To: Investors in the Investment Vehicles of Long‐Term Capital Portfolio, LP
From: John W. Meriwether
Subject: Impact on Net Asset Value of August Market Conditions
As you are all too aware, events surrounding the collapse in Russia caused large and dramatically increasing volatility in global markets throughout August, capped by a last‐day decline in the Dow Jones Industrial Average of 5123 points. The resulting dislocations in markets and greatly increased uncertainty have driven investors to safer and more liquid assets. With increases in both risk and liquidity premia‐‐investment funds widely, many Wall
Street firms, and money‐center banks have reported large trading losses with resulting sharp declines in their share prices. Investors everywhere have experienced large declines in their wealth.
Unfortunately, Long‐Term Capital Portfolio ("Fund") has also experienced a sharp decline in net asset value. As you know, our formal procedure for releasing our official net asset value normally takes about ten days after month end. Following our usual practice to give you an early estimate of the Fund's performance, it is down 44 percent for the month of August, and 52 percent for the year to date. Losses of this magnitude are a shock to us as they surely are to you, especially in light of the historical volatility of the Fund. The losses arising from the event‐driven major increase in volatility and the flight to liquidity were magnified by the time of year when markets were seasonally thin.
The losses in August occurred in a wide variety of strategies, distributed approximately 82 percent in relative‐value trades and 18 percent in directional trades. Emerging markets across both trade categories accounted for 16 percent of the month's total losses in the
Fund. Within emerging markes, holdings involving Russia accounted for less than 10 percent of total losses.
A distinguishing characteristic of the Fund's invetment philosophy has always been that its returns are generally expected not to exhibit systematic correlation with the returns on global bond, stock, and currency markets. August saw an accelerating increase in demand for liquidity in nearly every market around the world. Consequently, Government bonds have been the best performers, while small‐cap common stocks and other relatively illiquid and risky instruments such as high‐yield bonds have performed poorly. Many of the Fund's investment strategies involve providing liquidity to the market. Hence, our losses across strategies were correlated after the fact from a sharp increase in the liquidity premium.
The majority of the Fund's risks are in our core investment strategies; that is, convergence, relative‐value, and conditional convergence trades in the U.S., Japan, and in the larger markets of Europe. Although we have hedged risk‐exposure components that were not expected to add incremental value to performance, large divergences in August occurred in many of our key trading strategies that resulted in large losses. The use of leverage has accentuated these losses.
With the large and rapid fall in our capital, steps have been taken to reduce risks now, commensurate with our level of capital. We have raised the risk‐return tradeoff requirements for positions. Risk and position reduction is occurring in some strategies that do not meet the new standard. This is a prudent step given the level of capital and uncertainties in the marketplace.
On the other hand, we see great opportunities in a number of our best strategies and these are being held by the Fund. As it happens, the best strategies are the ones we have worked on over many years. We will focus on these high expected return‐to‐risk positions and, thereby we can manage them more aggressively.
A cornerstone of our investment management philosophy is the availability and efficiency…