Long Term Capital Management and the Hedge Fund Industry

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Introduction
The Hedge fund industry is surrounded by much controversy and debate; and that for many years. Lack of oversight, excessive returns, unclear impact on the market and more, are all subjects of concerns for market participants and the public. According to Priya Jestin on Hedge Fund Street, “on an average day, between 18 and 22 percent of all trading on the New York Stock Exchange is related to hedge funds”. The increasing role that hedge funds are playing in the market is a source of the debate surrounding them, fearing that the” too big to fail” problem arises in the hedge fund industry as well. With low regulatory oversight, the hedge fund industry worries financial professional and small investors who do not know how to accurately assess the risks associated with hedge funds. Indeed, although hedge funds are mainly operating like mutual funds, the managers do not. Low regulation and oversight, even from the Securities and Exchange Commission (SEC) allow them to not make public information on their investment strategies or profits and losses. Another controversy is the market capacity. Alpha has become rarer and that is mainly because of the volumes traded that reduced market irregularity. Hedge funds rely much on volumes to achieve profits and their reduced performance lead the managers to increasingly rely on the remuneration model. Since 1998, systemic risk became a major part of the debate. The Long Term Capital Management (LTCM) disaster showed the huge amount of risk that hedge funds can use to achieve the required return. The latter increases systemic risk and can negatively affect the real economy too. Fortunately, LTCM was bailed out and the series of falling dominos was aborted. Although the bailed out happened, the LTCM episode shook the industry and opened the curtain on some of the problems in the hedge funds industry, demystifying the high return, low risk legend. Clearly, the hedge fund is a complex industry, misunderstood by some, feared or revered by others. This paper will first explain in detail the hedge fund industry and its specificities. Second, it will cover the hedge fund LTCM and how it collapsed. Finally, the major impacts on the hedge fund industry brought by the LTCM disaster will be covered. I. The Hedge Fund Industry

A) Organizational structure and legal environment of a hedge fund A hedge fund is an alternative investment vehicle trading in securities and other financial instruments. For example, a hedge fund can invest in options, convertible debt, exchange traded futures, forwards, swaps, stocks, fixed income securities, foreign currencies and so on. Hedge funds are privately organized and usually administered by professional investment managers. Because of the nature of the investors hedge funds are looking for, and at the same time limited too, they are not open to the public like mutual funds are. Indeed, the “typical” hedge fund investor would be either a wealthy individual or an institutional investor. It is common to find hedge fund managers who would invest a part of their own money; with the purpose of “keeping skin in the game”, to show to their investors that they are doing their job seriously by having a stake in the fund too. Hedge funds are different from other financial organizations. Most hedge funds are organized as Limited Liability Companies (LLC) so that the money invested belongs to the partners of the company. Clearly, as mentioned earlier, the purpose is to limit the nature of the investors to sophisticated ones who will understand the risks associated with investing in such investment vehicles. As a result, unlike mutual funds, hedge funds are allowed to use leverage as they see fit, to use short selling, and to enter positions that would be considered as risky if taken by an institutional fund manager. Another common feature of hedge funds is...
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