he dot-com bubble did have a few hiccups along the way. One such hiccup was when Russia defaulted on its debt on 17 August 1998. The price of oil had fallen to $11 per barrel, the lowest in nearly a quarter century.1 Russia, a big producer of oil, could no longer continue to pay interest as well as repay the foreign debt it had raised in dollars.
In fact, Russia even went a step ahead and put a moratorium on its $13.5 billion domestic debt, the money which the Russian government owed to its citizens. This was unheard of. All Latin American governments which had defaulted on their foreign loans in the past had always repaid their domestic debt.2
Before the default, the interest on the Russian debt was at 50 per cent in dollar terms.3 Such a high rate of interest is paid only when the chances of default are very high. But even then, investors were ready to buy this risky debt. Why?
This con dence came from the fact that the IMF always came to the rescue of a defaulting nation. It had come to the rescue of Mexico in 1982 and 1994, the Asian 5 countries in 1997, and several other countries in between. Even if a country defaulted on its debt, there was no real reason to worry. The IMF would come up with some sort of rescue package for the country and the money given as a part of the rescue package would be used by the country to pay off the foreign investors it owed money to.
Investors knew that come what may, the IMF would come to their rescue. This happened primarily because American banks were always a part of such indiscriminate lending and the IMF was essentially an institution dominated and run by the Americans.
The IMF did come to the rescue with a package of $23 billion for Russia as expected.
But any IMF rescue came with its own terms and conditions, which would lead to economic austerity. This was something Russia was not ready to follow. The IMF decided that there was no point in lending money to Russia and Russia defaulted, leading to the bursting of what had been termed as the moral hazard bubble created by the IMF. As Franklin R. Edwards writes in a research paper titled ‘Hedge Funds and the Collapse of Long Term Capital Management’:
To understand the potential force of this moral hazard argument, consider the troubling possibility that the reason why the Russian default led to a worldwide
ight from all emerging markets and risky bonds is that the default may have
punctured a moral hazard bubble. Prior to Russia’s default, international creditors and investors had observed IMF and U.S. assistance to Mexico, [South] Korea, Indonesia, and other troubled countries. They may well have believed that major Western countries and the IMF would not permit a default by a major country like Russia to occur.4
Russia’s default also led to investors trying to exit the stock and bond markets of other emerging market countries all at once. Other than exiting emerging markets, investors also started to exit the stock markets in developed countries. The technology-heavy NASDAQ Composite Index started to fall from 19 August 1998, immediately after the Russian default. And by 8 October 1998, it was down by almost 22 per cent to 1,419.12. During the same period, the Dow, which comprised sturdier stocks than the NASDAQ Composite Index, fell by 11 per cent.
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While a global sell-off did hurt the investors, it caused more pain to some investors than to others. One such investor was Long Term Capital Management (LTCM), a hedge fund which operated from Greenwich in the American state of Connecticut. On 21 August 1998, a few days after Russia had defaulted on its debt, the hedge fund lost $553 million, or nearly 15 per cent of its investment capital in a single day. The mathematical investment models used by LTCM to make investments had predicted that it could not make a loss of more than $35 million in a single day.5 But the models turned out to be flawed.
Legally the term ‘hedge fund’ does not exist, unlike say, a ‘mutual fund’. The term was rst used by the Fortune magazine in a 1966 article to describe an investment fund managed by Alfred Jones, a Columbia University sociologist, diplomat and steamboat purser who had turned into a fund manager.6
In 1952, Jones wanted to launch an investment fund which would not only buy stocks on which he was bullish on, but also short-sell stocks (i.e., borrow and sell) which he felt were overpriced and would fall in price in the days to come. At the same time, he thought that with the expertise he brought to the table, the investors in the fund should be willing to pay him a slice of the profits he made for them.
The prevailing laws in the US would not have allowed him to launch a normal investment fund, so he had to launch a private partnership. Such partnerships had been common since the 1920s. Benjamin Graham, known as the father of the school of value investing and guru of Warren Buffett, probably ran the rst such partnership on Wall Street.7
Unlike Graham who bought what he thought were ‘value stocks’ (i.e., stocks which were underpriced and would go up in price in the days to come), Jones wanted to buy as well as short-sell stocks. The money that he generated from short-selling stocks would partially fund the buying of stocks which he felt were undervalued. This way, he ensured
that the exposure was ‘market neutral’, or, in simpler language, he ‘hedged his bets’. The term hedge fund was derived from the colloquialism ‘to hedge one’s bets’. 8
Let us try and understand this in a little more detail. Say a hedge fund raises $1 million from investors and short-sells shares worth $0.5 million which it thinks are overvalued by borrowing them. It uses the $1.5 million raised to buy shares which it feels are undervalued.
In the ideal scenario, the price of the shares which the hedge fund thinks are undervalued should go up and the price of the shares which the hedge fund thinks are overvalued should fall. Let us say that this is precisely what happens. The total market value of the shares it has bought goes up from $1.5 million to $2 million. These shares are then sold.
The market value of the shares which the hedge fund had short-sold falls from $0.5 million to $0.3 million. Since these shares are borrowed, they need to be bought back and returned. From the $2 million that the fund has got by selling the shares it owned, $0.3 million is used to buy back the shares which were short-sold.
This leaves $1.7 million in the hands of the hedge fund. Of this, $1 million is the investment. A pro t of $0.7 million, or a return of 70 per cent, has been made on an investment of $1 million. A pro t of $0.5 million has been made from the selling of undervalued shares once they had gone up in value. And $0.2 million has been obtained from the short-selling of overvalued shares. These shares had originally been sold for $0.5 million. They were bought back for $0.3 million, leaving a pro t of $0.2 million ($0.5–
$0.3 million) on the table.
But this was the best-case scenario. Consider another scenario in which the price of the undervalued stocks goes up, but at the same time, the price of the overvalued stocks which the hedge fund had thought would fall also goes up. So the value of the $1.5 million worth of stocks that has been bought increases in value to $2 million. These shares are sold and
$2 million is received for the sale. The shares that the hedge fund had short-sold need to be bought back. The price of these shares has gone up from $0.5 million to $0.8 million.
Since these shares were borrowed, they need to be bought back and returned. The hedge fund now uses $0.8 million of the $2 million it had obtained by selling shares to buy back the shares it had short-sold. This leaves the hedge fund with $1.2 million ($2 million–$0.8 million), or with a profit of 20 per cent on the investment of $1 million.
This is one kind of market-neutral or hedged strategy, where one part of the investment is loss-making but another part generates enough money so that the overall investment turns out to be profitable.
In the third situation, the value of the undervalued shares falls from an initial value of
$1.5 million to $1.3 million instead of rising. These shares are sold and $1.3 million is received from the sale. At the same time, the price of the stocks that had been short-sold falls from $0.5 million to $0.25 million. These shares need to be bought back as they were borrowed and need to be returned. An amount of $0.25 million is taken from the $1.3
million generated by selling shares to buy back the borrowed shares. This leaves $1.05 million ($1.30 million–$0.25 million) with the hedge fund, leading to a pro t of 5 per cent on the original investment of $1 million. This is another market-neutral strategy, in which losses from one trade are compensated for from gains from another.
The fourth situation is that which no hedge fund wants in which the price of the undervalued stocks that is supposed to go up, falls instead, and the price of the overvalued stocks, which is supposed to fall, goes up. So the value of the supposedly undervalued stocks falls from $1.5 million to $1.2 million. These stocks are sold and $1.2 million is received against the sale. At the same time, the value of the supposedly overvalued stocks goes up from $0.5 million, the price at which they had been short-sold, to $0.8 million. Of the $1.2 million generated by selling the undervalued stocks, $0.8 million is taken to buy back the stocks that had been short-sold. This leaves the hedge fund with just $0.4 million ($1.2 million–$0.8 million). The hedge fund has lost $0.6 million ($1 million–$0.4 million), or 60 per cent of the investors’ money of $1 million that it started with.
As we can see in this extremely simpli ed example, the hedge fund makes outright money in one situation. In two situations, it is hedged. And in the fourth situation, it loses money. The risk is not entirely eliminated. In the strictest sense of the term, no hedge fund is really totally hedged.
The strategy of Alfred Jones of buying some stocks and selling some others came to be known as the equity long-short strategy. He outperformed mutual funds which could only go long, that is, buy stocks. They could not sell them short because it was deemed to be a risky strategy. Jones also used leverage, that is, borrowed money, to spruce up his returns.
Jones received 20 per cent of the returns he generated for the fund as compensation.9
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The success of Alfred Jones was copied by many others. And by the early 1990s, around a thousand hedge funds were operating in the market.10 Jones, other than taking on 20 per cent of the returns generated by his fund, did not ask for anything else. The expenses that he ran up while running the fund were met out of his 20 per cent cut. Hedge funds that were launched in later years introduced a charge of 2 per cent of the total amount of the investment they were handling as a management fee.
Hedge funds with different investment strategies emerged over the years, but the basic idea of buying an undervalued asset and selling an overvalued one remained the same. In later years, leverage played a large part in sprucing up the returns of hedge funds. Jones’s initial bets were largely made on stocks. Over the years, hedge funds started to bet on different assets, like bonds, currencies and even commodities.
Investing in hedge funds was limited to investors who could invest a substantial amount of money at one go. Hedge funds also came outside the regulatory purview. The logic being that since rich investors were investing, they had a good idea of what to do with
their money.
LTCM was launched in February 1994 and the fund managed to raise $1.25 billion from investors. The goal when it started had been to raise $2.5 billion. Despite collecting half of what it had originally envisaged, LTCM was the largest start-up fund till that time.11
It required a minimum investment of $10 million, which was much more than what other hedge funds required at that point of time. The fund charged a fund management charge of 2 per cent of the total assets and would keep 25 per cent of profits.
Withdrawals were not allowed for three years, unlike other funds, which allowed investors to withdraw money after three months. The fund wanted to buy undervalued nancial securities and sell overvalued nancial securities. These securities could be bonds issued by governments around the world, mortgage-backed securities issued by banks and financial institutions, stocks, commodity futures, options, etc.
LTCM had plans of investing in nancial securities that their mathematical models showed to be undervalued. A nancial security which is undervalued is typically illiquid, i.e., it is neither easy to buy the security nor to sell it. It is dif cult to sell it in bulk at any point of time without driving prices down. With this in mind, the fund had plans of investing in a lot of undervalued securities.
This came with a lock in. Since the money was locked in for three years, the fund would be free from any pressure to sell its investments in order to repay investors who were withdrawing their money. This did away with any possibility of having to sell its investments in a hurry, subsequently driving down their price and losing money.
The company had a star-studded team of investment managers. At the top was the CEO John Meriwether, who had been the head of bond trading at Salomon Brothers, then a top investment bank on Wall Street in which Warren Buffett had a stake. Meriwether had moved along with his team of star traders at Salomon. The team also had on board David Mullins, a former vice chairman of the Federal Reserve. The economists Robert Merton and Myron Scholes, two of three creators of the famous Black–Scholes formula for options pricing, were also on the team.12 They would get a Nobel Prize in economics three years later in 1997.
This was the main reason why the hedge fund managed to attract the kind of money that it did. Of the $1.25 billion raised, nearly $100 million came from the people who ran LTCM. One of the rst investments of the fund was in bonds issued by the US government to finance the budget deficit. These bonds are typically referred to as US treasuries.
The US treasuries at that point of time were considered to be the safest investment in the world (and they still are). A hedge fund could not be making much money by investing in the safest investment in the world. Ultimately, return is also a function of the amount of risk that is taken on.
Around $170 billion worth of thirty-year US treasuries traded every day at that point.
The then latest lot of thirty-year US treasuries were most in demand, whereas the thirty-
year US treasuries issued, say, six months earlier did not have that much demand. The greater demand for the thirty-year US treasury meant that it sold at a price which was greater than its face value, which meant it was overvalued, because at the time of maturity, the government would repay only the face value of the US treasury bond.
The higher price also meant that the overall return on the bond came down because the amount of interest paid by the government remained the same. Let us understand this through an example. Say a bond with face value $100, paying an interest of 7.3 per cent, was issued by the government. Given that it was the latest issue, there was great demand for it and this ensured that the price of the bond soon rose to $100.5. An investor who bought it at $100.5 continued to get paid an interest of 7.3 per cent by the government on a face value of $100. But since he had bought it at a slightly higher price of $100.5, his overall return was a little lower than the interest of 7.3 per cent that he was paid on it.
On the ip side, let us consider a thirty-year bond which was issued six months earlier.
The bond had the same features. It had a face value of $100 and it paid an interest of 7.3 per cent per year. Since the demand for the bond was not that great, it sold at a price of
$99.5, which was lesser than its face value of $100. Any investor who bought this bond would continue to get the same interest of 7.3 per cent. But since he had bought it at a slightly lower price of $99.5, his overall rate of return was a little higher than the 7.3 per cent interest he was being paid.
Both the bonds were basically the same. They repaid the $100 at maturity and at the same time continued to pay the promised interest of 7.3 per cent, or $7.3 every year. If the investor was willing to bet that the American government would repay $100 at the end of 30 years, he might as well have bet that the government would repay the same amount 29.5 years later as well. The risk of investing in either of these bonds was the same.
The difference in price of both these bonds was an aberration and would soon go away.
LTCM shorted the bond (i.e., borrowed and sold) maturing in thirty years and it bought the bond maturing in 29.5 years. The bet was that in some time, the discrepancy in the prices would go away and both the prices would equate to $100. Technically, this situation is referred to as the ‘narrowing of the spreads’. When the spreads narrowed, LTCM would gain both ways, as was the case in the earlier example of the hedge fund. It would gain
$0.5 when the price of the undervalued 29.5-year bond would move to $100 from $99.5 and it would gain $0.5 when the price of the thirty-year bond would fall from $100.5 to
$100. This transaction would have given LTCM a minuscule return. To spruce up returns, LTCM used leverage. As we have seen earlier, borrowing money and investing, if and when it goes right, can generate huge returns.
LTCM planned to spot a lot of these small pro table opportunities through complicated mathematical formulae, hoping to latch on to them and spruce up its returns by using leverage. Scholes explained LTCM’s strategy to his mentor and Nobel Prize winner Merton Miller: ‘Think of us (LTCM) as a gigantic vacuum cleaner sucking up nickels from all over the world.’ 13