Thursday, April 24, 2008

When Hedge Funds Blow - A Historical Survey

The biggest single impediment I see for investors contemplating an investment into hedge funds is “blow up” risk. How can they not, with all the hype? The media enjoy little more than the self-immolation of a hedge fund - Rich Guys Get Theirs! Blow-ups score a 10 on the CNBC schadenfreude scale. (Note: for institutional investors, blow up risk translates more specifically into “headline risk,” which is basically the risk of losing one’s job if a hedge fund you invested in ends up in the papers for the wrong reason.)

How common are hedge fund blow-ups? How often do they happen? What do they do to returns? These are questions I wanted to get to the bottom of.

Fishing around, I found surprisingly little research on the subject, so I thought it might be useful to conduct a survey of our own. Specifically, we will look at hedge fund blow-ups through the years to see what kind of conclusions we can draw. For the sake of argument, we will call anything greater than a 50% loss a blow-up.

Hedge Fund Blow-Ups – A Brief Historical Survey


Askin Capital Management
David Askin, a star mortgage trader of the day, can lay claim to being the father of the modern hedge fund blow up. Interestingly, the industry had gone from its inception in 1948 to 1994 without a notable hair ball. (Of course, the industry was tiny back then.) Askin ran a mortgage fund that specialized in some of the complex mortgage instruments that had recently come into existence. If this doesn’t sound familiar, perhaps you’ve just returned from a long vacation. The Fed raised rates unexpectedly, crushing the risky “principal only” tranches in which Askin had loaded up, with leverage.
Losses: $600 million
Cause of death: Excessive leverage, concentration


Niederhoffer Investments
Famed investor, author, squash champion and philodox Victor Niederhoffer gets squashed himself by a leveraged bet on Thai stocks.
Losses: $130 million
Cause of Death: Concentration, excessive leverage


Long Term Capital Management
The ne plus ultra of hedge fund blow-ups. John Merriwether’s LTCM cratered when third world credit problems led to a sudden repricing of risk. Their book, seemingly diversified, was basically long risk and short safety. 40-1 leverage (accounts vary) led to margin calls they couldn’t meet and, subsequently, a Fed-engineered bailout by Wall Street. “When Genius Failed,” an account of the collapse, is recommended reading.
Losses: $4.6 billion
Cause of death: Excessive leverage


Manhattan Fund
Run by Michael Berger, a native Austrian, this fund shorted technology stocks from 1996-1999. Oops, a tad little early on that trade. Losses prompted Berger to falsify his track record, which caught up with him by 2000. Arrested, he skipped bail and remained on the lam until he was caught last year in Austria.
Losses: $400 million
Cause of Death: Fraud

Laser Advisors

Run by former Goldman partner Michael Smirlock, Laser concealed a series of bad bets on options by falsifying position prices on exotic securities. Smirlock spent three years in the Big House and now does charity work.
Losses: $70 million
Cause of Death: Fraud

Ashbury Capital Partners

This one, at $8 million, is a rounding error but it’s too funny to leave out. Manager Mark Yagalla told investors he had averaged 80% in his personal account for nine years. He was 23 years old. Hmm. He blew most of the money on his girlfriend, a Playboy centerfold by the name of Sandy Bentley. Among other thing he bought her furs and, yes, a Bentley, which she promptly sold for cash. Yagalla bought himself a helicopter. When his assets were seized the centerfold dumped him, news of which was promptly reported to Ripley’s Believe it or Not.
Losses: $8 million
Cause of Death: Fraud

Marque Partners

Rob Littel, a pal of JFK junior’s, had a magic black box that promised to churn out 20% returns regardless of market direction, only he wouldn’t explain it to anyone. Which makes sense, since all his box did, apparently, was eat money. Shortly thereafter he started lying about returns. Pleading poverty, he paid a paltry a paltry fine to the SEC. Immediately after this, he signed a book deal for a nice advance to write about JFK’s secrets, a book called “The Men We Became.” From ripping off investors to selling out a dead friend, Littel is currently not considered a candidate for the Integrity Hall of Fame.
Losses: $120 million
Cause of Death: Fraud


Integral Investment Management
The Chicago Art Institute suffered most of the loss here when this relatively unknown fund turned out to be a low-level scam. The term “headline risk” became widely used after this case, as the Institute had egg all over its face. The fund-of-funds industry, with its implicit protection from embarrassment, took off in the aftermath.
Losses: $70 million
Cause of Death: Fraud

Lancer Group
Lead manager Michael Lauer manipulated the prices of penny stocks to inflate investment performance. Morgan Stanley got taken in by this one, as did former Sotheby’s Chairman Al Taubman.
Losses: $200 million
Cause of Death: Fraud


Lipper Convertible Fund
Ken Lipper was a former Deputy Mayor of New York City. He was a former Salomon Brothers partner and Columbia professor. He even wrote the book “Wall Street” that later became the Oliver Stone movie. (Greed is good!) None of this meant, apparently, that he wasn’t a scam artist. His fund got killed in the convertibles market so he started falsifying returns. Julia Roberts got taken in by this one which, I know, is hard to believe.
Losses: $350 million
Cause of Death: Fraud

Beacon Hill Asset Management
These guys got tripped up by the mortgage market (I sense a developing theme…) and started falsifying returns. Does that ever work out? Just curious. Lots of institutional names got caught up in this one, and it ranks as the biggest fraud to date.
Losses: $800 million
Cause of Death: Fraud

Eifuku Master Fund
This was a Japanese fund, the name of which, if only slightly mispronounced, must have phonetically captured the sentiments of its founders. (Do not try to figure this out in front of your children, at least not out loud).
Losses: $300 million
Cause of Death: Concentration, excessive leverage


Sterling Watters
Angelo Haligiannis, a college drop-out from Queens, raised $27 million, mostly from friends and family, by lying about his returns. Haligiannis skipped on his bail and was arrested two years later in Greece.
Losses: $27 million
Cause of Death: Fraud


Portus Group
Set up as a Canadian hedge fund for the little guy, Portus accepted investments for as little as $5000. Money allegedly used to buy stocks was diverted to pay expenses.
Losses: $150 million
Cause of Death: Fraud

Bayou Group
Your basic Ponzi scheme with returns fabricated to cover losses. Only these guys took it a step further: they actually started their own accounting firm – complete with the waspy, fiduciary-sounding name of “Richmond Fairfield” – to sign off on fraudulent audits. Founder Sam Israel was just sentenced to 20 years.
Losses: $450 million
Cause of Death: Fraud

Wood River
How’s this for a hedge fund strategy: put 80% of your money in one high tech stock. That’s exactly what Wood River did, investing in a stock called Endwave, which promptly fell from $54 to $10 a share. One problem was that the fund’s marketing materials spoke much about benefits of diversification. Another was that Wood River never bothered to tell the SEC they owned 45% of Endwave.
Losses: $200 million
Cause of Death: Concentration, fraud

KL Group
This one was fraud from the outset. Perhaps recognizing their own limitations, they never even tried to make money. The proprietors, three Koreans, skimmed $150 million from the Palm Beach society crowd, all the while claiming 125% returns (note to future scammers: don’t overreach, 25% is far more credible, and the Ponzi scheme will last longer). Money was used to live large, however briefly.
Losses: $130 million
Cause of Death: Fraud


Matador Fund
Famed investor, squash player…wait, this guy again? Victor Niederhoffer becomes the first hedge fund operator to blow up twice.

Blow-up Artist Niederhoffer

Losses: $190 million Cause of Death: Excessive leverage

MotherRock L.P.
Big bet on natural gas futures goes the wrong way.
Losses: $230 million
Cause of Death: Concentration, excessive leverage

Amaranth Advisors
A sophisticated, $9 billion hedge fund in Greenwich gives most of their capital to a 29 year-old energy trader in Canada, who then makes a gigantic spread bet on natural gas futures with 8-1 leverage. Ka-Boom.
Losses: $6.4 billion
Cause of Death Concentration, excessive leverage


Caught off guard by a sudden widening in credit spreads (see Long Term Capital), Sowood announced a 57% loss. Founded by ex-Harvard endowment wiz Jeff Larson, the fund counted Harvard as one of their core investors. Harvard took a $350 million hit, which amounted to a 1% hit to their endowment.
Losses: $1.5 billion
Cause of Death: Excessive leverage

Bear Stearns High Grade Structured Credit Strategies Fund
This mouthful of a fund was the canary in the coal mine of the credit crisis last February. A big bet on subprime mortgages goes horribly wrong.
Losses: $1.6 billion
Cause of Death Concentration, excessive leverage


Carlyle Capital Group
This $230 million fund was founded in 2006 by the eminence grises of the private equity arena, the Carlyle Group. The purpose was to buy mortgages using tons of leverage. Oops.
Losses: $220 million
Cause of Death: Excessive leverage

You should be seeing a theme here: hedge fund blow-ups are almost always caused by fraud or excessive leverage (concentration is also listed, but almost all these examples would have survived with less leverage). Also notice that of the non-frauds, every blow-up was in a fixed income related fund, especially in the mortgage area.

A critical point here, though, is that the money lost in the non-fraud cases was not actually lost by the industry as a whole. Invariably, these losses were in instruments like futures (from whence the leverage), where every loser has a winner on the other side of the trade. So Amaranth’s pain was someone else’s gain, and that someone else was more than likely another hedge fund. When Bear’s hedge fund was blowing up because of sub-prime, John Paulson’s fund was on its way to the biggest payday in hedge fund history for exactly the same reason. So you see, most blow-up risk is really fund-specific. It is not an industry risk.
Ergo, blow-up risk is really only about fraud.

Hunt Taylor was a well-respected hedge industry veteran, known as a real free thinker. I was fortunate enough to have met him casually before his tragic death in a motorcycle crash last year. Hunt was perhaps the first person to put fraud blow-ups in context. Specifically, he added up all the blow-ups to assess the overall impact on the industry. I have taken the liberty to add to his work here:

Source: Hennessee Group

No doubt I missed a few small ones, but they won’t add up to much. The big point here is that fraud-related blow-ups have been 0.039% annual drag on industry performance since 1994. That’s 4 basis points. If you add up all the losses it comes to $2.9 billion. That’s a big number, right? No, it’s not. A couple of weeks ago, GE dropped 14% in one day. Know how much investors lost? $47 billion!

This is worth restating: all the hedge fund fraud losses since the dawn of the industry add up to about 1/20th of what GE cost investors in a single day. And yet institutional investors galore own GE but won’t touch hedge funds because they are terrified of fraud, which they call “headline risk.”