crisis that will cause huge losses among the fund's counterparties and potentially lead to a systemic crisis.

23 September 98: Goldman Sachs, AIG and Warren Buffett offer to buy out LTCM's partners for $250 million, to inject $4 billion into the ailing fund and run it as part of Goldman's proprietary trading operation. The offer is not accepted. That afternoon, the Federal Reserve Bank of New York, acting to prevent a potential systemic meltdown, organises a rescue package under which a consortium of leading investment and commercial banks, including LTCM's major creditors, inject $3.5-billion into the fund and take over its management, in exchange for 90% of LTCM's equity.

Fourth quarter 1998: The damage from LTCM's near-demise was widespread. Many banks take a substantial write-off as a result of losses on their investments. UBS takes a third-quarter charge of $700 million, Dresdner Bank AG a $145 million charge, and Credit Suisse $55 million. Additionally, UBS chairman Mathis Cabiallavetta and three top executives resign in the wake of the bank's losses (The Wall Street Journal Europe, 5 October 1998). Merrill Lynch's global head of risk and credit management likewise leaves the firm.

April 1999: President Clinton publishes a study of the LTCM crisis and its implications for systemic risk in financial markets, entitled the President's Working Group on Financial Markets (Governance and Risk Control-Regulatory guidelines-president's working group)

Analysis:The Proximate Cause: Russian Sovereign Default

The proximate cause for LTCM's debacle was Russia's default on its government obligations (GKOs). LTCM believed it had somewhat hedged its GKO position by selling rubles. In theory, if Russia defaulted on its bonds, then the value of its currency would collapse and a profit could be made in the foreign exchange

market that would offset the loss on the bonds.

Unfortunately, the banks guaranteeing the ruble hedge shut down when the Russian ruble collapsed, and the Russian government prevented further trading in its currency. (The Financial Post, 9/26/98). While this caused significant losses for LTCM, these losses were not even close to being large enough to bring the hedge fund down. Rather, the ultimate cause of its demise was the ensuing flight to liquidity described in the following section.

The Ultimate Cause: Flight to Liquidity

The ultimate cause of the LTCM debacle was the "flight to liquidity" across the global fixed income markets. As Russia's troubles became deeper and deeper, fixed-income portfolio managers began to shift their assets to more liquid assets. In particular, many investors shifted their investments into the U.S. Treasury market. In fact, so great was the panic that investors moved money not just into Treasurys, but into the most liquid part of the U.S. Treasury market -- the most recently issued, or "on-the-run" Treasuries. While the U.S. Treasury market is relatively liquid in normal market conditions, this global flight to liquidity hit the on-the-run Treasuries like a freight train. The spread between the yields on on-the-run Treasuries and off-the-run Treasuries widened dramatically: even though the off-the-run bonds were theoretically cheap relative to the on-the-run bonds, they got much cheaper still (on a relative basis).

What LTCM had failed to account for is that a substantial portion of its balance sheet was exposed to a general change in the "price" of liquidity. If liquidity became more valuable (as it did following the crisis) its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor.

As an aside, this situation was made worse by the fact that the size of the new issuance of U.S. Treasury bonds has declined over the past several years. This has effectively reduced the liquidity of the Treasury market, making it more likely that a flight to liquidity could dislocate this market.

Systemic Risk: The Domino Effect

The preceding analysis explains why LTCM almost failed. However, it does not explain why this near-failure should threaten the stability of the global financial markets. The reason was that virtually all of the leveraged Treasury bond investors had similar positions: Salomon Brothers, Merrill Lynch, the III Fund (a fixed-income hedge fund that also failed as a result of the crisis) and likely others.

There were two reasons for the lack of diversity of opinion in the market. The first is that virtually all of the sophisticated models being run by the leveraged players said the

same thing: that off-the-run Treasuries were significantly cheap compared with the on-the-run Treasuries. The second is that many of the investment banks obtained order flow information through their dealings with LTCM. They therefore would have known many of the actual positions and would have taken up similar positions alongside their client.

Indeed, one industry participant suggested that the Russian crisis was the crowning blow on a domino effect that had started months before. In early 1998, Sandy Weill, as co-head of Citigroup, decided to shut down the famous Salomon Brothers Treasury bond arbitrage desk. Salomon, one of the largest players in the on-the-run/off-the-run trade, had to begin liquidating its positions. As it did so, these trades became cheaper and cheaper, putting pressure on all of the other leveraged players.

Lessons to be learned:Market values matter

LTCM was perhaps the biggest disaster of its kind, but it was not the first. It had been preceded by a number of other cases of highly-leveraged quantitative firms that went under in similar circumstances.

One of the earliest was Franklin Savings and Loan, a hedge fund dressed down as a savings & loan. Franklin's management had figured out that many of the riskier pieces of mortgage derivatives were undervalued because a) the market could not understand the risk on the risky pieces; and b) the market overvalued those pieces with well-behaved accounting results. Franklin decided it was willing to suffer volatile accounting results in exchange for good economics.

More recently, the Granite funds, which specialised in mortgage-backed securities trading, suffered as the result of similar trading strategies. The funds took advantage of the fact that "toxic waste" (risky tranches) from the mortgage derivatives market were good economic value. However, when the Fed raised interest rates in February 1994, Wall Street firms rushed to liquidate mortgage-backed securities, often at huge discounts.

Both of these firms claimed to have been hedged, but both went under when they were "margin-called". In Franklin's case, the caller was the Office of Thrift Supervision; in the Granite Fund's, the margin lenders. What is the common theme among Franklin, the Granite Funds and LTCM? All three depended on exploiting deviations in market value from fair value. And all three depended on "patient capital" -- shareholders and lenders who believed that what mattered was fair value and not market value. That is, these fund managers convinced their stakeholders that because the fair values were hedged, it didn't matter what happened to market values in the short run — they would converge to fair value over time. That was the reason for the "Long Term" part of

LTCM's name.

The problem with this logic is that capital is only as patient as its least patient provider. The fact is that lenders generally lose their patience precisely when the funds need them to keep it — in times of market crisis. As all three cases demonstrate, the lenders are the first to get nervous when an external shock hits. At that point, they begin to ask the fund manager for market valuations, not models-based fair valuations. This starts the fund along the downward spiral: illiquid securities are marked-to-market; margin calls are made; the illiquid securities must be sold; more margin calls are made, and so on. In general, shareholders may provide patient capital; but debt-holders do not.

The lesson learned from these case studies spoils some of the supposed "free lunch" features of taking liquidity risk. These plays can indeed generate excellent risk-adjusted returns, but only if held for a long time. Unfortunately the only real source of capital that is patient enough to take fluctuations in market values, especially through crises, is equity capital.

In other words, you can take liquidity bets, but you cannot leverage them much.

Liquidity risk is itself a factor

As pointed out in the analysis section of this article, LTCM fell victim to a flight to liquidity. This phenomenon is common enough in capital markets crises that it should be built into risk models, either by introducing a new risk factor — liquidity — or by including a flight to liquidity in the stress testing (see the following section for more detail on this). This could be accomplished crudely by classifying securities as either liquid or illiquid. Liquid securities are assigned a positive exposure to the liquidity factor; illiquid securities are assigned a negative exposure to the liquidity factor. The size of the factor movement (measured in terms of the movement of the spread between liquid and illiquid securities) can be estimated either statistically or heuristically (perhaps using the LTCM crisis as a "worst case" scenario).

Using this approach, LTCM might have classified most of its long positions as illiquid and most of its short positions as liquid, thus having a notional exposure to the liquidity factor equal to twice its total balance sheet. A more refined model would account for a spectrum of possible liquidity across securities; at a minimum, however, the general concept of exposure to a liquidity risk factor should be incorporated in to any leveraged portfolio.

Models must be stress-tested and combined with judgement

Another key lesson to be learnt from the LTCM debacle is that even (or especially) the most sophisticated financial models are subject to model risk and parameter risk, and should therefore be stress-tested and tempered with judgement. While we are clearly privileged in exercising 20/20 hindsight, we can nonetheless think through the way in

which judgement and stress-testing could have been used to mitigate, if not avoid, this disaster.

According to the complex mathematical models used by LTCM, the positions were low risk. Judgement tells us that the key assumption that the models depended on was the high correlation between the long and short positions. Certainly, recent history suggested that correlations between corporate bonds of different credit quality would move together (a correlation of between 90-95% over a 2-year horizon). During LTCM's crisis, however, this correlation dropped to 80%. Stress-testing against this lower correlation might have led LTCM to assume less leverage in taking this bet.

However, if LTCM had thought to stress test this correlation, given that it was such an important assumption, it would not even have had to make up a stress scenario. This correlation had dropped to 75% as recently as 1992 (Jorion, 1999). Simply including this stress scenario in the risk management of the fund might have led LTCM to assume less leverage in taking this bet.

Financial institutions must aggregate exposures to common risk factors

One of the other lessons to be learned by other financial institutions is that it is important to aggregate risk exposures across businesses. Many of the large dealer banks exposed to a Russian crisis across many different businesses only became aware of the commonality of these exposures after the LTCM crisis. For example, these banks owned Russian GKOs on their arbitrage desks, made commercial loans to Russian corporates in their lending businesses, and had indirect exposure to a Russian crisis through their prime brokerage lending to LTCM. A systematic risk management process should have discovered these common linkages ex ante and reported or reduced the risk concentration.

No hedge fund now poses systemic risk: LTCM partnerMon Jun 1, 2009 12:42pm EDT

 

LONDON (Reuters) - No single hedge fund today poses a systemic risk to the global financial system, said a former partner at Long Term Capital Management (LTCM), as lawmakers continue to hammer out rules to control the industry.

Even though many funds are now much larger than LTCM, which collapsed in 1998 and received a $3.5 billion bailout to avert widespread financial chaos, Hans Hufschmid, currently chief executive at fund servicing firm GlobeOp, said prime brokers

now act as an effective brake on hedge fund risk. "I find it hard to believe -- I don't think a hedge fund today is big enough to pose a systemic risk," he said.

"Prime brokers would manage that -- they would say 'we're not lending you that much money'... The market regulates it to some extent, you couldn't have a situation where one hedge fund takes excessive risk with one prime broker."

Connecticut-based LTCM, which collapsed after its mathematical model failed to foresee the Russian debt crisis, estimated that a default could have cost its 17 top counterparties between $3 billion and $5 billion.

The fund was leveraged at up to 100 times at one stage, according to some estimates. In contrast, average prime broker leverage in the UK fell to around 1.15 times in October 2008 from around 1.9 times in October 2007, according to data from Britain's Financial Services Authority.

In a report in March, FSA chairman Adair Turner noted that hedge fund leverage is typically well below that of banks.

BLAME GAME

Hufschmid's comments, however, come as lawmakers in the U.S. and Europe draw up plans to step up regulation of the hedge fund industry.

In April the European Commission unveiled draft proposals for hedge fund managers to register and be subject to close scrutiny in an effort to control vehicles believed to pose systemic risks. France has since said the rules do not go far enough to control such dangers.

Hufschmid, who says LTCM "by today's standards ... was insignificant," said hedge funds had not caused the global financial crisis but were involved in subsequent deleveraging as they sold securities they'd bought with credit.

"The triggers of this crisis (mortgages, house prices, credit deterioration etc.) caused the excessive leverage in the system to tumble," he said.

"The de-leveraging that followed involved hedge funds -- to the extent they were risk-takers they too had to downscale like everyone else."

(Editing by Rupert Winchester

Monday, February 23, 2009

What is LTCM? While doing some follow-up research on my article that will appear in an upcoming volume of the University of Oklahoma Law Review, I came across this New York Times article.

It makes an interesting argument that I've also offered before--that is, the federal government's role in the bailout of the Long Term Capital Management (LTCM) hedge fund in the late '90s played a key role in today's crisis by advancing the "moral hazard" theory.

You see, by bailing out all of these banks, insurance companies, car manufacturers and such, the federal government is not only delaying the inevitable pain of default but it is also propping up the idea that bad decision-makers have a decent chance of finding a final backstop in the form of Uncle Sam and his ability to create money.

All in all, definitely an article worth reading

After watching a short excerpt of a Warren Buffet speech, I thought I may quickly summarise the collapse of the famous Hedge Fund, Long Term Capital Management. But First, Watch this excerpt, it is both funny and informative.

I have sourced most of the information below from an excellent paper done by Gregory Connor and Mason Woo (LSE) called An Introduction to Hedge Funds. I will separately write an introduction to Hedge Fund Strategies article after this article to have a more detailed look at Hedge Funds.

Long Term Capital Management

During the late 90’s, the largest tremor through the hedge fund industry was the collapse of the hedge fund Long-Term Capital Management (LTCM). LTCM was the premier quantitative-strategy hedge fund, and its managing partners came from the very top tier of Wall Street and academia. These funds are commonly known as “quant funds” or quantum funds and they typically use ma thematic strategies based on past market performance to predict future performance. They are typically very short term and are capable of providing very high returns.

From 1995-1997, LTCM had an annual average return of 33.7% after fees. At the start of 1998, LTCM had $4.8 billion in capital and positions totalling $120 billion on its balance sheet [Eichengreen, 1999].

Long Term Capital Management Strategy and Leverage ratio

LTCM largely (although not exclusively) used relative value strategies, involving global fixed income arbitrage and equity index futures arbitrage. As an example, LTCM

exploited small interest rates spreads, some less than a dozen basis points, between debt securities across countries within the European Monetary System. Since European exchange rates were tied together, LTCM counted on the reconvergence of theassociated interest rates.

Its techniques were designed to pay off many sets of small returns, with extremely low volatility. To achieve a higher return from these small price discrepancies, LTCM employed very high leverage. Before its collapse LTCM controlled $120 billion in positions with $4.8 billion in capital. In terms of calculating this leverage, this represented an extremely high leverage ratio (120/4.8 = 25). Banks were willing to extend almost limitless credit to LTCM at very low interest rates, because the banks thought that LTCM had latched onto a certain way to make money.

LTCM was not an isolated example of size-able leverage. At that time, more than 10 hedge funds with assets under management of over $100 million were using leverage at least ten times over [President’s Working Group, 1999].

The Collapse of Long Term Capital Management

In the summer of 1998, the Russian debt crisis caused global interest rate anomalies. All over the world, fixed income investors sought the safe haven of high quality debt. Spreads between government debt and risky debt unexpectedly widened in almost all the LTCM trades.

LTCM lost 90% of its value and experienced a severe liquidity crisis. It could not sell billions in illiquid assets at fair prices, nor could it find more capital to maintain its positions until volatility decreased and interest rate credit spreads returned to normal.

Emergency credit had to be arranged to avoid bankruptcy, the default of billions of dollars of loans, and the possible destabilisation of global financial markets. Over the weekend of September 19-20, 1998, the Federal Reserve Bank of New York brought together 14 banks and investment houses with LTCM and carefully bailed out LTCM by extending additional credit in exchange for the orderly liquidation of LTCM’s holdings.

This bail out of Long Term Capital Management is similar to the recent bail out by the New York Federal Reserve of Bear Sterns. I will not go into whether or not one was more justified than the other but I read an excellent article Brave New Fed which is worth reading if you are interested.

Since the collapse of LTCM, hedge fund leverage ratios have fallen substantially.The aftermath of the Russian debt crisis and LTCM debacle temporarily stalled the growth of the hedge fund industry. In 1998, more hedge funds died and fewer were created than in any other year in the 1990s [Liang, 2001].

The number of hedge funds as well as assets under management (AUM) declined slightly in 1998 and the first half of 1999. After that the growth of hedge funds resumed with no major changes to regulations but with guidelines for additional risk management. [Lhabitant, 2002; Financial Stability Forum, 2000].

To see an excellent written summary of the Warren Buffest speech, see Warren Buffett on long term Value Investing or to see another Warren Buffett Video, click here.

Hedge funds come in many flavors, including:

1. Equity market neutral funds, which offset long positions in stocks with equal short positions in order to eliminate systematic market exposure (beta).

2. Convertible arbitrage funds attempt to exploit anomalies between the price of a stock and the prices of instruments convertible into the stock.

3. Fixed income arbitrage tries to predict changes in credit ratings or the term structure of interest rates. Typically these funds strive for market-neutral positions by offsetting long and short positions.

4. Distressed securities funds exploit the fact that many investors lack the desire to participate in the bankruptcy process or the ability to identify their value.

5. Merger arbitrage captures any spread between the price of a company and the price that a planned acquiror has offered.

6. Hedged equity funds hold both long and short positions but typically remain net long.7. Global macro funds exploit systematic market moves in currencies, futures and option

contracts.8. Emerging markets funds focus on less mature investment markets.9. Funds of funds invest in a number of other hedge funds, offering diversification at the

cost of double fees.

Hedge fund styles, more generally, include:

Relative value, which seeks to exploit valuation discrepancies between their long and short positions

Event-driven, which focus on opportunities created by corporate actions such as mergers or offerings

Equity hedge, which invest long and short for varying degrees of market exposure and leverage

Global asset allocation, which opportunistically go long or short a variety of assets Short selling, which shorts equities in anticipation of a market decline

Question: What Are Hedge Funds?

Answer: Hedge funds are generally privately-owned investment funds, and so are not regulated like mutual funds whose owners are public corporations. Furthermore, hedge fund managers are compensated as a percent of the returns they earn. This

attracts many investors who are frustrated by mutual fund fees that are paid regardless of fund performance.

Thanks to this compensation structure, hedge fund managers are driven to achieve above market returns. Since they get zero no matter how much money they lose, they are also very risk tolerant. This makes the funds very risky for the investor, who can lose much more than zero.

Hedge fund managers are very good at using sophisticated derivatives, such as futures contracts, options and puts. Basically, these products all do two things: they use small amounts of money, or leverage, to promise large amounts of stocks or commodities. Secondly, they all say they will deliver this stock or commodity at a particular point in time. In that sense, hedge fund managers are trying to time the market, which some would say is very difficult if not impossible to do.

Question: Who Invests in Hedge Funds and Why?

Answer: The primary investors are wealthy individuals and institutions. They typically have a great deal of funds to invest, and can weather significant downturns in their portfolio in their quest for higher returns. Many of these investors are trying to outperform the market to recover losses incurred during the stock market crash of 2000. In addition, many pension funds are realizing they may not have the capital needed to cover the mass of retiring baby boomers, and are trying to outperform the market to cover these obligations. Unfortunately, the risky nature of hedge funds, and their lack of regulation, means these pension funds are less likely to cover their commitments.

Question: How Do Hedge Funds Impact the Stock Market?

Answer: Hedge funds have made the stock market much more risky. Since they are unregulated, they can make investments without scrutiny by the SEC. Unlike mutual funds, they don’t have to report quarterly on their holdings. This means no one really knows what they are invested in.

Their use of derivatives means that, with little actual money invested, they have the capability to create large swings in the market. For example, many experts have said

that the run-up in oil prices in July of 2006 was caused, in part, by hedge funds. Although no one really knows how much of the market is controlled by hedge funds, Credit Suisse estimates it could be half of the New York and London Stock Exchanges. (Source: International Herald Tribune, "U.S. Regulators Grow Alarmed Over Hedge Fund Hotels,” January 1, 2007)

Question: How Do Hedge Funds Impact the U.S. Economy?

Answer: If hedge funds can dramatically increase the cost of oil, they can have a huge impact on the economy. Oil prices are a component of inflation, which cuts into consumers ability to purchase. Since consumer products are 70% of the U.S. economy, a restriction in consumers buying power will lead to a slowdown in the economy’s growth.

The other real impact hedge funds can have on the economy is if they cause a run-up in the stock market, causing unsophisticated individual investors to buy stocks or mutual funds. If they then leave the stock market, and invest in bonds or commodities, those individual investors could lose a lot of their savings, thus jeopardizing their retirement. This all sounds like conjecture simply because no one really knows what hedge funds are invested in, and how much they have invested. Some estimates are that funds have over $1 trillion in assets around the world.(Source:The Economist, “Why Investors Should Fuss About Hedge Fund Fees," November 16, 2006)

Question: What Was the LTCM Hedge Fund Crisis?

Answer: Long-Term Capital Management (LTCM) was a very large hedge fund ($126 billion in assets) that nearly collapsed in late 1998. Like many hedge funds, its investment strategies were based on a fairly regular range of volatility in foreign currencies and bonds. When Russia declared it was devaluing its currency and basically defaulting on its bonds, it moved beyond the regular range that LTCM had counted on. In response, the U.S. stock market dropped 20%, while European markets fell 35%. Investors sought refuge in Treasury bonds, causing interest rates to drop by over a full point.

As a result, LTCM’s higly leveraged investments started to crumble. By the end of August 1998, it lost 50% of the value of its capital investments. Since so many banks and pension funds were invested in LTCM, its problems threatened to push most of them to near bankruptcy.

To save the U.S. banking system, then-Federal Reserve Chairman Alan Greenspan personally convinced 14 banks to remain invested in the hedge fund, averting disaster. In addition, the Fed started lowering the Fed Funds rate as a reassurance to investors that the Fed would do whatever it took to support the U.S. economy. Without such direct intervention, the entire financial system was threatened with a collapse.

There is growing concern that the large role of hedge funds in today’s markets could cause a repeat of that panic. However, the September 2006 financial distress of Amaranth Advisors, a fund nearly twice the size of LTCM, had little effect on global stock markets. (Source: IMF, World Economic Outlook, Interim Assessment, "Chapter III: Turbulence in Mature Financial Markets” December 1998; IMF Report: "International Contagion Effects from the Russian Crisis and the LTCM Near-Collapse”, April 2002; European Central Bank, “Financial Stability Report” December, 2006.)

Long-Term Capital Management

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Long-Term Capital Management (LTCM) was a U.S. hedge fund which used trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading, combined with high leverage. It failed spectacularly in the late 1990s, leading to a massive bailout by other major banks and investment houses,[1] which was supervised by the Federal Reserve.

LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences.[2] Initially enormously successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis and became a prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000.

The collapse of LTCM was the subject of Roger Lowenstein's book When Genius Failed: The Rise and Fall of Long-Term Capital Management, published in 2000.

Contents

1 Founding 2 Trading strategies 3 Downturn 4 1998 bailout 5 Aftermath 6 See also 7 Notes 8 Bibliography 9 Further reading

[edit] Founding

LTCM Partners

John Meriwether

Former vice chair and head of bond trading at Salomon Brothers; MBA, University of Chicago

Robert C. Merton

Leading scholar in finance; Ph.D., Massachusetts Institute of Technology; Professor at Harvard University

Myron Scholes

Author of Black-Scholes model; Ph.D., University of Chicago; Professor at Stanford University

David W. Mullins Jr.

Vice chairman of the Federal Reserve; Ph.D. MIT; Professor at Harvard University; was seen as potential successor to Alan Greenspan

Eric Arbitrage group at Salomon;

Rosenfeld Ph.D. MIT; former Harvard Business School professor

William Krasker

Arbitrage group at Salomon; Ph.D. MIT; former Harvard Business School professor

Gregory Hawkins

Arbitrage group at Salomon; Ph.D. MIT; worked on Bill Clinton's campaign for Arkansas state attorney general

Larry Hilibrand

Arbitrage group at Salomon; Ph.D. MIT

James McEntee

Bond-trader

Dick Leahy Executive at Salomon

Victor Haghani

Arbitrage group at Salomon; Masters in Finance, LSE

John Meriwether headed Salomon Brothers' bond trading desk until he was forced to resign in 1991 when his top bond trader, Paul Mozer, admitted to falsifying bids on U.S. Treasury auctions. Because Salomon was the largest bidder on treasury bonds at auction, the Treasury department feared that Salomon would be able to take a strategic position on the bonds in order to influence the price.[3] As such, Salomon (or any single bidder) was restricted from purchasing more than 35% of the bonds sold at any auction. Mozer circumvented this limitation by making fraudulent bids on behalf of Salomon clients and then transferring the bonds to Salomon's accounts following the transaction. The revelation of this scandal depressed the company's share price and drove investor Warren Buffett to sack its chief executive officer, John Gutfreund. Though Meriwether was not directly implicated, calls for his ousting rose within the company and he resigned before he was to be let go.[4]

In 1993 he announced that he would launch a hedge fund called Long-Term Capital.[5] Meriwether used his well-established reputation to recruit several Salomon bond traders and some brilliant mathematicians. He also recruited two future Nobel Prize winners, Myron Scholes and Robert C. Merton, both of whom worked in Salomon Brothers' fixed

income trading department.[6] Other principals in the firm included Eric Rosenfeld, Greg Hawkins, Larry Hilibrand, William Krasker, Dick Leahy, Victor Haghani, James McEntee, Robert Shustak, and David W. Mullins Jr..

Long-Term Capital consisted of Long-Term Capital Management (LTCM), a company incorporated in Delaware but based in Greenwich, Connecticut. LTCM managed trades in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands. The fund's operation was designed to have extremely low overhead; trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch.[7]

Meriwether chose to start a hedge fund to avoid the financial regulation imposed on more traditional investment vehicles, such as mutual funds, as established by the Investment Company Act of 1940—funds which accepted stakes from one hundred or fewer individuals with more than one million dollars in net worth each were exempt from most of the regulations that bound other investment companies.[8] In late 1993, Meriwether approached several "high net-worth individuals" in an effort to secure start-up capital for Long Term Capital Management. With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments. The bulk of the money, however, came from companies and individuals connected to the financial industry.[9] By 24 February 1994, the day LTCM began trading, the company had amassed just over $1.01 billion in capital.[10]

[edit] Trading strategies

The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. Government bonds are a "fixed-term debt obligation", meaning that they will pay a fixed amount at a specified time in the future.[11] Differences in the bonds' present value are minimal, so according to economic theory any difference in price will be eliminated by arbitrage. Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a 30 year treasury bond and a 29 and three quarter year old treasury bond should be minimal—both will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bonds because of a difference in liquidity [12] . By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting the more expensive, but more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond was issued.

As LTCM's capital base grew, they felt pressed to invest that capital and had run out of good bond-arbitrage bets. This led LTCM to undertake more aggressive trading strategies. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998, LTCM had extremely large positions in areas

such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). LTCM had become a major supplier of S&P 500 vega, which had been in demand by companies seeking to essentially insure equities against future declines.[13]

Because these differences in value were minute—especially for the convergence trades—the fund needed to take highly-leveraged positions to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of about 25 to 1. It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

Long Term Capital Management was found to have entered into certain tax avoidance transactions. Approximately $100 million of losses claimed by LTCM were disallowed by United States District Court of Connecticut. An e-mail dated March 10, 1995, to Jan Blaustein Scholes, Myron's girlfriend at the time and general counsel responsible for setting up leasing transactions associated with the disallowed losses, stated : "For our CHIPS III entity let’s use a name unrelated to CBB. It makes it just a bit harder for the IRS to link all the deals together." Equally alarming, Myron Scholes stated that he was not an expert on tax law. A textbook, "Taxes & Business Strategy" (principally written by Myron Scholes), contains chapters on both economic substance and step transactions, which are the two concepts under which the tax loss was disallowed by the IRS.

In a memorandum to Long Term’s management committee dated November 12, 1996, Myron Scholes wrote: "We must decide in the near future (1) how to allocate these capital losses; (2) how to "trade" them so that they are held in high-valued hands; and (3) how to plan to be able to enjoy the benefits of the use of these losses for the longest period of time. If we are careful, most likely we will never have to pay long-term capital gains on the 'loan' from the Government." He went on, "How should LTCM pay those who brought the Tax Losses to Fruition and allocate the expenses of undertaking the trade?"[14]

[edit] Downturn

Main articles: 1997 Asian Financial Crisis and 1998 Russian financial crisis

Although much success within the financial markets arises from immediate-short term turbulence, and the ability of fund managers to identify informational asymmetries, factors giving rise to the downfall of the fund were established prior to the 1997 East Asian financial crisis. In May and June 1998 returns from the fund were -6.42% and -10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Such losses were accentuated through the Russian financial crises in August and September 1998, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became

huge losses as the value of the bonds diverged. By the end of August, the fund had lost $1.85 billion in capital.

As a result of these losses, LTCM had to liquidate a number of its positions at a highly unfavorable moment and suffer further losses. A good illustration of the consequences of these forced liquidations is given by Lowenstein (2000).[15] He reports that LTCM established an arbitrage position in the dual-listed company (or "DLC") Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium relative to Shell. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch.[16] LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge. This may have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.[17]

The company, which was providing annual returns of almost 40% up to this point, experienced a flight-to-liquidity. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion to $600 million without shrinking the portfolio, leading to a significant elevation of the already high leverage.

[edit] 1998 bailout

Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. The contributions from the various institutions were as follows: [18][19]

$300 million: Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS

$125 million: Société Générale $100 million: Lehman Brothers, Paribas Bear Stearns declined to participate.

In return, the participating banks got a 90% share in the fund and a promise that a supervisory board would be established.

The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their own debt creating a vicious cycle.

The total losses were found to be $4.6 billion. The losses in the major investment categories were (ordered by magnitude):[20]

$1.6 bn in swaps $1.3 bn in equity volatility $430 mn in Russia and other emerging markets $371 mn in directional trades in developed countries $286 mn in equity pairs (such as VW, Shell) $215 mn in yield curve arbitrage $203 mn in S&P 500 stocks $100 mn in junk bond arbitrage no substantial losses in merger arbitrage

See also: East Asian financial crisis

Long Term Capital was audited by Price Waterhouse LLP.

Unsurprisingly, after the bailout by the other investors, the panic abated, and the positions formerly held by LTCM were eventually liquidated at a small profit to the bailers.

Some industry officials said that Federal Reserve Bank of New York involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf in the event of trouble. Federal Reserve Bank of New York actions raised concerns among some market observers that it could create moral hazard.[21]

LTCM's strategies were compared (a contrast with the market efficiency aphorism that there are no $100 bills lying on the street, as someone else has already picked them up) to "picking up nickels in front of a bulldozer"[22]— a likely small gain balanced against a small chance of a large loss, like the payouts from selling an out-of-the-money option.

[edit] Aftermath

After the bailout, Long-Term Capital Management continued operations. In the year following the bailout, it earned 10 percent. By early 2000, the fund had been liquidated, and the consortium of banks that financed the bailout had been paid back; but the collapse was devastating for many involved. Goldman Sachs CEO Jon Corzine, who had been closely involved with LTCM, was forced out of the office in a boardroom coup led by Henry Paulson. Mullins, once considered a possible successor to Alan Greenspan, saw his future with the Reserve dashed. The theories of Merton and Scholes took a public beating. In its annual reports, Merrill Lynch observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."[23]

After helping unwind LTCM, Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage.[24] Unfortunately, with the Credit Crisis, JWM Partners LLC has been hit with 44 percent loss since September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund is to be shut down in July 2009.[25]

Hedge funds

Hedge funds' exorbitant fees

Nov 16th 2006 From The Economist print edition

THERE is an old Wall Street story that can be adapted for the modern world of hedge funds. A young hedge-fund trainee is taken to the harbour. “Here”, says his boss, “are the partners' yachts. And over there are the yachts of the bankers who lend to us.” The naive youth replies: “But where are the customers' yachts?”

Recent weeks have shown how alluring a berth on that bounteous marina is. Morgan Stanley, a big investment bank, has bought stakes in three groups, Avenue Capital, FrontPoint Partners and Lansdowne, at a total cost believed to be more than $1 billion. Two former American treasury secretaries, Larry Summers and John Snow, have discovered hedge-fund lucre, as has another former Washingtonian, Chelsea Clinton, the ex-president's daughter. In the hope of tapping new sources of capital, Fortress Investment Group, which offers both hedge funds and private equity, has announced plans to float 10% of itself on America's stockmarket. Marshall Wace, a British manager, has launched a €1.5 billion ($1.9 billion) hedge fund on the Euronext exchange in Amsterdam

Long-only leads hedge fund returnsWed Aug 12, 2009 1:13pm IST

 

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-Text+LONDON (Reuters) - Long-only hedge fund strategies posted the best returns of the asset class in July as global stock markets continued their upward trend, according

to data in a report published by Lipper Global on Tuesday.

As the industry looks to repair itself following last year's heavy losses and record redemptions, these new figures will give more ammunition to market watchers who claim that the industry is on the road to recovery.

The data from the Thomson Reuters company showed that long-only hedge funds posting a 4.75 percent return for the month, building on gains of 14.34 percent for the year-to-date.

"Hedge funds have benefitted from an equity market certainly boosted and buoyed by better-than-expected corporate earnings," said Aureliano Gentilini, global head of hedge fund research.

He pointed out the sustained rally in the second part of July in global stock markets.

The information released ahead of Lipper's monthly Hedge Fund Insight Report, which is due at the end of August, showed that all hedge fund strategies posted a positive performance last month, with long/short equity and multi strategies both giving returns of 0.81 percent.

Short bias strategies made a 0.40 percent return, boosted by profitable short sale strategies in the first half of the month, Lipper data showed.

Global stock markets gained 8.5 percent in July, according to the MSCI World TR Index. They continued their rally from March lows, fuelled by hopes that the worst of the financial crisis has passed.

However, stock markets remained very sensitive to macroeconomic factors, said Gentilini.  Continued...

The market is already looking for the next macro catalyst to drive market direction; there are a still a number of risks of market correction," he said.

Among the other hedge fund strategies, options arbitrage performed strongly in July, with returns of 0.88 percent. Event-driven was the worst-performer, posting a 0.19 percent return.