The failure of a small hedge fund doesn't come as a particular surprise to anyone in the financial services industry, but the meltdown of a multi-billion fund certainly attracts most people's attention.
When such a fund loses a staggering amount of money, say 20% or more in a matter of months, and sometimes weeks, the event is viewed as a disaster. Sure, the investors may have recovered 80% of their investments, but the issue at hand is simple: Most hedge funds are designed and sold on the premise that they will make a profit regardless of market conditions. Losses aren't even a consideration—they are simply not supposed to happen.
Losses that are of such magnitude that they trigger a flood of investor redemptions that force the fund to close are truly headline-grabbing anomalies. Here we take a closer look at some high-profile hedge fund meltdowns to help you become a well-informed investor.
Strategies Used by Hedge Funds
Hedge funds have always had a significant failure rate. Some strategies, such as managed futures and short-only funds, typically have higher probabilities of failure given the risky nature of their business operations. High leverage is another factor that can lead to hedge fund failure when the market moves in an unfavorable direction. It cannot be denied that failure is an accepted and understandable part of the process with the launch of speculative investments, but when large, popular funds are forced to close, there is a lesson for investors somewhere in the debacle.
While the following brief summaries won't capture all of the nuances of hedge fund trading strategies, they will give you a simplified overview of the events leading to these spectacular failures and losses. Most of the hedge fund fatalities discussed here occurred at the onset of the 21st century and were related to a strategy that involves the use of leverage and derivatives to trade securities that the trader does not actually own.
Options, futures, margin, and other financial instruments can be used to create leverage. Let's say you have $1,000 to invest. You could use the money to purchase 10 shares of a stock that trades at $100 per share. Or you could increase leverage by investing the $1,000 in five options contracts that would enable you to control, but not own, 500 shares of stock. If the stock's price moves in the direction that you anticipated, leverage serves to multiply your gains. If the stock moves against you, the losses can be staggering.
Although the collapse of Long Term Capital Management (discussed below) is the most documented hedge fund failure, the fall of Amaranth Advisors marked the most significant loss of value. After attracting $9 billion worth of assets under management, the hedge fund's energy trading strategy failed as it lost over $6 billion on natural gas futures in 2006.
Faced with faulty risk models and weak natural gas prices due to mild winter conditions and a meek hurricane season, gas prices did not rebound to the required level to generate profits for the firm, and $5 billion dollars were lost within a single week. Following an intensive investigation by the Commodity Futures Trading Commission, Amaranth was charged with the attempted manipulation of natural gas futures prices.
Bailey Coates Cromwell Fund
In 2004, this event-driven, multistrategy fund based in London was honored by Eurohedge as Best New Equity Fund. In 2005, the fund was laid low by a series of bad bets on the movements of U.S. stocks, supposedly involving the shares of Morgan Stanley, Cablevision Systems, Gateway computers, and LaBranche (a trader on the New York Stock Exchange). Poor decision-making involving leveraged trades chopped 20% off of a $1.3-billion portfolio in a matter of months. Investors bolted for the doors and on June 20, 2005, the fund dissolved.
This high-flying California-based hedge fund attracted $1.7 billion in capital and put it to work using credit arbitrage and convertible arbitrage to make a large bet on General Motors. Credit arbitrage managers invest in debt. When a company is concerned that one of its customers may not be able to repay a loan, the company can protect itself against loss by transferring the credit risk to another party. In many cases, the other party is a hedge fund.
With convertible arbitrage, the fund manager purchases convertible bonds, which can be redeemed for shares of common stock, and shorts the underlying stock in the hope of making a profit on the price difference between the securities. Since the two securities normally trade at similar prices, convertible arbitrage is generally considered a relatively low-risk strategy.
The exception occurs when the share price goes down substantially, which is exactly what happened at Marin Capital. When General Motors' bonds were downgraded to junk status, the fund was crushed. On June 16, 2005, the fund's management sent a letter to shareholders informing them that the fund would close due to a "lack of suitable investment opportunities".
Aman Capital was set up in 2003 by top derivatives traders at UBS, the largest bank in Europe. It was intended to become Singapore's "flagship" in the hedge fund business, but leveraged trades in credit derivatives resulted in an estimated loss of hundreds of millions of dollars.
The fund had only $242 million in assets remaining by March 2005. Investors continued to redeem assets, and the fund closed its doors in June 2005, issuing a statement published by London's Financial Times that "the fund is no longer trading." It also stated that whatever capital was left would be distributed to investors.
In 2000, Julian Robertson's Tiger Management failed despite raising $6 billion in assets. A value investor, Robertson placed big bets on stocks through a strategy that involved buying what he believed to be the most promising stocks in the markets and short selling what he viewed as the worst stocks.
This strategy hit a brick wall during the bull market in technology. While Robertson shorted overpriced tech stocks that offered nothing but inflated price-to-earnings ratios and no sign of profits on the horizon, the greater fool theory prevailed and tech stocks continued to soar. Tiger Management suffered massive losses and a man once viewed as hedge fund royalty was unceremoniously dethroned.
Long-Term Capital Management
The most famous hedge fund collapse involved Long-Term Capital Management (LTCM). The fund was founded in 1994 by John Meriwether (of Salomon Brothers fame) and its principal players included two Nobel Memorial Prize-winning economists and a bevy of renowned financial services wizards. LTCM began trading with more than $1 billion of investor capital, attracting investors with the promise of an arbitrage strategy that could take advantage of temporary changes in market behavior and, theoretically, reduce the risk level to zero.
The strategy was quite successful from 1994 to 1998, but when the Russian financial markets entered a period of turmoil, LTCM made a big bet that the situation would quickly revert back to normal. LTCM was so sure this would happen that it used derivatives to take large, unhedged positions in the market, betting with money that it didn't actually have available if the markets moved against it.
When Russia defaulted on its debt in August 1998, LTCM was holding a significant position in Russian government bonds (known by the acronym GKO). Despite the loss of hundreds of millions of dollars per day, LTCM's computer models recommended that it hold its positions. When the losses approached $4 billion, the federal government of the United States feared that the imminent collapse of LTCM would precipitate a larger financial crisis and orchestrated a bailout to calm the markets.
The Bottom Line
Despite these well-publicized failures, global hedge fund assets continue to grow as total international assets under management amounts to approximately $2 trillion. These funds continue to lure investors with the prospect of steady returns, even in bear markets. Some of them deliver as promised. Others at least provide diversification by offering an investment that doesn't move in lockstep with the traditional financial markets. And of course, there are some hedge funds that fail.
Hedge funds may have a unique allure and offer a variety of strategies, but wise investors treat hedge funds the same way they treat any other investment - they look before they leap. Careful investors don't put all of their money into a single investment, and they pay attention to risk. If you are considering a hedge fund for your portfolio, conduct some research before you write a check, and don't invest in something you don't understand.
Most of all, be wary of the hype: when an investment promises to deliver something that sounds too good to be true, let common sense prevail and avoid it. If the opportunity looks good and sounds reasonable, don't let greed get the best of you. And finally, never put more into a speculative investment than you can comfortably afford to lose.