Fund crashes after wrong-way volatility trade

The e-mail arrived in clients' inboxes shortly after the market opened on Tuesday: "LJM strategies have suffered significant losses."

LJM Partners, a Chicago-based hedge fund with about half a billion dollars in assets, pinpointed the damage on spiking volatility, a trade that has claimed more than one scalp in the last few trading days. Their mutual fund, known as the LJM Preservation and Growth Fund, collapsed by 82 percent over the last week and was closed to new capital on Wednesday.

Investors in the industry are calling LJM among the most prominent funds to fall victim to the popular "short vol trade." The trade had become profitable for many hedge funds, including LJM, whose "Preservation and Growth" fund posted positive returns every year except one since it launched in 2006, according to fund documents.

But the risk amplified this week after the CBOE Volatility Index, or VIX, more than doubled on Tuesday to the highest levels in six and a half years. The move caused an exchange-traded note called the VelocityShares Daily Inverse VIX, which was betting on continued calmness in the markets, to collapse in after-hours trading on Monday. Subsequently, Credit Suisse, which issued and managed the ETN announced that it would ultimately be liquidated. ProShares Short VIX Short-Term Futures also suffered massive declines after volatility spiked.

"Short volatility strategies, selling options and collecting premium, have been critically described as picking up dimes in front of a steamroller," wrote Don Steinbrugge, the founder and CEO of Agecroft Partners, a hedge-fund consulting firm, in a blog post. "They generate very good risk adjusted returns until volatility spikes and then have the potential to lose most of their assets if not properly hedged."

Tuesday's client note, signed by LJM's Founder and Chairman Tony Caine, said that the portfolio management team has been hedging "with as many futures as possible to attempt to insulate portfolios from further losses." He caveated that their "ability to do so depends on market conditions and liquidity."

"Our goal is to preserve as much capital as possible," he said.

LJM did not respond to multiple requests for comment.

The firm sent a note last Friday, describing the specific aspects of their portfolio that created losses in the month of January — before the market turmoil of this past week. Even still, rumblings in volatility during just the first month of the year caused losses in each of their three strategies.

"A rapidly rising market coupled with volatility at this magnitude is a rare market occurrence and is particularly challenging to the LJM strategy," the firm wrote to clients, according to a letter reviewed by CNBC. "Since the LJM strategies provide exposure to volatility, the strongest headwind came from the sharp rise in volatility and accounted for most of our losses in January."

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