Hedge fund blow-ups happen the same way every time.

It isn’t leverage.
It isn’t concentration.
It isn’t illiquidity.

It’s the combination of the three that proves fatal.

Most hedge fund strategies are built around three tools that multiply underlying skill:

• Leverage – borrowing money to boost returns.
• Concentration – investing meaningful capital in a small number of ideas.
• Illiquidity – owning assets that can’t be sold at market prices quickly.

Used alone and effectively, each amplifier can be a legitimate source of excess returns. Combine two or more, and the margin for error shrinks. Push hard enough, and normal market volatility can suddenly become an existential risk.

The headlines change. The lesson doesn’t.

Long-Term Capital Management (1998) generated extraordinary returns for several years using enormous leverage on market-neutral, relative value trades. But when markets wobbled in August, spreads blew out and LTCM’s leverage and illiquidity proved to be a fatal combination. Its positions were highly correlated around a common factor of illiquidity at the wrong time.

Amaranth (2006) was an early pod shop with a simpler, faster fate. One of its traders built a concentrated, leveraged bet on the shape of the natural gas curve. When prices moved the wrong way, the position was too large to exit. The entire multi-strategy fund lost two-thirds of its capital in less than two weeks.

Bear Stearns (2007) was the canary in the coal mine for the financial crisis. Two of its internal hedge funds paired concentrated subprime mortgage bets with heavy borrowing. When the mortgages started declining in value, banks pulled overnight repo lines. The fund had no diversification to absorb the hit and no time to unwind the leverage.

Archegos (2021) took concentration to an extreme most people never saw coming. Bill Hwang’s family office grew from $1.5 billion to $36 billion in a single year, using swaps to control $160 billion of exposure to a handful of stocks. His relentless buying of the same names continued unabated until the stocks reversed and banks moved to reduce their loans. The leverage that built the position up destroyed it just as fast.

Melvin Capital (2022) got caught in the next year’s meme-stock craze. The firm generated outstanding returns for years from astute stock selection and a leveraged balance sheet, but when its short positions got caught on the wrong side of a frenzy, it couldn’t get out in time to avoid front page headlines.

The latest example comes from Leopold Aschenbrenner’s Situational Awareness. The fund returned more than 1,000% since its launch in 2024, including 439% in the first half of this year. It benefitted from concentrated, leveraged bets on AI-related stocks and private securities. When sentiment for AI-names turned, margin calls came in from prime brokers, and the fund had to fire sell a $45 billion portfolio to stay alive.

Each blow-up began with leverage and concentration. It ended when creditors demanded liquidity that wasn’t available in the market.

These war stories do not mean the three amplifiers should be avoided at all costs. Quite the opposite – some of the world’s greatest investors have built extraordinary records by embracing one of them.

• Warren Buffett loves concentration.  As Charlie Munger famously said, “put all your eggs in one basket and watch that basket closely.”
• Millennium and Citadel employ significant leverage, but pair it with exceptional risk management, including wide diversification and ample liquidity.
• Venture capital and private equity managers own portfolios of illiquid businesses but avoid fund-level leverage and have partnership structures that prevent forced selling.

The lesson is not that these risks are dangerous. It’s that adding a second or third risk changes the game.

• Citadel learned how dangerous leverage becomes when combined with illiquidity. During the financial crisis, a relatively small pocket of illiquid investments on top of leverage threatened its survival. Two decades later, it found itself on the other side of the trade, purchasing the Situational Awareness portfolio at a discount.
• Private equity may be next to test these limits if widespread NAV lending adds too much leverage to portfolios already built around concentration and illiquidity.

Every investor needs to generate excess returns, and leverage, concentration, and illiquidity are tools great managers use to convert skill into outperformance.

The biggest investment blow-ups rarely come from taking one kind of risk.

They come from blending them together.