(HBS Case No. 9-200-007)
Long-Term Capital Management, LP. (A)
According to the book, “Financial Markets and Institutions” by Anthony Saunders, hedge funds are financial intermediaries that pool the financial resources of individuals and companies and invest those resources in (diversified portfolios of assets. In other words, they are a type of investment pool that solicit funds from (wealthy) individuals and other investors (e.g., commercial banks) and invest these funds on their behalf.
They are also similar to mutual funds in that they are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis. However, hedge funds are not required to register with the SEC.
Hedge funds are also not subject to the numerous regulations that apply to mutual funds for the protection of individuals, suck as regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations limiting the use of leverage (Saunders, p. 490).
Further, hedge funds do not have to disclose their activities to third parties. Thus, they offer a high degree of privacy for their investors. Hedge funds offered in the U.S avoid regulations by limiting the number of investors to less than 100 individuals (below that required for SEC registration), who must be deemed “accredited investors.” To be accredited, an investor must have a net worth of over $1 million or have an annual income of at least $200,000 ($300,000) if married). These stiff financial requirements allow hedge funds to avoid regulation under the theory that individuals with such wealth should be able to evaluate the risk and return on their investment. According to the SEC, these types of investors should be expected to make more informed decisions and take on higher levels of risk (Saunders, p. 512).
According to the website, www.investopedia.com, these types of funds use different types of strategies to benefit their investors in many different ways. For example, “short selling” which involves selling securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. Also, “arbitrage strategy” which attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. May also use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage (www.investopedia.com). Thus, hedge funds do carter to investors looking to offset any long or short positions they may have. For example, LTCM engaged primarily in the convergence and relative value strategies. Both types of strategy involved taking long and offsetting short positions in instruments that were close substitutes. It is important to mention that hedge funds grew in popularity in the 90’s as investors saw returns of over 40 percent after management fees (often more than 25 percent of the fund’s profits). They came to the forefront of the news in the late 90’s when one of the large hedge fund, Long-Term Capital Management (LTCM), nearly collapsed. The nearly collapse of the LTCM not only hurt its investors, but arguably came close to damaging the world’s financial system. So great was the potential impact...