/ Opinion

5-Minute Finance: When Genius Failed

By Sean Chai

When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein

Background

The book details the rise and fall of Long-Term Capital Management (LTCM), once the largest global hedge fund boasting 2 noble prize winners, Robert C. Merton and Myron S. Scholes. At its peak, the fund managed around $140 billion before eventually crumbling to ruin. The fund’s key strategy was to identify mispriced bonds with their computer models and profit from a mean reversion strategy, that is, the narrowing of the overall security mispricing. On individual trades, the profits were relatively small, however, the fund implemented thousands of trades simultaneously and used large amount of leverage, hence multiplying their overall profits. This was summed up by Lowenstein as “Leveraging its tiny margins like a high-volume grocer, sucking up nickel after nickel and multiplying the process a thousand times.” At the beginning, the fund was very successful with this approach, however as their success became more widespread, banks and competitors began to copy their strategy, diminishing LTCM’s once bountiful returns. In response to this, the fund partners ventured into less familiar territories such as merger arbitrage, pair trades, emerging markets and equity investing to achieve comparable returns to before. Though a well-intentioned strategy, the traders were taking on excessive risks with relatively unknown strategies.

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Lessons Learned

  1. The risk of excessive leverage: Although the fund grew to such a size at its peak, this growth was mostly achieved by taking on large amounts of debt, up to 30 times the value of its equity. Leverage can multiply gains but also multiply losses, and in a declining market, too much leverage increases the chance of bankruptcy.
  2. History does not always tell the future: As Nobel Prize winning and LTCM partner Merton Miller said, “In a strict sense, there wasn’t any risk – if the world had behaved as it did in the past”. LTCM based their strategy solely on a model they built using past years historical data. Their overreliance on the past as a predictor of the future blindsided them from the potential problems of the future. The past and the future may be similar, but not the same.
  3. Winning strategies eventually get competed away: LTCM’s original play of betting on the narrowing of bond spreads afforded them significant returns. However, as competitors began to recognise such returns, they began copying LTCM’s strategy. Consequently, this led to a narrowing of spreads, diminishing their profits.
  4. Academic success does not equate to practical success: Theory does not always translate to reality, especially when certain generalisations or assumptions are made. The world does not always operate rationally and predictably. Merton and Scholes learnt this the hard way. After winning the Nobel Prize, Merton noted that “It’s a wrong perception to believe that you can eliminate risk just because you can measure it.”
  5. Size does matter: As more investors poured money into the fund, the size of their trades got bigger. This eventually led to a problem especially in the illiquid markets they were in as liquidating such positions would have moved the market and further harming their position. The trade off with size is agility as it becomes more difficult to react to and anticipate market changes.
  6. Stick to your area of expertise: As competitors caught on to their initial strategies and competed away their profits, LTCM felt compelled to branch out into other areas. They had an edge in trading bonds, however they did not have such an edge in. Despite being new to the space, they continued taking on the same amounts of risk as before such as their $2.3 billion on the pair trade bet between Shell and Royal Dutch. Their trades in these uncharted territories eventually contributed to their failure.

The story of LTCM serves as a cautionary tale for all investors of the dangers of excessive leverage and pitfalls of overconfidence of one’s ability to outsmart the market.