When Was Hedge Fund Born?
Reported on Business Times Mar 2005, the first hedge fund was started in1949 by this man call Alfred Jones. Jones was able to identify undervalue and overvalue stocks and his strategy was to buy the undervalued stocks and short the overvalued one. Over time, he will make money. So Jones has “hedged” his portfolio and the term hedge fund was born.
But personally, I don’t understand that article. In what way can “buy the undervalued stocks and short the overvalued stocks” produced a hedge effect? If Jones bought put option on his stock I would agree. But buying overvalue stocks? Different stocks? Regardless of correlation between these stocks? All I can say this, that when stock market enters into a period of correction or collapsed totally, undervalued and overvalued stocks suffer the same fate. Anyway, the word hedge has different meaning in (corporate) finance term.
The Collapse of Major Hedge Funds
Lately I was reading an article from Moody’s – “large hedge fund may collapse”. The article points out that current credit crunch in global market may cause major hedge funds to collapse thus disrupt market stability. In the article, it mentioned “Long Term Capital Management, a hedge fund that borrowed heavily and had to be bailed out by Wall Street banks after collapsing in 1998”. This again brings back memory of a friend who attended options training for a few thousand bucks. But the study materials contain pictures of bankrupted hedge fund managers. But yet the training was to impact skills in options trading. So is the trading activity more profitable or the training?
So out of curiosity and interest, I started to do some search on hedge funds, particularly on those with big size and had collapsed. Naturally I started with Long Term Capital Management. Through Yahoo search, the information available is an endless list. I really want to thank the creator of Internet. He made the world into a global village and information readily available. I remember during college days when many of my friends had encyclopedia at home. And there were salesmen going door-to-door selling their encyclopedia. I was poor then so the only way to have assess to encyclopedia is to go to the national library. Today, nobody go door-by-door selling encyclopedia; nobody buy encyclopedia.
So from Wikipedia (see, don’t need to buy encyclopedia any more) and through yahoo search, I found lots of information on Long Term Capital Management. And then I remember of a bankrupted fund known as Tiger Fund. I continue searching and I also found information on Basis Hedge Fund. In summary about these three funds:
1) Tiger Fund (CNN, Mar 2000). Julian Robertson (once regarded as one of Wall Street's highest rollers) liquidated all six of his Tiger Management funds in 2000. This marks the downfall of a veteran hedge fund manager, whose fund bets on value stocks but was backfired as investors turned to technology stocks - the dot.com era. Tiger Fund's success over the years was based on the “buy the best stocks, short the worst” strategy. In a letter to investors, Robertson wrote. "In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much". The Tiger Fund suffered sharp losses for more than a year, tumbling 7.8% in February and 13.8% as of 29 Feb. The fund's assets plunged from roughly $20 billion in 1998 to about $6.5 billion.
2) Long Term Capital Management (LTCM). LTCM was a hedge fund founded in 1994 by John Meriwether (former vice-chairman and head of bond trading at Salomon Brothers). On its board of directors were Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics. Similarly, the fund was very successful initially. With complex mathematical models, the fund makes good money from the fixed income arbitrage deals. By 1998 LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options. In order to generate significant profit, the fund borrowed to speculate. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. Its off-balance sheet derivative positions amounts to $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.
In May and June 98, net returns from the fund fell 6.42% and 10.14% respectively, reducing LTCM's capital by $461 million. In Jul 98, Salomon Brothers pulled out from the arbitrage business. Such losses were accentuated through the Russian Financial Crises in Aug and Sept 98, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to earn as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August the fund had lost $1.85 billion in capital.
3) Basis Hedge Fund. In Aug 2007, Basis Yield Alpha, a hedge fund backed by Australian funds management firm Basis Capital, filed for bankruptcy protection. The Basis Yield Alpha fund began to lose value as investments it made in subprime mortgage-backed securities in the U.S. began to falter in June. Worried investors avoid buying mortgages on the secondary market. With almost no market for the loans, their value has fallen precipitously. The drop in value led to margin calls, which Basis Yield Alpha was unable to meet. That led investors to issue default notices, which would have given them the right to seize the fund's assets. Besides Basis Yield, Bear Stearns Cos. Also shut down two hedge funds in July after announcing they were essentially worthless because of bad bets on subprime mortgage-backed securities.
The Lesson
Out of the three hedge funds listed above, the first two were huge in size. I am able to sum up the three stories into a few points:
- Hedge funds are managed by best of the best.
- Hedge funds can make huge returns double that of
Warren Buffett's.
- Aggressively they speculate and have complex system or “proven betting system”.
- There may be incidence that comes along the way; so sudden, so unexpected and may strike down funds within very short time. It is like a time-bomb. When it exploded, it will be very damaging.
- When the fund suffers huge losses, it doesn’t have the chance to recover. The fund manager usually pull the plug.
- A zero sum game. Yes, God has never drop a single cent into this game. If someone made the money, then someone else has to pay for it.
There are tens of millions of genius out there. Since it is a zero sum game, everyone is trying his best to make money out of someone else’s pocket. You can do it by depending on sheer luck, or by developing a sophisticated system to trade. But human brain is complex, unpredictable and ever changing. So even the best mathematical system can fail too as in the case of LTCM. And in the case of Tiger Fund, the fund bought undervalued stocks and short on overvalued one. Without the shorting part, the fund would have grown in size today. Warrant Buffett and many other value investors equally turned a blind eye to the dot.com; he is still one of the top ten richest men today.
So really there is never quick and easy money. As the saying goes, high risk high gain, low risk low gain. But if an insurance agent came to you with this statement, you give him/her 50 cents to buy a “kite”. Because if that’s the kind service he/she can offer (high risk high gain, low risk low gain), why pay him/her? I mean what value has the agent (or a fund manager) added? But for value investment, we are low risk high gain. Every value investors will tell you that they have zero tolerance for losses. Hedge fund is really for people who can throw away a few hundred thousands or a million and yet feel no pain. If you want to sleep peacefully, knowing that the assets you invested in will always be there regardless of the business cycle; and you don’t like to receive a sudden call in the morning telling you that you have just in a huge loss position; and you don’t want to be worried about the index in the midst of a meeting with your CEO; invest base on fundamental.
Before I end, the article on Basis Hedge Fund actually warned of the collapse of more hedge funds due to subprime woes. This may destabilize the global market. And this has been my primary worry since the market wipe off my entire portfolio’s unrealized gain in Jul 07 – will the housing slump and loan problems in US become a catalyst to send US into a recession? Is the subprime problem over yet?
Reported on Business Times Mar 2005, the first hedge fund was started in1949 by this man call Alfred Jones. Jones was able to identify undervalue and overvalue stocks and his strategy was to buy the undervalued stocks and short the overvalued one. Over time, he will make money. So Jones has “hedged” his portfolio and the term hedge fund was born.
But personally, I don’t understand that article. In what way can “buy the undervalued stocks and short the overvalued stocks” produced a hedge effect? If Jones bought put option on his stock I would agree. But buying overvalue stocks? Different stocks? Regardless of correlation between these stocks? All I can say this, that when stock market enters into a period of correction or collapsed totally, undervalued and overvalued stocks suffer the same fate. Anyway, the word hedge has different meaning in (corporate) finance term.
The Collapse of Major Hedge Funds
Lately I was reading an article from Moody’s – “large hedge fund may collapse”. The article points out that current credit crunch in global market may cause major hedge funds to collapse thus disrupt market stability. In the article, it mentioned “Long Term Capital Management, a hedge fund that borrowed heavily and had to be bailed out by Wall Street banks after collapsing in 1998”. This again brings back memory of a friend who attended options training for a few thousand bucks. But the study materials contain pictures of bankrupted hedge fund managers. But yet the training was to impact skills in options trading. So is the trading activity more profitable or the training?
So out of curiosity and interest, I started to do some search on hedge funds, particularly on those with big size and had collapsed. Naturally I started with Long Term Capital Management. Through Yahoo search, the information available is an endless list. I really want to thank the creator of Internet. He made the world into a global village and information readily available. I remember during college days when many of my friends had encyclopedia at home. And there were salesmen going door-to-door selling their encyclopedia. I was poor then so the only way to have assess to encyclopedia is to go to the national library. Today, nobody go door-by-door selling encyclopedia; nobody buy encyclopedia.
So from Wikipedia (see, don’t need to buy encyclopedia any more) and through yahoo search, I found lots of information on Long Term Capital Management. And then I remember of a bankrupted fund known as Tiger Fund. I continue searching and I also found information on Basis Hedge Fund. In summary about these three funds:
1) Tiger Fund (CNN, Mar 2000). Julian Robertson (once regarded as one of Wall Street's highest rollers) liquidated all six of his Tiger Management funds in 2000. This marks the downfall of a veteran hedge fund manager, whose fund bets on value stocks but was backfired as investors turned to technology stocks - the dot.com era. Tiger Fund's success over the years was based on the “buy the best stocks, short the worst” strategy. In a letter to investors, Robertson wrote. "In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much". The Tiger Fund suffered sharp losses for more than a year, tumbling 7.8% in February and 13.8% as of 29 Feb. The fund's assets plunged from roughly $20 billion in 1998 to about $6.5 billion.
2) Long Term Capital Management (LTCM). LTCM was a hedge fund founded in 1994 by John Meriwether (former vice-chairman and head of bond trading at Salomon Brothers). On its board of directors were Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics. Similarly, the fund was very successful initially. With complex mathematical models, the fund makes good money from the fixed income arbitrage deals. By 1998 LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options. In order to generate significant profit, the fund borrowed to speculate. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. Its off-balance sheet derivative positions amounts to $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.
In May and June 98, net returns from the fund fell 6.42% and 10.14% respectively, reducing LTCM's capital by $461 million. In Jul 98, Salomon Brothers pulled out from the arbitrage business. Such losses were accentuated through the Russian Financial Crises in Aug and Sept 98, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to earn as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August the fund had lost $1.85 billion in capital.
3) Basis Hedge Fund. In Aug 2007, Basis Yield Alpha, a hedge fund backed by Australian funds management firm Basis Capital, filed for bankruptcy protection. The Basis Yield Alpha fund began to lose value as investments it made in subprime mortgage-backed securities in the U.S. began to falter in June. Worried investors avoid buying mortgages on the secondary market. With almost no market for the loans, their value has fallen precipitously. The drop in value led to margin calls, which Basis Yield Alpha was unable to meet. That led investors to issue default notices, which would have given them the right to seize the fund's assets. Besides Basis Yield, Bear Stearns Cos. Also shut down two hedge funds in July after announcing they were essentially worthless because of bad bets on subprime mortgage-backed securities.
The Lesson
Out of the three hedge funds listed above, the first two were huge in size. I am able to sum up the three stories into a few points:
- Hedge funds are managed by best of the best.
- Hedge funds can make huge returns double that of
Warren Buffett's.- Aggressively they speculate and have complex system or “proven betting system”.
- There may be incidence that comes along the way; so sudden, so unexpected and may strike down funds within very short time. It is like a time-bomb. When it exploded, it will be very damaging.
- When the fund suffers huge losses, it doesn’t have the chance to recover. The fund manager usually pull the plug.
- A zero sum game. Yes, God has never drop a single cent into this game. If someone made the money, then someone else has to pay for it.
There are tens of millions of genius out there. Since it is a zero sum game, everyone is trying his best to make money out of someone else’s pocket. You can do it by depending on sheer luck, or by developing a sophisticated system to trade. But human brain is complex, unpredictable and ever changing. So even the best mathematical system can fail too as in the case of LTCM. And in the case of Tiger Fund, the fund bought undervalued stocks and short on overvalued one. Without the shorting part, the fund would have grown in size today. Warrant Buffett and many other value investors equally turned a blind eye to the dot.com; he is still one of the top ten richest men today.
So really there is never quick and easy money. As the saying goes, high risk high gain, low risk low gain. But if an insurance agent came to you with this statement, you give him/her 50 cents to buy a “kite”. Because if that’s the kind service he/she can offer (high risk high gain, low risk low gain), why pay him/her? I mean what value has the agent (or a fund manager) added? But for value investment, we are low risk high gain. Every value investors will tell you that they have zero tolerance for losses. Hedge fund is really for people who can throw away a few hundred thousands or a million and yet feel no pain. If you want to sleep peacefully, knowing that the assets you invested in will always be there regardless of the business cycle; and you don’t like to receive a sudden call in the morning telling you that you have just in a huge loss position; and you don’t want to be worried about the index in the midst of a meeting with your CEO; invest base on fundamental.
Before I end, the article on Basis Hedge Fund actually warned of the collapse of more hedge funds due to subprime woes. This may destabilize the global market. And this has been my primary worry since the market wipe off my entire portfolio’s unrealized gain in Jul 07 – will the housing slump and loan problems in US become a catalyst to send US into a recession? Is the subprime problem over yet?
