Way of the turtle

When Genius Failed
Long-Term Capital Management (LTCM) used a strategy that
relied on very high leverage and the tendency for the price of fixed-
income bonds to converge in certain circumstances. Its use of very
high leverage caused its positions to become so large relative to the
rest of the market that it was very difficult for LTCM to unload
those positions when it was faced with losses. 
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Way of the Turtle

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That strategy worked well for several years, but when a financial
crisis caused by the Russian default on bonds triggered an adverse
price movement, its size worked against LTCM. This occurred
because the rest of the market knew that it could keep moving prices
against LTCM’s positions and that the firm eventually would have
to reverse those positions. LTCM ended up losing almost the entire
fund, which had been valued at $4.7 billion before the collapse.
Before the crisis, LTCM had averaged almost 40 percent annual
returns that were distributed very smoothly. In other words, before
that point it had an excellent Sharpe ratio. You can read more
about the collapse of Long-Term Capital Management in the book
When Genius Failed by Roger Lowenstein. (I liked the title so much
I was compelled to use it for the heading of this section.)
Not Too Sharp
A similar problem happened recently in natural gas trades at Ama-
ranth, which also built up positions that were very large relative to
the rest of the market. Amaranth ended up losing about 65 percent
of its $9 billion fund in just two months. Before that it had an excel-
lent Sharpe ratio.
A Brewing Storm?
Currently, there are many hedge funds that achieve returns by sell-
ing out of the money options, meaning that they are betting against
significant price movement. This can be a very effective strategy that
offers particularly smooth returns if the risks are managed properly.
The problem with this approach is that it is difficult for non-
professionals to understand the actual risks incurred by the funds.
It is possible to generate very high and consistent returns by using
By What Measure?
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this strategy while having a very high exposure to any sort of price
shock. For example, anyone writing options against the eurodollar
in 1987 might have been wiped out. The loss from that price shock
combined with the exposure incurred by writing the options could
have been enough to result in a single-day loss greater than the
value of the fund.
Prudent managers can contain these risks. Unfortunately, many
investors find out about these sorts of risks only after it is too late
and they have lost their entire investment. They are seduced by the
steady returns and multiyear track records of funds that have not
yet experienced a truly bad day.