Evaluating Hedge Fund Performance

CHAPTER 9

Buyers Beware

Evaluating and Managing the Many Facets of the Risks of Hedge Funds

Long-Term Capital Management (LTCM) has been etched into the collective memory of investors and the history of Wall Street as the ultimate folly of hedge funds. Formed in 1993 by the former star trader John Meriwether of the now-defunct Salomon Brothers, and populated by celebrity Harvard professors and Nobel Prize winners, it made a big splash by raising $1.25 billion at the start, only to require a multibillion-dollar bailout organized by the Federal Reserve following its near collapse in September 1998. Postmortem analyses abound as to what and whom to blame for the disaster.¹ Yet it is an irony that the types of strategies that led to the LTCM disaster are now being employed every day at hedge funds, often successfully and profitably for their clients. LTCM itself has been reincarnated to become JWM Capital Management with close to $1 billion of assets under management.

LTCM engaged in a variety of fixed income arbitrage trades. Among the basic ones employed by the firm were going long off-the-run Treasuries and going short on-the-run Treasury bonds. Because the former have higher yields due to their relative lack of liquidity, the trade yielded a small price advantage of a few hundredths of 1 percent. In order to generate returns in the low teens, say 10 to 12 percent, leverages of 20 or 30 times and higher had to be used.

Two things went wrong. First, as success piled up, the firm ...