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and co-head of LTCM’s London office, had borrowed $14.6 million to increase his stake in the fund.4 In 1993, Salomon denied rumors that Hans’s compensation was as high as $28 million. Perhaps it was only $20 million. Hufschmid decamped for LTCM, because he thought it was a better opportunity.5 John Meriwether was a managing partner (formerly head of Salomon Brother’s arbitrage group) and a University of Chicago MBA. LTCM’s staff included Myron Scholes and Robert Merton, co-winners of the 1998 Nobel Prize in Economics, pioneers of equity option model pricing. David Mullins, a former Federal Reserve Bank vice-chairman, was also a partner. LTCM opened for business at the end of February 1994. In the late 1990s, LTCM was the largest hedge fund in the world, until it lost around $2 billion on its highly leveraged investments.

According to When Genius Failed, Roger Lowenstein’s book on the Long-Term Capital Management failure, if you invested $1 at the end of February 1994 when LTCM opened for business, it would have been worth $4.11 in April 1998 and only 33¢ by the time of the September 1998 bailout. But that was before fees. After fees that dollar would have been worth only $2.85 at its heyday value at the end of April 1998 and it would have been worth only 23¢ at the time of the bailout.6

Meanwhile, a dollar invested in Berkshire Hathaway at the end of February 1994 would have been worth $4.44 in April 1998, and while much of the market suffered, it still would have been worth $3.95 at the time of the LTCM bailout. Berkshire Hathaway handily beat LTCM’s peak performance, as shown in Table 4.1.

Berkshire Hathaway beat Long-Term Management Capital’s best after-fee performance by a very wide margin, and maintained strong value while LTCM stock plummeted.

Table 4.1 Value of a One-Dollar Investment

Source: Roger Lowenstein, When Genius Failed (New York: HarperCollins, 2002), Pp. 224,225.,Tavakoli Structured Finance, and Yahoo! Finance.

Soon after LTCM’s bailout, John Meriwether started Greenwich-based JWM Partners LLC. Its $1 billion fixed income hedge fund reportedly lost 24 percent in first quarter 2008.7

Berkshire Hathaway continues to exhibit the characteristics most of us look for in a life partner: maximum upside for its size with minimum volatility.

Warren’s mentor, Benjamin Graham, said that speculators should do so with their eyes wide open. When you speculate, you will probably end up losing money. If you want to try it anyway, limit the amount you risk, and separate speculative enterprises from your investment program. Hedge funds, no matter how safe they are made to sound, engage in speculation.

Some hedge funds call themselves “arbitrage” funds, or “quant” funds that perform well in either up or down markets. In reality they are merely hedge funds, and they have risk. If a trade is an arbitrage, you can go long (buy) and short (sell) the identical security in the same time frame and lock in a risk-free return after paying trading commissions. A genuine arbitrage is a money pump. It guarantees a positive payoff with no possibility of a negative payoff and with no net investment. If a hedged trade makes money, then after the fact, it may be tempting to call it an “arbitrage.” To make money, however, historical relationships between your long and short position must remain aligned or must work in your favor. It is much better practice to call a hedge by its real name so that everyone understands you are making a bet, even if it is an educated bet. Many hedge funds that drain investors’ money faster than a blood spurting artery drains your body, proudly—and inaccurately—call themselves arbitrage funds.

A quantitative hedge fund, or a “quant” fund, uses models to perform statistical analyses of historical data.They leverage up market bets when they think something is out of whack with history. They hope observed “anomalies” will revert back to historical levels. The future will not necessarily resemble the past. They know this, but they seem to be so in love with their own math that they brush away any