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Victor Niederhoffer—1997.

On October 27, 1997, Niederhoffer, a contrarian trader, was highly leveraged while trading S&P 500 options. He received a $50 million margin call on a large short position on S&P index futures puts from his clearing broker, Refco, when the Dow Jones Industrial Average fell 554 points on October 27. He was forced to liquidate after the market plummet.

A volatile trader, he had been down 51 percent in August, up 28 percent in September, and then out of business by the end of October. Investors in the fund had limited liability.

David Askin—1994

David Askin's Granite Funds collapsed in 1994. He traded $600 million in mortgage-backed securities. In February 1994, the Federal Reserve increased interest rates for the first time in five years. When interest rates increased, mortgage prepayments fell. This caused the value of Askin's bonds to fall. Askin used his own estimates to value the portfolio in February, indicating a 1.7 percent loss. This was later revised to a loss of 28 percent. The funds filed for bankruptcy, and Kidder Peabody and Lehman Brothers filed lawsuits. Other civil suits occurred as well.

LESSONS FOR INVESTORS

Despite these problems, investors find that the rewards outweigh the risks in hedge funds—if the managers are selected carefully.

These problems have made investors more aware of what can go wrong and have led to better due diligence efforts. This is all very good for the hedge fund industry.

Investors make a better effort to understand the strategies, to determine whether managers are trading the styles they say they are or drifting into other areas that are not their expertise. This occurred with the Russian problem in 1998. Investors found out that many managers had Russian positions even though the funds were not ostensibly emerging market funds.

Investors now try harder to determine whether managers are truly hedging or just saying so. If long-only, protection will not be provided