John Meriwether Channels His Inner P.T. Barnum

(MoneyWatch)  "There's a sucker born every minute" is a phrase credited to P.T. Barnum. John Meriwether seems to agree. Meriwether is opening his third hedge fund after his first two attempts blew up, including one that nearly caused an epic financial disaster.

In 1994, Meriwether launched Long Term Capital Management, which included some of the top trading stars on Wall Street and two Nobel Prize-winning economists. In the summer of 1998, the fund blew up, costing investors about $4 billion. The Federal Reserve had to coordinate a bailout with several investment and commercial banks to stop a potential financial crisis.

Shortly thereafter, Meriwether formed his second hedge fund, JWM Partners, employing the same strategy of relative value trades, which aim to profit by betting on unusual pricing relationships between securities, anticipating a return to their historically "normal" state. Like its predecessor, JWM did well in the early years. However, it experienced large losses in 2008 and saw its capital base shrunk by the losses and redemptions. In July 2009, the fund was shut.

In the spirit of Barnum, Meriwether is back for a third attempt, as JM Advisors Management is set to open in 2010. The fund will use the same strategy of relative value trading. Since these trades work most of the time, a fund employing this strategy can appear to be successful -- as long as the world is "normal." However, once the inevitable crisis arrives, these strategies blow up, the prior gains get wiped out (except the fund manager's fees, of course), and investor capital is "gone with the wind." Let's see how this happens.

Relative value trading depends on exploiting pricing anomalies between two similar securities. Because of the intense competition for profits, pricing errors tend to be small, and the very act of exploiting them makes them disappear quickly. Thus, the strategies require large amounts of leverage to generate sufficient profits to overcome fund costs and fees.

However, leverage magnifies gains and losses. The danger of using leverage is you may have to be right all the time to be successful, not just in the long term. The reason is short-term losses may lead to margin calls having to be met. If a fund cannot meet the margin call, its collateral will be liquidated. So, even if the trade would have worked in the long term, the fund is not around to enjoy the gain.

LTCM used leverage of over 25:1. (A 4 percent move against your position will wipe out your capital.) And JW Partners used leverage of 10:1.

Meriwether's example is just one of the many reasons why I placed hedge funds in the ugly category when I wrote The Only Guide to Alternative Investments You'll Ever Need. It's a nice game if you can keep getting away with it and finding suckers to play along.