John Meriwether announced that he planned to shut down JWM Partners and create his third hedge fund, JM advisors. Why people would invest with him is unfathomable. Clearly if Meriwether blew up twice in the past decade, he is very likely to do it again.
John Meriwether was part of the group of Nobel prize winners that created LTCM. Long Term Capital Management ironically traded short term strategy that scalped the price differences between two similar securities. This process is known as arbitrage.
Arbitrage occurs when prices of two similar securities trade at different prices. To use a simple example, let’s pretend that xyz stock trades in Europe at 10.45 USD and the exact same aecurity trades for 10.47 USD in Hong Kong. Abitrage firms would buy xyz stock in Europe and sell the same xyz stock in Hong Kong. Eventually if the process us is done correctly prices should reach 10.46 USD in both markets assuming normal market conditions.
The strategy while simplistic, works across many different asset classes (stocks, bonds , futures, derivatives). The problem is that the strategic relies on liquidity ( a topic discussed in the last post). We are assuming normal market conditions that might not always be available as we’ve seen in 2008-2009.
Another risk from this strategy is that since arbitage firms essentially scalping small profits here and there, it needs tremendous leverage for the firms to actually make a decent return. Most arbitrage firms will leverage up about 7-8 times their assets under management. LTCM reportedly used up to 25x leverage. JWM Partners reportedly used 10x leverage.
The problem with leverage is that when positions move against you, your prime broker (the financial institution that lent you the capital in the first place) will demand more collateral. If you don’t have any collateral to post, you have to liquidate positions immediately, this is known as puking. Many hedge funds puked starting from 2007-2009, selling securities left and right. Puking causes efficient markets to be inefficient and also shows the dangers of a highly levered strategy. A firm levered 25 times can only withstand a 4% hit against their portfolio before they are wiped out. The less leverage you use, the longer you are able to withstand irrational markets.
John Meriwether lost a tremendous amount of capital for LTCM investors as well as for the investors that invested in JWM partners (44% losses from 2007-2009). This strategy can be best described as picking up pennies in front of a steam roller. It will work most of the time until you get rolled over.
John Meriwether wiki profile:
http://en.m.wikipedia.org/wiki/John_Meriwether?wasRedirected=true
John Meriwether to start JM Advisors
http://www.ft.com/cms/s/0/331bae80-be93-11de-b4ab-00144feab49a.html?nclick_check=1
