Massive Hedge Fund Failures

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.

Background
Hedge funds always have had a significant failure rate. Some strategies, such as managed futures, had an attrition rate as high as 14.4% per year between 1994 and 2003, according to a study recently released by the European Central Bank titled, “Hedge Funds And Their Implications For Financial Stability” (August 2005). 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 in 2005 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.

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 disolved.

Marin Capital
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
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.

Tiger Funds
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. A $3.65-billion loan fund was created, which enabled LTCM to survive the market volatility and liquidate in an orderly manner in early 2000.

Conclusion
Despite these well-publicized failures, global hedge fund assets were still growing at a rate of 20% at the end of 2005, according to the International Monetary Fund. 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.

by Jim McWhinney, investopedia.com

The Running of the Hedgehogs

Maybe you were hoping that hedge funds were another passing fad that you could safely ignore. Well, they are a fad, but they show no evidence of passing, and we are now living in the wildest, most unrestrained financial moment in recent history. So it’s time to stop faking it and figure out what it’s all about.

By Duff McDonald

Not so long ago, the talk about hedge funds was all about their money—some guy you’d never heard of buying an $80 million piece of art or a $25 million teardown in Greenwich, Connecticut, or paying himself $1 billion for a single year’s work. It was a spectator sport, absurd but entertaining, to a degree. Then the talk started to get serious, like, were hedge funds artificially bidding up the price of oil? What about that deal where a single trader ripped through $6 billion on a bad hunch about natural-gas prices—should that concern more than just the pissed-off people who entrusted him with their money? Or those two little bouts of panic the market has suffered this year already: Are hedge funds the virus that’s going to make the markets keel over? Are they an evil cabal?

Questions like this now come up in casual conversation, but those conversations run out of steam fast because, though plenty of people fake it, few know much about hedge funds, other than that they made George Soros so rich he can influence world events and then everybody else wanted in. But as for what a hedge fund actually does—the only ones who know work at them, and they don’t talk about it. Plus you never see them anymore because they’re either in their caves or scuba-diving off Bora Bora.

But really, it’s time you understood them. As of March, by one estimate, there was a staggering $2 trillion invested in hedge funds worldwide, up nearly tenfold from 1999. Today, there are more than 9,000 hedge funds, 351 of which manage $1 billion or more. Traditional investment firms are bleeding talent to hedge funds, and there’s a lot of room left for this thing to run: A recent study by consulting firm Casey, Quirk and the Bank of New York predicts that institutional assets in hedge funds could nearly triple by 2010. Last year, the average hedge fund was just 5.3 years old.

Lesson one: Just what is a hedge fund?
It’s only a vehicle for investing, albeit one that happens to be less constrained than most. Your run-of-the-mill mutual fund, for example, buys stocks and bonds, and that’s pretty much it. Most are not even allowed to employ short selling, a way of betting that the price of a security will fall. Hedge funds can employ whatever investing tools they want, including leverage, the use of derivatives like options and futures, and short sales. The New York Times decided years ago to incessantly refer to hedge funds’ use of these instruments as “exotic and risky,” thereby adding to their aura of mystery. The funny thing: Practically all financial institutions use these “exotic” instruments.

There’s a much simpler way of putting it, offered by one of the industry’s luminaries. According to Cliff Asness of AQR Capital, “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years, they deliver a one-in-a-hundred-year flood.”

Although the origin of hedge funds dates back to Alfred Winslow Jones and the fifties, it wasn’t until the late sixties that the category became a recognizable seedling of its current state: a group of highly skilled traders catering to a very wealthy clientele willing to gamble to get humongous returns.

The first true stars of the hedge-fund universe—people like Soros, Michael Steinhardt, and Bruce Kovner—were experts in commodities and currencies and figured out how to exploit inefficiencies in those markets. Because they raised money privately—largely from friends and business associates—they avoided most of the disclosure requirements of U.S. securities laws. That meant they didn’t have to explain to anybody how much money they had or what exactly they did with it.

The deal, in effect, was this: Rich guys could gather up money from other rich guys without oversight, so long as they agreed not to utter a word to the general public that could be construed as “solicitation,” including “communication published in any newspaper, magazine, or similar media.” Not that there was any point in soliciting the public anyway. To get into a fund, you had to invest $2.5 million. Managers were expected to have their own money in the fund, an informal check against reckless risk-taking.

A mythology began to take shape.
People in the financial world became enamored of investing superheroes. Some deserved it: Soros almost broke the Bank of England by shorting the pound. As Soros’s reputation grew, so did his power as an investor. Julian Robertson’s Tiger Management was another legendary outfit that nobody wanted to bet against. Their $1 billion or $2 billion portfolios seem quaint today—like Mike Myers’s Dr. Evil demanding “one million dollars!” to not destroy the world—but their ballsy moves inspired imitators. Of course, the more people out there tried to copy the Soroses and the Robertsons, the less well it worked out. John H. Makin, a principal at Kovner’s Caxton Associates, puts it this way: “The extraordinarily high returns earned by hedge funds during their golden age in the eighties and early nineties were not too good to be true. They were just too good to be true for everyone.”

A hedge fund is a hedge fund is a hedge fund …
A persistent misconception in the general public is that all hedge funds act alike. Not true. On the one hand, you have the nerd brigade, with their fine-tuned software-driven investment strategies that are constantly refined by “rocket scientists”—Ph.D.’s who have decided they want more out of life (i.e., money) than the view from an ivory tower. They’re called “quants,” short for quantitative investors, and their current king is Long Island–based James Simons of Renaissance Technologies. He’s an academic at heart: Simons’s interview process is said to involve a presentation on some finding about the capital markets. At the opposite extreme, you have the table-pounding, executive-belittling activists such as Daniel Loeb of Third Point and Thomas Hudson of the imaginatively named Pirate Capital. (Argh! We be swashbuckling investors!) Tactics like theirs get the most press—and thus tend to define public perception of hedge funds—despite the fact that most hedge funds rely far more on brains than brawn. That said, some of the finest drama does come from public battles like that launched by Loeb on home-appliance maker Salton Inc., in which he claimed to have seen the company’s CEO “sipping chilled Gewürztraminer” at the U.S. Open on the company dime. (Real hedge-fund managers don’t drink German wine?)

In the popular imagination, a hedge-fund trader sits at a console that looks like it could launch a mission to Mars and spends his whole day making rapid-fire decisions about what to buy and sell. There are definitely people like this (Stevie Cohen of SAC Capital, for one), but most hedge-fund offices are a lot quieter. A typical long/short firm sets up its positions and then might spend days or weeks doing nothing more than seeing what happens to them. Maybe one afternoon, they’d really throw down and have a tweedy professor in to pitch an arcane finance theory. It can be really, really boring to work at a hedge fund.

A brief psychographic portrait:
According to a survey of 294 fund managers with a net worth of $30 million or more by Russ Alan Prince, the author of Fortune’s Fortress, 97 percent of hedge-fund managers see their portfolios as themselves personified. And here’s what else they think about: failure. Fifty-four percent of them say they suffer from the Icarus syndrome, a fear of flying too close to the sun and crashing to Earth. They also think about staring down the barrel of a gun: Almost three-quarters believe their wealth makes them a target of criminals. This is the life we can’t stop talking about? (Yes, it is. And here’s why: Three out of ten of us think the average hedge-fund pro makes more than $10 million a year. He doesn’t, but he might as well for how much we already hate him for it.)

Hedge funds sometimes get confused with private equity, the financial specialty that’s gotten the most ink these past few months. Private-equity investors like the Blackstone Group or KKR differ from your typical hedge fund in that they tend to take more long-term, controlling stakes in companies—often taking them private in the process—in hopes of doing some financial engineering that results in a huge windfall. The luminaries in private equity—men like Blackstone’s Stephen Schwarzman (he of the $3 million, Rod Stewart–entertained birthday party in February) and KKR’s Henry Kravis—are more a product of the pin-striped, backroom, cigar-smoking ethos than hedge-fund managers, who generally wear khakis at their trading desks and shrink from attention.

You can think of them as products of the yin and yang of Wall Street’s traditional powerhouses. Private-equity people are “people people”—their ranks full of former pros of the relationship-driven investment-banking side of the business. Hedge-fund people are much more likely to come from the trading side: quicker to draw, quicker to shoot, and not inclined to spend a whole lot of time discussing the thinking behind it all. “They measure their performance every day. They wonder, ‘If I buy this today, will I look stupid tomorrow?’ ” says a private-equity professional. “A private-equity guy is sitting there thinking, ‘What will the world look like in three to five years?’ ”

Both industries share an addiction to leverage, which is to say, borrowed money. They use it liberally to maximize the return of a good deal or a good trade. From the very beginning, in fact, hedge funds were premised on the notion that they could exploit minute profit-making opportunities by placing big leveraged bets. The “hedge” in hedge funds originally referred to the downside protection a fund would simultaneously employ by, yes, hedging. Typically, that would mean buying one stock and shorting another. While many hedge funds still employ actual hedging techniques, the practice has gone out of vogue. But leverage hasn’t, and that means big bets with little or no downside protection. In a word, risky.

And why are they so rich?
One thing hedge-funders uniformally agree on is that they are worth what they are paid. Running your own hedge fund is the fastest way to make a fortune known to man. The typical fee structure is known by the vernacular “2 & 20”—most funds take a 2 percent management fee and 20 percent of any profits. (Some take far more. James Simons, for example, charges a nominally obscene 5 & 44.) The result: A $1 billion fund posting a 30 percent return delivers a $78.8 million payday for its managers. A $1 billion fund posting a zero percent return can still spread around $20 million to its employees. The best managers do a lot better than breaking even, mind you, and as a result, a handful of hedge-fund kingpins take home more than $500 million in annual compensation. Although hedge-fund people tend not to advertise their wealth to the world, those in the community are hyperaware of who among them is hot and who is not. Consider that David Einhorn of Greenlight Capital, a widely respected manager, has lately been the talk of the hedge-fund town for his big losses in a subprime-lending stock. Hedge-funders go in for Schadenfreude as much as the next guy.

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In a sign of hedge funds’ growing clout in other spheres, in late January, Senator Chuck Schumer called twenty or so of the top hedge-fund managers and invited them to the Upper East Side Italian restaurant Bottega del Vino. It was supposed to be a friendly chat—Schumer’s message was, you talk to us about what’s going on, and nobody has to worry about too much interference from regulators. It’s chilling to think of all that secret power assembled in one place, like the Cosa Nostra Apalachin summit in 1957. Attendees included Jim Chanos of Kynikos Capital, Rich Chilton of Chilton Investment Co., Stevie Cohen, Stanley Druckenmiller, Paul Tudor Jones II of Tudor Capital, and David Tepper of Appaloosa Management. The combined assets under management of those attending had to have been $200 billion.