For all of you who remember Long Term Capital Management, the huge hedge fund that collapsed in late 1998, it could be interesting to hear that their (original) trading strategy is back on track after more than a decade in the shadows!
Long Term was the financial poster child of the 90s; the fund was managed by the famous Salomon Br. trader John Meriwether, it was co-run by J.M.s old Salomon friends Hilibrand, Haghani and Rosenfeld and, most impressively, had two Nobel laureates as partners, i.e. Merton and Scholes, the options pricing gurus!
Long Term used complex models to make money on government bond prices in major countries converging over time. Of course, the pricing errors in US, Japan and EU government bond markets are typically extremely small so the trades had to be done with a lot of leverage to boost the returns. That was also the way Long Term liked to do it and their debt was often ten or twenty times their equity. Towards the end their leverage ratio was as high as 100! Due to this humongous leverage, the fund returned enormous amounts of money to the investors, and to the partners, and it was not until the Asian crisis in 1997 that the luck turned against them all. With the Russian debt moratorium in 1998 the rumor spread that Long Term had trouble and since they were the biggest player at the time (bigger than Goldman for instance) it meant that the fund behaved like an oil tanker; it needed weeks/months to change direction. Everyone knew that everyone knew (etc.) that long Term was in trouble and that just led traders to start taking opposite trades. To make a long story short; Long Terms risk management mistakes together with an (ir)rational market forced the Fed to orchestrate a takeover of the fund by a consortium of Wall Street banks. Since then, fixed income relative value trading has had a bad name.
Until now, that is! In fact, it is not too surprising that fixed income relative value trading (fixed income arbitrage) is back in vogue considering the market intervention of governments all around the world. It is exactly in times such as these when treasuries and central banks around the world behave irrationally and erratically (if you ask me) that directional trading in government bonds, currencies and “policy” is motivated. As a result, I would assume that even the leverage ratios, i.e. the risk, can be kept low these days. And when it comes to the results, Hedge Fund Research claims that the strategy returned more than 5% over the first six months of 2010 and that is almost four times as high as the average hedge fund. My guess is that the strategy will continue to do well!