Will the Third Time Be a Charm for Meriwether?

When I read the news (or more a rumor at that time) last Wednesday (3/19) from Bloomberg, I could smell something coming. These days in the financial market, unfortunately many rumors have turn out eventually to be true  So I waited and believed that there would be more news on this, and there it was. On last week's WSJ C-1 page, there was news about John Meriwether is scrambling again. His Relative Value Opportunity Fund is down 28% this year, more than 24% as rumored by the Bloomberg.

I first heard about John in mid 1990s from the popular book Liar's Poker, where the then Chairman and CEO of Solomon Brothers, John Gutfreund, famously wanted to bet $1M with Mr. Meriwether (who was the Vice Chairman) in a single hand of the liar's poker game, which Mr. Meriwether declined. There were not many details about Mr. Meriwether's group, even for people inside Solomon, since he maintained a very tight grip on leaking out any "secrets". His group was very isolated, operated on their own and no one knew what they were working on, like the top inner small circle inside the CIA.

In the book My Life as a Quant: Reflections on Physics and Finance by Emanuel Derman there was a short chapter about his interview with John's group, an interesting read. Emanuel was regarded as one of the best quants at that time on Wall St., but still got turned down by this group. You can see how isolated, closed and arrogant this group was. If they had hired Emanuel, LTCM crisis might not even have happened, since Emanuel is not only the best on math models, he also has a deep understanding of human behavior.

After the famous Solomon Brothers debacle, Meriwether and his lieutenants left Solomon and formed the again famous LTCM, including two Nobel Laureates. You know what happened afterwards in 1998. I think LTCM gives traders many lessons (all of them are actually more common sense than anything else): first of all, leveraging $5B into $1,000B is dangerous, obviously; secondly, mean-reversion on spread will happen only after it sucks everyone into Hell first, to make sure no one will be alive to see it happen; third, emerging market bonds are worth nothing if their currencies are worthless and most of this risk can't be hedged or diversified away in the currency market.

But the most important lesson I think few discussed is: math models, no matter how complicated they are, will never be able to predict human behavior. That was the 2nd debacle. Then John and his lieutenants launched JWM Partners in 1999. This time, they promised to be conservative, with leverage of no more than 15:1. But it seems this time, he invested in the wrong products, thus mortgage securities,  and even they are backed by Fannie Mae and Freddie Mac. His fund had never been at the frontline (until now), probably due to his low profile, also probably due to its mediocre  performance.

The WSJ article published their bond fund return since 2000, comparing it to Lehman Brothers Aggregate bond Index. Basically if you include this year, the annualized return of 7% since 2000 is almost the same as LEH Index of 6.5%. This is very interesting. Even he is not using 15:1 leverage but say only 5:1 leverage, it is hard to imagine the return is almost the same as LEH index which has no leverage at all. Where is the leverage effect, either up or down?

Even if we remove this year, his fund is down 28% while LEH index is up so far, his fund is only marginally beating the LEH index with some years better and some years worse, and the majority of the return was only in one year, 2003. In other words, if you join after 2003 and withdraw last year, you might as well invest in LEH index bond fund instead, which has no risk of leveraging at all and costs very littlle. Same story if you invested in 2000 and have held until today.

The risk of many hedge funds involves too many funds investing in the same products. If Carlyle Capital has to liquidate due to tighter lending requirements and  is putting up more collateral requested from major banks, every other fund has to liquidate at the same time at fire sale prices for their survival. A bond fund losing 28% is a much bigger problem than equity fund, since the upside return is usually capped too. Also due to the current credit crisis with everyone deleveraging, it is much harder to make up the 28% loss and to get back above water with a much lower leverage ratio in the coming years than previous years. Hedge fund investors realize that too, so it usually creates a downward spiral, and redemption pressure from some investors forces more other investors to withdraw. I hope his hedge fund can survive the withdrawal this time.