Hedge fund blowups come in all shapes and sizes, but many of the most high-profile failures share a couple of common traits: high leverage and bets on debt, technology stocks, or both.
But thousands of hedge funds suffer losses each year and close quietly. So why do the problems at these few - roughly a dozen in the past nine years - stand out so prominently?
Michael F. Griffin, an attorney with Dorsey & Whitney LLP, New York, who specializes in hedge funds, said failures fall into four broad categories: outright fraud; unusually high use of leverage; mispricing of securities, intentional or otherwise; and strategy failure.
"It's a business where people are constantly looking for innovative approaches to investment management and testing them," Mr. Griffin said.
Long Term Capital Management, he said, would fit into the excessive leverage category. And although they were less highly leveraged, so would Askin Capital Management, Convergence Asset Management and, most recently, Eifuku.
Strategy failures include Soros Fund Management, Tiger Management, Niederhoffer Investments and Everest Capital.
Securities mispricing helped claim Beacon Hill Asset Management and Lipper & Co.
There are also examples of outright fraud in Cambridge Partners and Manhattan Investment.
And even within these categories there are interrelationships, combinations of strategies that failed and then increased leverage to try to make up for that failure, as with LTCM. There are mispricings bordering on fraud, as in the case of Beacon Hill and Lipper. A federal grand jury is said to be looking into possible fraud at Beacon Hill.
Don't forget ego
Yet another common thread is the personalities of the fund managers themselves, said Jonathan S. Bean, managing director of Mellon HBV Alternative Strategies LLC, New York.
Some funds blow because of the way the managers approach their business.
"What are the commonalities? Hubris, lack of risk control, lack of an efficiently running back office," Mr. Bean said. "Hedge fund guys consider themselves to be iconoclasts. They get up in the morning and do great things; they don't make doughnuts. There's a certain amount of infallibility about their decisions. There's luck and there's skill. But it's sometimes hard to tell the difference between the two."
LTCM, considered to be one of the largest and most high-profile hedge fund failures ever, leveraged thousands of tiny trades designed to capture pricing inefficiencies in various securities - mostly foreign government debt - by an overall ratio of 25 to 1. Some individual trades were leveraged much higher, while some were less leveraged.
Overall, that meant Long Term Capital had $25 of market exposure for every $1 in actual invested capital. With equity capital of $5 billion, LTCM's market exposure was roughly $125 billion. Its failure in late 1998 was largely the result of not having enough actual capital to cover margin calls on the securities it had borrowed to leverage its bets.
Leverage only became a problem, however, after LTCM started moving into equity volatility and equity risk arbitrage, strategies less familiar to the firm than relative value fixed income.
The same problem of abandoning a successful strategy also led to large losses at hedge funds run by George Soros and Julian Robertson, said Thomas A. Hickey III, an attorney with the Boston law firm Kirkpatrick & Lockhart LLP. Mr. Hickey advises pension funds on hedge funds and other financial matters.
"With (Messrs. Soros and Robertson), they primarily abandoned their core expertise," Mr. Hickey said. "When they went into value and tech stocks, betting and hedging, shifting their strategies, that's when they had problems."
Mr. Hickey said managers have to identify their strategy, give notice when they shift strategies and allow investors to pull their money out if they're not comfortable with the shift. "I want to make sure my client knows exactly what he's getting into, and I want to build in as many ways as I can to get out."
LTCM is the standard by which spectacular hedge fund failures are now measured. But it doesn't take an LTCM-sized loss to qualify as a blowup; all it takes to trigger concern is losing 25% or more of the portfolio in a year, said Chris Sugrue, chairman of hedge fund advisory and monitoring firm PlusFunds, New York.
"Lots of hedge funds lose money, even 25%," Mr. Sugrue said. "It's when you get to 25%, 30%, 35% and up which brands you a disaster."
And even those losses might not be so bad, but some hedge fund managers can't handle losing money or telling investors they lost money. So they try to make it up by ratcheting up the leverage and taking bigger directional bets, Mr. Sugrue said. If those don't work out, the manager gets deeper into a hole, and it becomes easier to start doctoring financial statements to mislead investors.
"They're already in trouble with the loss," Mr. Sugrue said. "They'll be in more trouble if they have to disclose the loss. They figure they can get out of it if they make the money back. It's the best of two bad choices. The sad thing is, it's part of the nature of a person who would set up a hedge fund. They believe they have demonstrated skill, a past record. More often than not, they have an innate belief that they can make it back. They're not always right."
Askin Capital's failure in April 1994 will go down in history as one of the first big hedge fund meltdowns, and the one that first drew attention to the risks involved in investing in this area. Fund manager David Askin was leveraged 21/2-to-1, held large positions in illiquid securities, believed he and his computer models were absolutely right and completely misjudged the prices of the securities he held. To a certain extent, there is a little Askin in many of the blowups that followed.
Mr. Askin's computer models were not set up to account for a 50 basis-point rise in the discount rate in four months, which is what happened between January and April 1994. That increase caused deep devaluations in the mortgage bonds he held and outpaced his Treasury hedges.
His leverage was not high compared with LTCM; in fact, it was only slightly above average, according to a 1999 article by Franklin R. Edwards in the Journal of Economic Perspectives. But in a relatively illiquid market like collateralized mortgage obligations, Mr. Askin's leveraged positions were too large to cover when the markets moved against him.
Beacon Hill Asset Management also dabbled in the mortgage-backed securities markets and got burned by interest rates. Beacon Hill's problems stemmed from falling interest rates. The fund, run by Jack Barry, invested in specialized collateralized mortgage obligations and was structured on the premise that interest rates would remain steady or rise. So when interest rates fell, so did the value of Beacon Hill's securities. Hedges against falling interest rates were inadequate to cover the falling CMO values, and Beacon Hill lost 54% of its roughly $800 million in equity capital.
In acknowledging it had mispriced its investments, Beacon Hill officials also told investors the firm was liquidating the two hardest-hit funds and that while the liquidation took place, investors could not remove their money or get any further information about the funds.
Recently, questions have been raised on how much Beacon Hill officials knew about the prices of their securities and whether they misled investors before disclosing the losses.
In February 2002, Kenneth Lipper unexpectedly told investors he was slashing the value of his Lipper Convertibles LP fund by 45% and Lipper Offshore Convertibles LP by 10%, following the departure of two executives who were responsible for running the funds. At the end of 2001, Lipper & Co. told investors the convertible bond fund had earned a 7% return. It turned out the fund had lost about 40%. Similar mispricings were also discovered in the offshore fund. By March, Mr. Lipper decided to liquidate both funds, and later all of his mutual funds, too.
Initially, LTCM's idea was to use a computer model to find pricing inefficiencies between specific kinds of bonds. LTCM would take positions in those bonds, betting that the prices would get closer together, although there was no guarantee that would happen. For the strategy to work, LTCM first had to discover the mispricing, then place its bets and rely on other traders to discover the mispricing and push the prices together.
The inefficiencies were relatively small and by themselves would not have generated returns like the 40% net of fees that the fund earned in 1995, according to a 1999 report by the President's Working Group on Financial Markets. LTCM inflated the returns using leverage.
Later, LTCM expanded its model to equity markets.
Then Russia devalued the ruble and declared a debt moratorium. That action affected bond spreads in other countries as investors began selling more risky bonds and buying less risky bonds. Prices fell on the more risky bonds LTCM owned and rose on less risky bonds the firm sold short - the opposite of the firm's bet. As with Askin, the computer was not set up to conceive of such a situation. LTCM officials believed their model was correct, that everyone else was wrong and that prices would snap back. They didn't, and LTCM lost almost all of its $2.3 billion in equity capital.
And in January, the Japanese hedge fund Eifuku lost its entire $300 million portfolio in just seven days on a handful of large directional Japanese telecom stock bets that were leveraged about 21/2 times, according to published reports.
Mr. Sugrue said the key to preventing future blowups isn't more regulation but improving the flow of information.
"(Hedge fund investing) is not an investor-friendly structure, as it's set up," he said. "The key theme among all this is transparency. Not transparency in that the manager shows all 600 trades, but transparency as in someone who's independent enough to say the value (of the fund) is correct. Until you have something like that, you're going to have more of these blowups."