The Rise and Fall of LTCM - Essay Example

Company Analysis The Rise and fall of LTCM Hedge fund and mutual funds The hedge funds and Mutual funds are managed by the portfolio, whereby a group of managers selects securities that are expected to perform well, and they are gathered, in a single portfolio, and portions of the funds are sold to investors. In fact, the main advantage of mutual and hedge funds to the investors relates to acquiring instant professional management and diversification of their money. Therefore, the paper will discuss issues related to rise and fall of Long Terms Capital management (LTCM), identify whether there are certain investors to whom hedge funds might be suitable and identify whether there are other resent mutual funds where investors have suffered. On the other hand, there are differences between hedge and mutual funds, whereby the hedge funds are managed more aggressively compared to the mutual funds, hence making it possible to take speculative positions in derivative securities like decisions to short sell stock. Moreover, this increases leverage and risk of the funds hence are making it possible for the funds to gain profits when the market is declining. On the other hand, mutual funds are not allowed to be involved in highly leveraged positions; hence, they are considered safer than the hedge funds. Main sources of LTCM initial success The main sources of success for LTCM were associated with a complex mathematical model that the company had established in order to benefit from fixed income arbitrage deals within the bonds of U.S.A, Japanese and European governments (Dunbar, 5). They applied the fundamental idea of the changes in the values of the long dated bonds issued a short time apart, which becomes similar. Nevertheless, the bonds were approached at a different rate, and they were more traded bonds like the US Treasury bonds, whereby the long-term prices are approached more effectively, though they are less heavily traded and liquid. The other main of success factor was the financial transactions, which related to purchasing cheaper bonds, short selling them more expensive and liquid, hence generating profit from the difference in the value of the bonds. In fact, their capital grew, and they were willing to invest the capital somewhere; hence, they run out of outstanding bond-arbitrage bets leading to LTCM to apply strategies that were beyond their expertise (MacKenzie, 349). Nonetheless, their trading strategies were nonmarket directional, whereby they did not depend on the overall market interest rates or fluctuations of stock prices, since they had no convergence trades. Main reasons for LTCM collapse The success of the LTCM in the financial markets occurred within a short period, and this was attributed to informational asymmetries by the fund managers, hence resulting to a downfall before the establishment of the East Asian financial crisis, in 1997. The downfall began with a reduction noted on the net returns in 1998 for the period between May that had 65% and June, 10.4%, resulting to a reduction of their capital by $461 million, in fact, when the Salomon Brothers withdrew from the arbitrage business in July 1998, the downfall was escalated. The losses were accentuated by crisis experienced in Russia during the month of August and September in 1998, when the bonds were defaulted in Russia by their government, leading to investors’ decision to sell European and Japanese bonds in order to purchase the treasury bonds in U.S.A due to their worries. Profits anticipated as the value of the bonds purchased in U.S.A resulted to losses due to convergence of bonds while their value diverged; consequently, the LTCM had incurred losses worth 1.85 billion dollars by the end of August. LTCM could no longer provide investors with annual returns of 40%; instead they were they went through a Flight–to-Liquidity, and in the beginning of September, their equity reduced from 2.3 billion dollars to 600 million dollars with no dwindling portfolio, and this resulted to a further increase in leverage (Lowenstein, 6). The other reason that contributed to their downfall was due to the rejection of the offer made by Goldman Sachs, AIG and Berkshire Hathaway, whereby they were willing to buy out fund’s partners for 250 million dollars, and invest four billion dollars for them to operate within their own trading. This rejection was preceded by a bailout of 3.625 billion dollars by key creditors, which was planned by Federal Reserve Bank of New York for the avoidance of a bigger subsides in financial market, and it was finally liquidated at insignificant profit to bailers after an audit by Price Waterhouse LLP. Investors to who hedge funds might be suitable There are investors who are suited by hedge funds, and this establishes the difference between investors of mutual funds and those who invest in hedge funds. In this case, the hedge funds are available to a certain group of highly experienced investors, who have high net worth. These investors are referred to as "accredited investors,” by the U.S government, and the process of becoming such an investor is highly restrictive and lengthy, however, the mutual funds are remarkably easy to purchase since they require minimal of money. Recent abuse cases in other mutual funds Resent case of abuse related to mutual funds in the industry has been attributed to the adaptability of segmenting customers by through the levels of experience in investment. In this case, the mutual funds companies are taking advantages of the customers’ ability through charging a higher expense to customers with less knowledge in investing. These companies tend to attract the investors with higher levels of experience by offering them a lower expense. An exemplary example is the resent annual expense ratio of load equity funds, which was 50 basis points that was not higher than any load equity funds. There is significant evidence related to cost disparity among the existing equity, bond and index fund, since the load funds investors are more subjected to pay higher expenses, through the returns are lower. Therefore, I strongly support efforts to prohibit operations of the hedge funds, since they have not shown any benefit to the investors. Works Cited Dunbar, Nicholas. Inventing Money: The story of Long-Term Capital Management and the legends behind it. New York, NY: John Wiley & Sons. 2001 Lowenstein, Roger. When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York, NY: Random House, 2000 MacKenzie, Donald. "Long-Term Capital Management and the sociology of arbitrage". Economy and Society. Volume 32 Number 3 August 2003: 349–380 Available at: http://bscw.cs.ncl.ac.uk/pub/bscw.cgi/d61379/MacKenzie,%20D.%20Long-Term%20capital%20management%20and%20the%20sociology%20of%20arbitrage.pdf [Accessed on October 13 2012] Read More