3 of the Biggest Hedge Fund Failures in History

Date: Wednesday, June 11, 2014
Author: Dan Ritter, Wall St. Cheat Sheet

Rule No. 1 of investing, as Berkshire Hathaway Chairman and CEO Warren Buffett famously put it, is to never lose money; rule No.2 is never forget rule No. 1.

As intuitive as this rule is, it’s not actually straightforward in practice. The market moves in mysterious ways, and almost without exception investment involves the risk of partial or total loss. Equity investors are perhaps the most exposed, but as the financial crisis reminded us, even high-quality debt investments can go bad. Add to this human error and bad judgement, and you have an investment environment where losses are not just common but are expected to occur for almost everyone, at least some of the time. This is particularly true in the risk-on world of equity investing.

While savvy investors have always aimed to maximize returns while minimizing risk, it wasn’t until 1949 that the idea of a hedge fund really emerged. Alfred Jones, a doctor of sociology, cooked up the idea as a member of the Fortune editorial team. Raising some funds and putting up a lot of his own money, Jones experimented with a strategy of hedging long positions in equity with short positions, giving birth to the now classic long-short equity model. By combining this model with leverage — the use of borrowed capital to increase potential ROI — Jones was able to deliver outsize returns with minimal risk. Taken at its purest, a hedge fund promises to deliver a target return no matter what the market does.

Today, the term “hedge fund” conjures up a large number of images, some of which are contradictory and all of which are vague. As initially conceived, hedge funds were relatively small investment pools with an eye toward mitigating risk. However, come 2006, the Congressional Research Service was describing hedge funds as “private, high-risk, unregulated investment pools for wealthy individuals and institutions.”

The reason is this: There is no common definition of what a hedge fund is. Hedge funds are unregulated, and little was known about them until a provision of the Dodd-Frank Act gave the U.S. Securities and Exchange Commission the authority to collect data from registered investment advisers. The first report by the SEC of this type was published in July 2013.  The provision was established in light of the 2008 financial crisis, which drove many hedge funds into the ground and saw the bailout of many more.

Here are some of the biggest failures in hedge funds in history, all of which helped bring the funds into focus for both regulators and the public.

1. Long-Term Capital Management

At the time the Congressional Research Service was writing in 2006, it estimated that about 8,000 hedge funds were responsible for up to 30 percent of trading volume in U.S. stocks, and higher volumes in more esoteric markets such as convertible bonds and derivatives. Collectively, the funds managed more than $1 trillion in assets,  a sum that has since climbed to about $2 trillion. “Their trades can move markets,” the CRS said.

The message behind the report was clear: Hedge funds are systemically important and deserve the attention of regulators. Outside of the financial crisis, the best — and really, the first –example of this is Long-Term Capital Management (LTCM).

LTCM was founded in 1994 by John Meriwether, who previously headed fixed income arbitrage at Salomon Brothers. Meriwether surrounded himself with some of Wall Street’s best investors and even two Nobel laureates — Myron S. Scholes and Robert C. Merton, who shared the prize in 1997 “for a new method to determine the value of derivatives” — and enjoyed several years of enormous success. However, following back-to-back financial crises in Asia in 1997 and Russia in 1998, the fund ended up losing $4.6 billion in less than four months. The primary catalyst for the failure was Russia’s default and a model that advised the fund to hold its position even as losses mounted.

Traditionally, U.S. financial regulators dispassionately observe the collapse of a hedge fund and simply let the market take its course. “In the LTCM case, however, the Fed concluded that default might have repercussions beyond the losses that would accrue to the hedge fund’s principals and investors,” wrote the CRS. “From the Fed’s perspective, a default might have jeopardized the solvency of LTCM’s creditors, which included several of the world’s largest financial institutions, and its numerous derivatives counterparties. Moreover, if LTCM had been forced to liquidate its positions quickly, prices of bonds and other instruments might have been severely depressed, and other holders would have suffered unexpected losses, even though they had no dealings whatsoever with LTCM.”

The Fed, in this case, was the Federal Reserve Bank of New York, which extended a $3 billion emergency loan to the hedge fund. The fund liquidated in early 2000.

2. Tiger Management

There’s some truth to the saying “the larger they are, the harder they fall.”

In 1997, there were few bigger hedge funds than Tiger Management, an operation run by legendary stock picker Julian Robertson. Robertson founded the fund in in 1980 with $8 million and grew it to $10.5 billion by 1997, making it the second-largest hedge fund in the world at the time. One year later, assets under management reached $22 billion — and then everything started falling apart.

A series of bad bets destroyed Tiger’s returns, and investors began to flee. As the tech bubble began to inflate in the late 1990s and early 2000s, Robertson was unable to keep up with the frenetic returns of the market. Robertson addressed the issue in a 2000 letter to investors. Per CNN Money, he wrote:

“As you have heard me say on many occasions, the key to Tiger’s success over the years has been a steady commitment to buying the best stocks and shorting the worst. 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 current technology, Internet and telecom craze, fueled by the performance desires of investors, money managers and even financial buyers, is unwittingly creating a Ponzi pyramid destined for collapse. The tragedy is, however, that the only way to generate short-term performance in the current environment is to buy these stocks. That makes the process self-perpetuating until the pyramid eventually collapses under its own excess.”

Robertson’s refusal to participate in the madness may be admirable, but it spelled doom for Tiger Management.

3. Atticus Global

By most accounts, Atticus Global was a good fund that simply got whooped by the 2008 financial crisis. The hedge fund was founded by Tim Barakett in 1995 with less than $6 million in hand and by 2007 was one of the largest hedge funds in the world with $20 billion of assets under management. Barakett managed to pull that rare and neat trick of providing market-beating returns over a long time period until 2008, when the financial crisis swept his feet out from under him. After two years of losses, Barakett closed the fund in 2009.

Atticus Global’s track record, from a returns perspective, is still impressive. From its inception to its closing, the fund reported a compounded annual return of 19.3 percent compared to just 3.9 percent for the S&P 500. Few money managers did better over that period.

Barakett was an activist investor, meaning that at any given point in time he was likely focused on just a few big positions. Activist investors like Barakett — and more recently and notoriously, Carl Icahn — take large positions in a company and use that influence to push changes in management style or even within the leadership itself.