How to Lose $215 Million

In Part 6 of our continuing series, In Need of Adult Supervision: Ohio Edition, we examine the hedge fund strategy that lost $215 million last year:

In September, 2003, guessing like many others on Wall Street at the time that interest rates were about to rise, the managers of the $22 billion state fund began taking "short positions" on long-term U.S. treasury bonds.
The state, acting through Pittsburgh-based MDL Capital Management, an outside investment adviser, began selling the bonds on the belief that it would be able to repurchase them at a steep discount later as bond prices fell.

There are two reasons why such a hedge is inappropriate for many investors. First, this kind of a hedge requires detailed monitoring of the risks on a daily basis. An investor that doesn't have the ability to understand the workings of the hedge should stay away. There are far less hazardous ways to moderate investment rate risk. In other words, don't try this at home.
The second reason is that Wall Street's conventional wisdom has a short memory:

Had markets behaved as normal, the gains from the hedge fund, dubbed the Active Duration Fund, would have helped offset losses in the state's traditional bond fund, which bought and held bonds, and once was worth $355 million.
Instead, the value of those types of bond funds rose. But because many of those bonds were sold off in the state's hedging strategy, the benefit was diminished.

The problem is Wall Street defines normal market behavior as what happened in the last business cycle. Any event beyond that is characterized as the proverbial hundred-year storm, which is another way of saying, "We didn't think it could happen based on our lack of long-term memory."
Standard financial theories are seriously flawed in underestimating financial risk. The wizards at Long-Term Capital Management -- who invented much of modern financial theory -- couldn't believe that their models weren't working as they went belly up in 1998.
Benoit Mandelbrot, in The (mis)Behavior of Markets, cites a 2002 Citigroup survey to point out just how off the mark standard theories are:

But the biggest fall [in the currency markets] was a heart-stopping 7.92 percent, or 10.7 [standard deviations]. The normal odds of that: Not if Citigroup had been trading dollars and yen every day since the Big Bang 15 billion years ago should it have happened, not once.