Too close to the hedge: the case of long term capital management LP: Part one: hedge fund analytics

In September 1998, the well-known US hedge fund, Long Term Capital Management (LTCM) announced it had lost 44 per cent ($2.1 billion) of its investors' money in August alone, and more than 52 per cent from the beginning of the year. This shock caused the Federal Reserve System to organise a bail-out by banks and investment houses to save the fund from liquidation and to prevent follow-on damage to US financial markets. Part One of this Case Study briefly reviews the loss of value by LTCM and the damage caused to investors and creditors. LTCM is placed in context as the Case looks at the nature of hedge funds in the investment business in general -- their structure, regulatory position, trading strategies and risk/return profiles. Hedge fund investment (sometimes called 'skill-based investment strategies') is examined to see how compatible it is with traditional theoretical models of investment -- notably modern portfolio theory and the capital asset pricing model. As far as hedge funds are concerned, traditional theory is deficient in several respects. Skill-strategy investment managers claim to be able to produce superior absolute returns, in most cases at lower risk, to traditional long-only mutual funds. Hedge funds, although varying widely in their trading styles, are usually characterised by short selling and leverage. LTCM shares these characteristics which provide some of the background against which the imminent collapse of the fund can be assessed.