LTCM also highlighted the problem of credit risk in the alternative investment market.
Credit risk is the risk that a counterparty is uncreditworthy and may default on paying back borrowed money. LTCM was unable to meet its margin calls and, ultimately defaulted. The flip side of this is that among those that had lent it money or invested in the first place, few, if any seemed to have understood the fund’s risk profile and the potential losses it might incur.
Credit risk is a particular problem for any investor or counterparty in the hedge fund market because the funds are not regulated by an investment authority. This means that the funds are not obliged to report on their financial positions. They may also change their strategy, thus altering their risk/return profile, without necessarily informing their counterparties.
It is because of these risks that most countries have laws in place to restrict who can invest in these types of funds. Investors usually have to qualify to invest under a series of criteria that demonstrate they have sufficient financial sophistication to understand the risks they are taking.
These criteria often include financial thresholds. Or, the investor may have to seek the advice of an advisor as an intermediary to the fund. The fund may also be restricted in the number of investors it may approach. These rules do not usually apply to structured products, which are more typically regulated investment vehicles.
The dramatic events of August 1998 have, however, had a considerable impact on the alternative investment market. With hindsight, managers are now testing their risk analysis far more rigorously—so called stress testing—to check that their investment models will hold up, even in the most extreme circumstances. Managers are also far more transparent in providing details to investors and their counterparties about the risks that they are taking on within their strategy and portfolio.
For the investor, it is also worth remembering that LTCM was only one alternative investment fund among thousands that were operating at the time. Estimates suggest that there are currently between 4000 and 6000 hedge funds in the world managing investment capital of US$400-500 billion.
No two funds are exactly alike, but we can state with some confidence that the amount of leverage used by LTCM was an aberration. Many funds do not use leverage at all. Among those that do, on average, managers use leverage of 1.5 or 2 times capital invested.
Furthermore, many funds held up reasonably well during the difficult market conditions of August 1998. While the S&P500 fell –14.6% during that month, hedge fund returns fell only half that amount on average. In other words, most alternative investment managers achieved their objective of minimising downside risk during a market collapse.
