Sunday, March 15, 2009

Madoff vs. LTCM

I've been trying to articulate this for a few days now...

There's this hedge returned too-good-to-be-true, above-the-market returns that were rock solid, never a blip.  Then one day people invested got a call: there's nothing left, the fund is wiped out, your money is gone.  If an investor got out of the fund early enough, they made a killing.  The ones who stayed in got nothing.

Am I referring to Bernie Madoff's ponzi-scheme of a hedge fund?  No -- I am thinking of Long Term Capital Management.

Madoff "blew up" his customers by paying old customers' pretend returns via new customers' pretend interest.

LTCM lost all their money by borrowing a ton of money and investing in international debt - the 1998 debt crisis caused bonds to do things their computers said was impossible, and they lost all their principle.

Here's what's bugging me: if you invested in either fund, the results are the same.  What Madoff done is clearly criminal; what LTCM did was pretty stupid (in hindsight) but completely legal. In both cases, people had to beg to get into the fund, everything was very secretive, and the methods were "too complex" for normal investors to understand.

Perhaps there is something fundamentally fishy about hedge funds if their normal investment behavior can look exactly like the results of a huge fraud.

Minor historical note: the principle managers of LTCM actually forced redemptions on some of their  customers.  The fund grew to a point where they had too much capital*.  The managers wanted to keep their own personal wealth in the fund, and as a result, they did their client what was in hindsight a favor and got their client's money out, while leaving their personal fortunes in the fund to get squashed.

* LTCM used leverage, that is, borrowing money cheaply, to amplify the effective return on investment.  Since there is a finite amount of money they could put into any given trade, they had to make sure their capital base was small enough that they could do the trade mostly with borrowed money, making the effective return on investment appear high.  Of course, it was that huge amount of leverage that caused them to go completely broke when the market went sour.

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