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Analyst report
When funds fall over
November 28, 2007
Brendon Lau, ShareAnalysis

Investors worldwide are worried that the credit crisis may deepen and cause the collapse of high-profile hedge funds. Even if one such fund were to crumble, history has shown it could shake the foundations of global sharemarkets. So why do such funds fail?

Large hedge fund failures are normally linked to a crisis in liquidity and leverage. While it is quite common for small hedge funds to come and go, the fall of a high-profile fund can trigger a panic run on the entire industry as investors line up to liquidate their holdings.

General Electric (GE) felt a small taste of this when institutional investors withdrew investments from its asset management subsidiary. This subsidiary manages a US$5B short-term bonds fund and houses part of GE's employee pension fund.

Institutional investors are worried that this fund, along with others, could be sitting on mounting losses due to the falling value of asset-backed securities held in its portfolio. Although GE has said that its fund can still operate viably, investors will not be in any rush to return.

The exodus of capital is creating a liquidity issue in financial markets, and all that is missing is a crisis in leverage to spark a more catastrophic fallout. If you are wondering why, you only need to look back a decade to the spectacular collapse of Long Term Capital Management (LTCM).

LTCM was founded by a renowned bond trader, from Solomon Brothers, and had two Nobel Prize winners in economics sitting on its board. LTCM developed a complex model to profit from small price differences between different government bonds, primarily US, Japanese and European treasuries.

The idea was that long-dated bonds issued a short time apart would reach the same value over time, but the rate of convergence would differ depending on how liquid the bond was. The more heavily traded US bond will reach its long-term value more quickly than its less liquid counterpart. Since the differences in value were so small, the fund had to employ highly leveraged derivatives to magnify profits. Just before its collapse, it was estimated that LTCM had about US$125B in debt versus an equity base of US$4.7B.

In the first four years of operation, LTCM made annualised returns of about 40%. Then came the Asian economic crisis in 1997 and the Russian financial crisis in 3Q 1998, when the Russian government defaulted on its bonds. Panicky investors stampeded out of illiquid European and Japanese bonds to US Treasuries, and the profits that LTCM should have made, as the value of these bonds converged, became huge losses. In less than four months, LTCM had almost wiped out its entire equity base.

This development forced the Federal Reserve Bank of New York to orchestrate a bail out for the fund in order to avoid a wider collapse in the financial market. The fear was that a vicious cycle would emerge where LTCM would be forced to sell its securities at any price to cover debt, leading to a drop in prices of these distressed securities and forcing others to follow suit in order to protect their own investments. This vicious cycle shares an eerie similarity to what is happening in our credit markets today.

Another lesson for investors is that a well-diversified portfolio is not immune to a significant repricing of risk. Even if you invest in multiple markets that are generally not correlated to each other, the sudden bout of risk aversion can force almost all markets to march in lockstep and move irrationally. The question for the leverage investor is whether he can stay solvent long enough for rational market behaviour to return.

Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.

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