Long Term Capital Management and the Hedge Fund Industry
| Long Term Capital Management and the Hedge Fund industry| | | | | | Introduction The Hedge fund industry is surrounded by much controversy and debate; and that for many years. Lack of oversight, excessive returns, unclear impact on the market and more, are all subjects of concerns for market participants and the public. According to Priya Jestin on Hedge Fund Street, “on an average day, between 18 and 22 percent of all trading on the New York Stock Exchange is related to hedge funds”.
The increasing role that hedge funds are playing in the market is a source of the debate surrounding them, fearing that the” too big to fail” problem arises in the hedge fund industry as well. With low regulatory oversight, the hedge fund industry worries financial professional and small investors who do not know how to accurately assess the risks associated with hedge funds. Indeed, although hedge funds are mainly operating like mutual funds, the managers do not. Low regulation and oversight, even from the Securities and Exchange Commission (SEC) allow them to not make public information on their investment strategies or profits and losses.
Another controversy is the market capacity. Alpha has become rarer and that is mainly because of the volumes traded that reduced market irregularity. Hedge funds rely much on volumes to achieve profits and their reduced performance lead the managers to increasingly rely on the remuneration model. Since 1998, systemic risk became a major part of the debate. The Long Term Capital Management (LTCM) disaster showed the huge amount of risk that hedge funds can use to achieve the required return. The latter increases systemic risk and can negatively affect the real economy too.
Fortunately, LTCM was bailed out and the series of falling dominos was aborted. Although the bailed out happened, the LTCM episode shook the industry and opened the curtain on some of the problems in the hedge funds industry, demystifying the high return, low risk legend. Clearly, the hedge fund is a complex industry, misunderstood by some, feared or revered by others. This paper will first explain in detail the hedge fund industry and its specificities. Second, it will cover the hedge fund LTCM and how it collapsed.
Finally, the major impacts on the hedge fund industry brought by the LTCM disaster will be covered. I. The Hedge Fund Industry A) Organizational structure and legal environment of a hedge fund A hedge fund is an alternative investment vehicle trading in securities and other financial instruments. For example, a hedge fund can invest in options, convertible debt, exchange traded futures, forwards, swaps, stocks, fixed income securities, foreign currencies and so on. Hedge funds are privately organized and usually administered by professional investment managers.
Because of the nature of the investors hedge funds are looking for, and at the same time limited too, they are not open to the public like mutual funds are. Indeed, the “typical” hedge fund investor would be either a wealthy individual or an institutional investor. It is common to find hedge fund managers who would invest a part of their own money; with the purpose of “keeping skin in the game”, to show to their investors that they are doing their job seriously by having a stake in the fund too. Hedge funds are different from other financial organizations.
Most hedge funds are organized as Limited Liability Companies (LLC) so that the money invested belongs to the partners of the company. Clearly, as mentioned earlier, the purpose is to limit the nature of the investors to sophisticated ones who will understand the risks associated with investing in such investment vehicles. As a result, unlike mutual funds, hedge funds are allowed to use leverage as they see fit, to use short selling, and to enter positions that would be considered as risky if taken by an institutional fund manager.
Another common feature of hedge funds is their redemption policy. Indeed, investors have some restriction to follow when it comes to withdrawing their funds from a hedge fund. Usually, redemptions are quarterly or even yearly with a notice period. In doing this, hedge fund managers can vary their strategies by investing in illiquid assets since they can hold onto their investors’ money for a longer and predictable period. Last but not least, the fee structure of hedge funds is quite unique. The fees are much higher than regular institutional fund managers.
The administrative fee usually range from 1 % to 2% of the assets under management (AUM) and the incentive fee, the large one, ranges from 15% to 20% of net new profits. The latter fee is subject to a condition. The “high watermark” provision requires a hedge fund managers to make up for incurred losses, if any, before receiving any incentives; which would happen only after the returns are back to the previous levels. B) Trading practices Nowadays, hedge funds have developed the trading practices to a level never imagined before.
Indeed, in order to keep investors interested in using the alternative investment world as a better strategy to achieve profits, hedge fund managers keep finding new innovative ways to achieve alpha. Investment strategies and styles are very diverse and adapted to the different risk profiles of investors; some of which are quantitative while others are more qualitative in their approach. For instance, global macroeconomic funds take positions based on their forecasts of global macroeconomic events while event-driven funds do based on time specific events such as bankruptcies or mergers.
Hedge funds are also diverse in the type of financial instruments they use. They used a wide array of instruments to hedge their portfolios or to exploit market inefficiencies. They are very active in their use of derivatives and, unlike mutual funds, have the right, and largely use it, to enter short positions. Despite their difference in investment styles and strategies, hedge funds do have common features. They are similar in their use of mark-to-market discipline, leverage, and active trading. a) Mark-to-market
Even if hedge funds are subject to less regulatory requirements, they are still counterparties to others. As such, hedge funds need to periodically value their positions at current market prices. They have to do so because of internal risk management and also for counterparties’ valuation of trading risks and collateral. This practice is useful in avoiding the cover-up of losses and encouraging problems’ resolution. Furthermore, mark-to-market is used for managing margin’s variation to decrease credit risk which can lead to liquidity restrictions or even dry up.
The latter can be, as proven later, a severe event for a highly leveraged firm, especially in extreme price volatility environment. b) Leverage Leverage is one of the most common and used tool in the hedge fund world. It allows the funds to magnify their returns by extending their positions and hence their risks. In accounting terms, leverage can be defined as being the ratio of assets to net worth. But it can also be explained in terms of risk as being a measure of risk relative to capital.
The choice of investment is highly influenced by the leverage’s availability; and it the alternative investment world, the higher the leverage is, the higher the risk and return are. As mentioned, hedge funds are not subject to the same regulatory requirements as other regular trading institutions. Consequently, hedge funds are not required to respect regulatory capital requirements that would constrain their leverage level. The only limits they have are the willingness of their counterparties and creditors in providing leverage.
In addition, they have various ways of obtaining leverage; through the use of repurchase agreements, short positions, and derivative contracts. As mentioned earlier, the use of leverage can be dangerous for hedge funds. Indeed, even if other institutions such as trading desks of banks might use similar investment strategies; they or their parent company have the liquidity safety net needed to survive through a liquidity shock. The latter not being the case for hedge funds that use excessive leverage with no capital requirement that would decrease the riskiness of their positions.
For instance, according to September 1998 CPO filings, “at least ten hedge funds with capital exceeding $100 million leveraged their capital more than ten times. At the extreme, the most leveraged hedge funds in this group levered their capital more than thirty times”. c) Active trading The very nature of hedge funds and their activities make them trade in high volumes with a high frequency; that is active trading. It is done this way to insure a desired risk and return ratio as the market prices change.
C) Growth of the industry The hedge fund industry has known a tremendous growth attributable to its attractive performance and also to the demographics of the potential investors. According to the Journal of Economic Perspectives, 80 percent of hedge funds investors are high net worth individuals and their numbers have grown, and still growing, rapidly. Those sophisticated investors expect not only double digit returns but also a low correlation with the market. There are possible explanations for hedge funds high returns.
Hedge funds managers possess better skills in stock picking, and they are better motivated by the incentive fee they get after making profits. Also, they take advantage of the price inefficiencies, especially in foreign markets. Markets in those countries are in a primary state, so price inefficiencies are captured by those skilled hedge funds managers. Finally, with high returns come high risks; hence explaining the unusually high incentive fees that hedge fund managers get. This risk consideration becomes greatly relevant when considering a common measure for risk called the “Jensen alpha”.
It is the amount by which the average return on the asset exceeds what would be predicted by the capital asset pricing model. According to Edward and Liew (1999), 40 percent of hedge fund had positive alphas. In sum, hedge funds have become an attractive investment approach for many investors. Unfortunately, the year 1998 was a wakeup call for those who thought that high return with low risk was now possible. Long Term Capital Management (LTCM), a giant hedge fund, in size and reputation in the industry, collapsed. But who was LTCM? And what did really happen? II.
Long Term Capital Management A) Background LTCM, formed in February 1994, started with an initial capital stake of $1. 3 billion. Although LTCM was a Delaware limited partnership, the fund it was operating (Long-Term Capital portfolio, L. P) was a Cayman Island Partnership. LTCM’s principals were individual with a solid reputation in the financial industry and especially in economic theory. Thanks to that and to its large capital stake, LTCM had a considerable position in the hedge fund world. It had net of fees returns of 40 percent in 1995-1996 and around 20 percent in 1997.
By late 1997, LTCM’s principals decided to return $2. 7 billion to their investors, claiming that the investment opportunities were scarce. The hedge fund was following a market neutral strategy. It was holding long positions in undervalued bonds and short positions in overvalued positions. LTCM’s bread and butter business was based under the assumption that the yield spread between high and low risk bonds was going to narrow. Nevertheless, the Fund was active in many other markets, such as OTC derivatives or Exchange Traded Futures (ETFs).
According to the Report of The President’s Working Group on Financial Markets: The LTCM Fund took part in diverse fixed income markets, such as corporate bonds and emerging bond markets. Also, it held long and short positions in these markets, and maintained those positions with repurchase agreements (repo) and reverse repo and securities lending agreements with a large number of counterparties. Among other positions, the LTCM fund invested heavily in futures on multiple international exchanges; two areas were targeted: interest rate futures and equity index futures.
OTC derivatives transactions were also conducted and included swap, forward, and option contracts, and were predominantly focused on interest rates and equity markets. In addition, LTCM participated in the foreign exchange markets to support its trading activities in other national markets. Even though the hedge fund held open foreign exchange positions, it was not engaged in those markets to profit from foreign exchange variations. B) What happened? In following its strategies in diverse manners, like replicating them with derivatives contract, LTCM used an increasing amount of leverage.
Indeed, in 1998, with $5 billion in equity and $125 billion borrowed, the leverage ratio of the hedge fund was 20 to 1, unusually high even by the standards of the hedge fund industry. By 1998, the Asian collapse became more serious and many banks started unloading their illiquid positions by fear of what would happen in the markets. At that time, LTCM’s derivatives positions amounted to $1 trillion. With the leverage ratio used, either LTCM wins the lottery or it loses everything. In August 1998, Russia defaulted on its sovereign bonds. The markets got scared and there was a flight to quality.
Consequently, yield spreads rose by 17. 05 percentage points above Treasury rates. This matter of fact was the exact opposite of LTCM’s bet. The hedge fund lost $4 billion and its equity dropped to $600 million. With a liquidity crisis on hand and margin calls to make, LTCM was going to be forced to put assets on a fire sale which directly could lead to a fatal decrease of securities prices in the whole market. This situation could have been a disaster because of the high systemic risk associated to it. The Federal Reserve (Fed) was contacted by LTCM in early September 1998.
The Fed arranged meetings with executives from the top investment banks to arrange the purchase by those banks of 90% of equity stake in LTCM. III. The hedge fund industry after LTCM The hedge fund industry was shaken by the LTCM collapse. Policy issues were raised after 1998. Did the LTCM collapse point out the industry’s weaknesses? Was it a proof of need for more regulation? A) Government regulation in market discipline of risk taking In a market based economy, government oversight and regulation is maintained to a minimum and risk taking is left to the markets counterparties.
Indeed, creditors are in fact responsible for assessing through due diligence the creditworthiness of its counterparties and allow them to take on more risk through amplified leverage. Any financial counterparty, such as a hedge fund, will think twice about increasing leverage if the cost of fund rises. As such, the constraint on leverage imposed by creditors through credit terms can be a powerful weapon in mitigating risk by reducing leverage. In trading relationships, due diligence of creditors is essential. Unfortunately, in the LTCM case, none of its creditors played its role well.
Truly, such market discipline, controlled by creditors, has to be based on some kind of incentive; but when high profits are mirrored, creditors turn a blind eye. When such incentives do not exist, or if hedge funds are able to obtain financing from unsophisticated investors, accurate risk exposure to any counterparty is not well assessed and the effects on the economy can be disastrous. Hence, it is advised that market discipline of risk taking and government regulation should be tightly related. In other words, it becomes necessary to have, as the economist Keynes said, an “invisible hand”.
Government regulation becomes necessary if market failures leading to impacts on the real economy are foreseen. Nonetheless, in a market based economy like the U. S. ’s, regulation should be clear to avoid any loopholes, which are always taken advantage off. B) Correlation of the economy relative to the financial markets In 1998, Alan Greenspan testified before Congress arguing that the LTCM bailout helped avoiding a “systemic meltdown in the global financial system”. The Federal Reserve believed that financial markets were in a weak tate and that any shock would end up in a disaster; hence inaction was not an option. The Russia default was a trigger and the investor community inexplicably asked for high premia for all emerging markets related securities, even if they were not related to Russia, even by far. The involvement of LTCM and hedge funds as a whole in derivatives contracts is a major concern. Indeed, there are clauses in those contracts allowing one party to terminate the contract and liquidate the position in case the other party is defaulting.
This matter of fact is problematic when dealing with an off balance sheet and none regulated market. The counterparty risk is unclear, and in the event that the previously mentioned clause is used, a series of dominos can start to fall and affect diverse banks, creditors, financial institutions, and lead to a full scale blow to the markets. In this case, clearly a bailout was a timely and needed solution. The problem with that is that the issue of moral hazard is raised. Is it an extension of the safety net offered by the Fed to certain banks? How is the financial market going to react?
Is everyone going to think that a bailout will occur anyways and start taking unconsidered risks? The answer is probably not. The lender-of-last-resort imposes high cost of borrowing on banks that have taken uncalculated risks and that creates incentives for banks to try to make markets less fragile through better due diligence and risk assessment of counterparties. Unfortunately, with LTCM’s success and unexpected high returns, banks started copying the hedge fund’s strategy which created an unprecedented correlation of the banking industry with the hedge industry and global markets.
Clearly, oversight should be put on those practices that increase systemic risk. IV. Conclusion The hedge fund industry is indeed a controverted and subject to much debate industry. Whether it is about more disclosure, regulation, reducing leverage or indignation about hedge fund managers’ fees; the industry is surrounded by much “heat”. The public debate should actually be directed toward more pressing concerns such as how to avoid in the future systemic risk, exposing the entire economy.
The LTCM disaster exposed how financial markets were tied to the economy and how much banks are tightly entangled with the health of the big hedge funds. Risk management was weak and the financial system underestimated the usefulness of that discipline, putting at risk global financial markets. Much has been proposed as reforms and solutions to the problems exposed by the LTCM collapse. Some asked for the release of useful and reliable information on hedge funds including disclosure of financial institutions of their exposure to highly leveraged companies.
Also, even though not mandatory, capital requirement levels should be encouraged in an effort to avoid a catastrophe. Nowadays, with hindsight, after the financial crisis of 2008, the hedge fund industry has tried to regulate itself by being more careful in the investment strategies used and the leverage level tolerated. But because of the relative size of that industry and the sophistication of the investors nothing has really changed in terms of regulating the hedge fund industry. References Barboza, David and Jeff (1998) “On Regulating Derivatives” New-York Times December 15, p.
C1 The President’s Working Group on Financial Markets, (April 1999), “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management” Edwards, Franklin R. , (Spring 1999) “Hedge funds and the Collapse of Long Term Capital Management”, Journal of Economic Perspectives Born B. , Interview with FRONTLINE, (August 2009) “Where’s The Heat On Hedge Funds” (June 2006 ) http://www. businessweek. com/magazine/content/06_25/b3989062. htm Needham, A. W. and Brause C. , “Tax Management Portfolio”, Hedge Funds, No. 73