CAIA Level I: An Introduction to Core Topics in Alternative Investments, 2nd Edition

CHAPTER 26

Lessons from Hedge Fund Failures

This chapter examines major hedge fund collapses. The purposes of reviewing these failures are to understand the reasons for each of the failures, to distill the experiences into their underlying central causes, and to develop insights to better prevent or avoid future tragedies.

This chapter illustrates important principles of risk management by using an anecdotal approach. History often repeats itself, so the lessons of history are valuable tools for due diligence in the future. Due diligence should be performed before investing in a hedge fund, but due diligence should also be an ongoing process, as investors should be willing to redeem their investments whenever the situation at a hedge fund begins to deteriorate.

While this is not a comprehensive and scientific empirical analysis, a brief discussion of some of the recent disasters can provide insight into what can go wrong. These experiences serve as a good foundation for Chapter 27 on qualitative risk analysis and Chapter 28 on due diligence.

26.1 PROBLEMS DRIVEN BY MARKET LOSSES

This section begins with four examples of the impact of market forces in generating losses. Losses should be expected as a natural consequence of seeking profits with strategies involving risk. However, best practices require that prospective and current investors should be provided with sufficient information to have a reasonable basis on which to understand the total potential risk. One major problem, ...