Fund of Funds Investing: A Roadmap to Portfolio Diversification

Chapter 7. Understanding Risk and the Need for Due Diligence

The term systemic risk is generally used to describe a series of interactions between financial institutions and the capital markets, and the risk of the failure of one market participant among other financial institutions. The demise of Long-Term Capital Management (LTCM) in 1998 in the aftermath of the Russian default of debt has come to be recognized as the first large-scale event that created major market dislocations as a direct result of systemic risks.

LTCM ISSUES

While many books have been written about "genius" failing, LTCM, started in 1994 and led by Salomon Brothers alumni, achieved unprecedented 40 percent plus returns for investors after fees. LTCM's managers simply thought they could master the investment universe. With a team of academics, traders, and former Federal Reserve officials, John Meriwether and his team used leverage to increase LTCM's asset base from $1.25 billion under management to more than $100 billion of investments in the markets. After thousands of arbitrage trades across the global markets and among various investment classes were made, the bottom fell out for the firm in the summer of 1998. The investment managers had significant exposure to many different markets. They were investing in developed markets and emerging markets, along with fixed-income and equity markets, and they used many varied and complex investment models. Coupled with the leverage, this was a recipe for disaster. ...